Can natural disasters set off a full-fledged banking crisis?

The wildfires in Hawaii this summer, Colorado in 2021, and Oregon in 2020 are bringing home to even die-hard climate change deniers the investment consequences of global warming.

The utilities serving the areas in each case are being sued for not shutting down their power grids during heat waves, contributing to some of the worst blazes in U.S. history.

PacifiCorp alone potentially faces $1 billion in class-action fines for the Oregon fires. Hawaiian Electric Industries’ shares plunged 40% during the fires in Maui.

But there is a sector that’s potentially on the hook for many times the size of those losses. And it’s not on anyone’s sell list—yet.

Banks.

Take a recent article by CNBC that listed seven industries most at risk from climate change. Not surprisingly (once you think about it), it listed vineyards and ski resorts along with the agriculture, energy, and insurance sectors.

Wall Street? CNBC warned it was at risk—only because of possible flooding in downtown Manhattan.

The U.S. Environmental Protection Agency does not even have finance on its list of Climate Change Impacts by Sector.

An enormous yet unacknowledged problem

That’s a massive oversight. Banks are exposed to climate change risk through direct lending to industries like housing, construction, utilities, agriculture, and infrastructure.

They are particularly vulnerable because insurance companies have been pulling back—some have even gone bankrupt. This development leaves banks on the hook for more, in some cases the entire, cost of extreme weather events.

Of the 5,000-plus houses destroyed in Oregon in 2020, and the 2,200 structures destroyed in August in Maui, many were either uninsured or had inadequate coverage.

That’s because housing replacement prices have far outstripped the amount of mortgage insurance homeowners carried.

Swiss Re estimated that the global bank protection gap—losses minus insurance—in 2020 was $113 billion (lower than the 10-year average of $143 billion). Banks, and the owners of the destroyed assets, were on the hook for most of that $113 billion.

To put that in perspective, that is about as much as the U.S. spent to bail out the banks in the Great Recession. And it is happening year after year.

Natural disasters worldwide caused $313 billion in economic losses in 2022. (See Figure 1.) Insurance covered only a small fraction of this figure.

And it is not getting any better.

The U.S. property and casualty industry suffered losses of $5 billion in 2021, and that ballooned to losses of $26.5 billion in 2022, according to government reports.

“There have already been 15 confirmed weather/climate disaster events with losses exceeding $1 billion each in the U.S. as of August 8, 2023, with losses almost certain to exceed 2022,” one observer noted about the data.

Regulators race to rescue

U.S. bank regulators are only now getting around to being worried about this.

In October 2021, the regulators published a report on Climate-Related Financial Risk that identified “ climate change as an emerging risk to financial stability.”

The three biggest bank regulators, the Federal Reserve, FDIC, and the Office of the Comptroller of the Currency, are only now running pilot “climate stress assessments” (CSAs) to figure out the extent of the problem.

The Fed is farthest along, and its pilot program only involves six big banks.

The regulators are right to be worried. A recent report by McKinsey, a consulting firm, found that 15% of European banks’ balance sheets are at risk from climate change-related losses.

Even worse, the firm estimated that banks will have to shell out a total of $500 billion in annual adaptation costs to deal with the issue.

Mind you, that’s not some “nightmare” scenario estimate. These are actual losses that will bite hundreds of billions of dollars off banks’ bottom lines in the coming years.