Lending from the Shadows: Physical Climate Risk and Shadow Bank Mortgage Financing in US Flood Prone Areas

Abstract

This article aims to investigate the impact of physical climate risk, in particular flood-related property damage on shadow bank mortgage underwriting activity. While existing literature has explored the intersection of physical climate risk and financial markets, the specific impact of shadow banking on mortgage underwriting in flood-prone areas remains underexplored. Using data from the Home Mortgage Disclosure Act (HMDA) and the National Oceanic and Atmospheric Administration (NOAA) from 2010 to 2017, this article analyses shadow banks’ lending behaviour in the three states most prone to flood-related property damage: Texas, New Jersey, and Louisiana. The research is particularly timely given that shadow banks currently originate more than 50% of US mortgages by value, and recent estimates indicate that more than $1 trillion worth of private coastal property is at risk from climate change in the US. I find that shadow bank lending, as a proportion of total lending, increases by 5.3%, on aggregate, following a high damage flood event. I believe this is driven by reduced credit supply from depository institutions due to their regulatory constraints and capital requirements, as a result of the Dodd-Frank Act, thus leaving a gap for non-depository institutions to fill. Whilst this paper focuses on Texas, New Jersey, and Louisiana, which in aggregate account for 79.5% of flood-related property damage during the study period, the findings can be applied to the rest of the US with differing orders of magnitude. Overall, this study seeks to contribute to the corpus of literature by examining how shadow bank lending activity changes following a physical climate risk, such as a flood event and how their unique regulatory framework and risk management practices may affect financial stability in flood-exposed areas. These findings have important implications for policymakers concerned with systemic risk, consumer protection, and the resilience of the mortgage market in flood and physical climate risk prone areas more broadly.