Raffaella Calabrese, Edinburgh Business School

will give a presentation on

Climate stress-testing for mortgage default probability

Abstract:

Extreme natural disasters like tropical cyclones have a low probability of materialising but a high social and economic impact, including spillover to financial institutions. We focus on the mortgage portfolio in Louisiana (one of the most disaster-prone countries in the U.S.) and propose a framework to perform a climate stress testing exercise of the default probability. First, we estimate a dynamic credit scoring model based on a survival analysis incorporating the damage index from the wind speed of tropical cyclones among climate-related variables. Second, we estimate scenarios of wind speed from tropical cyclones with different return periods (up to a scenario of 1-in-1,000 years) and the relative damage index using a power function as a damage function. Our findings suggest that coastline areas are the most exposed to severe damage from tropical cyclones. If the country is exposed to an event with a very large return period of 1-in-1,000 years, the probability of default increases by about nine percentage points compared to a baseline scenario in the absence of tropical cyclones. This finding is, however, mitigated by insurance coverage present in the country.