How Banks are Impacted by and Mediate the Economic Consequences of Natural Disasters and Climate Shocks: A Review

Natural hazard shocks (such as natural disasters, extreme weather events, and climate shocks) have significant negative consequences for real economic activity. The banking sector can mitigate (or exacerbate) some of these consequences. This paper reviews the recent empirical literature on how banks are affected by such shocks, and how banks mediate the economic consequences to households and the real economy. After conceptualizing the theoretical transmission channels between the real economy and the banking sector, the review proceeds in two steps. First, it synthesises the existing literature on the direct effects of natural hazard shocks on bank stability, bank profitability, and credit supply. Then, the critical role of banking in economic recovery is analysed, including research on spillovers into unaffected regions through the banking system. Negative direct effects of natural hazard shocks on banks can be significant but are often transitory. Banking systems in less developed countries appear more vulnerable and are less able to maintain credit supply under adverse conditions. Banks that are better capitalised and that have incentives to support affected economies contribute to economic resilience. The review identifies several avenues for future research and highlights specific features and trade-offs relevant to policymakers interested in enabling the banking system to contribute to sustained economic development in the face of worsening physical climate risks.