Assessing Flood Risks: How Climate Change Threatens Financial Stability in the Netherlands

The IMF Working Paper assesses the financial risks posed by floods in the Netherlands, highlighting how climate change amplifies these risks but adaptation measures, like reinforced flood defenses, can mitigate the impact on the banking sector. Extreme flood scenarios pose the most significant threat, though proactive planning and defenses offer resilience.

The International Monetary Fund (IMF) Working Paper "Beyond the Dikes: Flood Scenarios for Financial Stability Risk Analysis," authored by Caterina Lepore and Junghwan Mok from the IMF's Statistics and Monetary and Capital Markets Departments, explores the financial stability risks posed by floods in the Netherlands. The research, conducted in collaboration with Dutch climate experts from HKV and the Ministry of Infrastructure and Water Management, offers a comprehensive approach to assessing these risks by examining multiple flood scenarios. These scenarios are shaped by factors like geography, flood type, climate conditions, and the effectiveness of flood defenses. With the increasing severity of climate change, which amplifies the frequency and intensity of floods, the paper's stress tests highlight the potential for significant economic damage to the Dutch banking sector if adaptation measures are not sufficient.

Rising Flood Risks: A Global and Local Concern

Floods are among the most destructive natural disasters in terms of economic losses, with global insured losses exceeding 88 billion dollars over the decade ending in 2022. The Netherlands, with its large areas of low-lying land, is especially vulnerable to floods from rivers, lakes, and the sea. The research models flood scenarios across four key regions in the Netherlands, focusing on areas that are particularly prone to flooding due to both coastal and river threats. These regions are chosen because of their high population density and significant economic activity, making the impact of floods in these areas especially critical for the Dutch economy. The authors pay particular attention to two types of floods: those in unembanked areas (which are not protected by dikes) and breaches in primary flood defenses. These types of floods cannot be privately insured, making them more dangerous for the banking sector.

The Climate Factor: How Future Conditions Worsen Flood Risks

The analysis incorporates current and future climate conditions, projecting how climate change could worsen the hydraulic loads on flood defenses. The study uses a three-year horizon for stress testing the banking sector, assuming that even though the worst impacts of climate change may be projected for 2050 or 2100, these shocks could materialize unexpectedly sooner. The IMF Global Macro-Financial Model is used to generate scenarios, and the results show that the impact on banks varies widely depending on the severity of the flood and the region affected. The scenarios highlight that climate change will intensify the impact of floods, with future climate conditions significantly increasing the risk to banks. For instance, in unembanked areas, flood damage under future climate conditions results in higher losses for banks, with the probability of default for mortgage portfolios rising more sharply in scenarios with a higher hydraulic load. However, the study also demonstrates that the Netherlands' strong flood defenses, particularly the government’s planned reinforcements, can significantly reduce the risks. The adaptation measures help absorb some of the damage by lowering the probability of dike failure, thus reducing the associated bank credit risks.

Extreme Floods: Understanding the Worst-Case Scenarios

In the most extreme scenarios, referred to as EDO (Ergst Denkbare Overstromingen) or worst credible floods, the potential damage is far greater. These scenarios assume a large-scale breach of multiple dikes, leading to extensive flooding in heavily populated and economically significant regions. Under these conditions, the study estimates that the Dutch banking sector could experience a capital depletion of between 30 to 60 basis points, depending on the severity of the flood. This highlights the non-linear relationship between flood damages and bank capital depletion, where the impact on the banking sector increases disproportionately with more severe flood events. The paper emphasizes that while the banking sector shows resilience in most flood scenarios, the extreme events pose a notable threat to financial stability. The study also finds that floods in neighboring countries, such as Belgium and Germany, which share the Rhine and Meuse river basins with the Netherlands, do not significantly impact Dutch banks. Despite some spillover effects, the cross-border exposures are relatively small compared to the total exposure of the Dutch banks.

Stress Testing for the Future: A Tool for Proactive Planning

The research highlights the importance of forward-looking stress tests that account for physical risks like floods, particularly in regions where climate change poses an escalating threat. While transition risk stress tests focused on the financial impact of policy and technological changes aimed at reducing carbon emissions have advanced significantly, physical risk analysis has lagged behind. This paper aims to fill that gap by incorporating detailed flood scenarios, including the impact of climate change and adaptation measures. It shows that while the current flood defenses are strong, continued investment in adaptation will be crucial to maintaining financial stability in the face of increasingly severe climate risks.

Adaptation: The Key to Mitigating Financial Risks from Climate Change

Overall, the findings underscore the importance of adaptation in mitigating the impacts of climate change on financial systems. The Dutch government's flood reinforcement plans, which include upgrades to dikes and other critical infrastructure, are crucial in buffering the economy from the adverse effects of floods. By including these measures in their analysis, the authors provide a more nuanced understanding of how adaptation can reduce the risk to the banking sector. Although the study's framework is tailored to the Netherlands, it offers insights that could be applied to other countries facing similar climate-related risks. The results emphasize that while floods pose a growing threat due to climate change, proactive adaptation can significantly reduce the damage to financial systems.