DNB constantly monitors the potential risks for the financial system under changing circumstances. What will happen, for example, if the Netherlands would flood at several places at once? Recently, we have seen the impact that floods can have. New research by DNB and Deltares has mapped out the extent to which property damages could result in higher credit risks for banks. It emerged that, under current conditions, the effects from a financial stability perspective would be manageable. Below, we explain why.
How is climate change linked to the financial sector?
A quarter of the surface area of the Netherlands is below sea level and about half of the country is vulnerable to flooding from the coast and rivers. Much of the real estate is located in this flood-prone part of the country. Moreover, this real estate makes up a large share of the balance sheets of banks. Loans for homes and offices make up almost half the assets of Dutch banks. Floods therefore represent a financial risk for banks.
A lot has been written about the climate risks affecting the housing market and how they affect the financial sector. Why conduct new research?
In the present times, with increasing concerns about sea level rise and higher peak river discharges, it makes sense to study the link between flooding and the financial sector. A lot of attention is therefore being paid to this issue. It is important to look at potential risks from a systemic perspective as well. Floods affect different parts of our country at the same time. Because the building damage is typically not insured for this type of floods, banks will have to take higher credit risks into account. It is important to know to what extent risks may affect the banking sector as a whole.
How big is the problem really?
At first glance, the risk seems manageable. If there were to be flooding today, we estimate that the credit risks of banks as result of damage to buildings would increase only slightly. The possible damage to buildings with mortgages ranges from 0.5 to 10 billion euros. Banks will most likely not get into immediate difficulties as a result of damages in this range. However, it is important to point out that the research is based on the current situation. The effects of climate change – more frequent extreme weather and rising sea levels, for example – have not been included. Other types of damage that result in higher risks for banks, particularly in the event of very extensive flooding, were not studied here either. These other types include damage to infrastructure or the fact that production activities will be shut down. Follow-up studies are required here.
Why are the effects apparently less severe than one may expect?
It should be pointed out first that any flooding has a major impact on those directly affected. Everything in Dutch water management policy is aimed at preventing this kind of serious situation (with a lot of damage and casualties). It is therefore all the more striking that the impact on the financial sector is limited. Why is that?
Well, although about half of the Netherlands is vulnerable to flooding, a lot less will be flooded simultaneously during a single event. Even if there were to be very extensive flooding, much of the loan portfolio would therefore not be affected.
In addition, the values of most properties in high-risk areas are on average almost double the outstanding mortgage. This means that the damage would have to halve the value of the collateral to come close to the mortgage value. This does not happen at a large scale in the flood scenarios studied. Flood damage usually amounts to less than half of the value of the home, in our scenarios.
How can Deltares help the financial sector?
Climate change will lead to more frequent extreme weather and sea levels will continue to rise. It is important for banks and other financial organisations to determine the potential effects in good times. This study focuses on one important effect of flooding. Buildings lose value in the event of a flood, while the outstanding mortgage or loan remains unchanged. Deltares can help financial institutions to identify current and future flood risks.