Flood risk and residential lending

In recent years, Canadians have increasingly been impacted by natural disasters. When a residential neighbourhood is hit by a disaster, houses, as well as public infrastructure, are damaged. For some homeowners, the financial impacts of this damage may be large enough to cause them to default on their mortgage. Because residential properties serve as collateral for both mortgages and home equity lines of credit (HELOCs), lenders may also suffer financial losses following natural disasters.

Natural disasters come in many forms—including storms, droughts and wildfires—but flooding has so far emerged as the most common and costly in Canada. To explore the potential impacts of natural disasters on the financial system, staff at the Bank of Canada looked at current and projected flooding across Canada.

To help make sense of the findings in this study, Bank staff answered some key questions about flood risk and residential lending.

What is flood risk?

Floods can impact lenders—such as banks or credit unions—through residential mortgages and, to a lesser extent, HELOCs. These two types of loans are secured by the market value of houses.

Flooding could leave some homeowners unable to pay back their loan, and as a result they could default on their debt. For instance, a flood may cause extensive damage, resulting in additional expenses—such as temporary accommodation—or a loss of income if the borrower is unable to work, leaving the borrower without enough money for their loan payments. Or flood damages could lead to a strategic default by the borrower. No matter the reason for a default, the lender becomes the owner of the house. If a property is worth less on the resale housing market because of flood-related damages, the lender may have to sell it at a loss. In other words, the revised market value of a flooded house could be lower than the balance of the loan remaining on the house.

Banks and credit unions also lend to businesses and governments. However, this study did not look at the impacts on lenders when flooding severely damages commercial, industrial or governmental properties and structures.

How did Bank staff assess the extent of flood risk among residential lenders?

The first step is to have a good idea of where flooding could occur and the extent of damage expected. Bank staff collaborated with Public Safety Canada to obtain detailed information about the projected precise location and extent of flood-related damage that could be expected to occur in any given year. Public Safety Canada also provided information on how flood-related damages are expected to evolve under different paths of global warming.

Second, staff obtained anonymized information from 63 Canadian financial institutions about loans that are tied to residential properties—namely, mortgages and HELOCs. The data were collected in partnership with the Office of the Superintendent of Financial Institutions (for federally regulated lenders) and several provincial regulators (for credit unions).1 In total, the study covered 7.7 million properties—almost all the mortgaged properties in Canada.

Third, staff applied this loan-level dataset to the maps of projected flood damages and flood insurance, doing so by the first three digits of postal codes, known as forward sortation areas. A reason for including flood insurance information is that lenders’ potential losses may be less severe if an insurance policy covers flood damage.

Finally, staff considered different scenarios—notably, a typical flood year and a more extreme 1-in-100-year flood. They then calculated the financial losses that lenders could expect, assuming that some borrowers will default on their loans and after taking into account the presence of flood insurance.

Does flood risk represent a large concern for residential lenders?

In an average year in Canada, flooding is expected to cause about $2 billion in structural damages to residential properties. Nearly half of these damages affect properties where households carry a mortgage or a HELOC. But the risk of credit losses by banks and credit unions depends on several factors, including key factors we discuss below.  

The study shows that an average year of flooding in Canada would result in only modest financial losses for lenders. For instance, in a typical flood year, the average lender incurs a loss that represents less than 0.1% of the total outstanding value of mortgages and HELOCs on its residential loan book. Even in the case of a 1-in-100-year flood, the average lender suffers financial losses equivalent to only 0.2% of its residential loan book.

A key reason for these modest impacts is the large amount of home equity that borrowers have built up in recent years. Between the beginning of the COVID-19 pandemic and the end of the second quarter of 2022, home prices in Canada increased by over 50%. This means that a homeowner with a mortgage owns a larger share of their home than they did before the pandemic. In other words, the mortgage now makes up a smaller share of the market value of the house. In the event of defaults, lenders will have a better chance of recouping their capital and avoiding losses.

What factors determine whether lenders are more or less exposed to flood risk?

A key finding is that flooding does not impact lenders equally. In fact, the study shows that for the 10% of lenders most affected by flooding in a typical year, the financial losses are about four times larger than those of the average lender.

Five key factors influence the extent of a lender’s financial losses from flooding:

• Concentration of lending in flood zones—Small financial institutions sometimes have much of their lending activities concentrated in geographical areas that are prone to floods; therefore, they are more exposed to flood risk than large financial institutions are. Yet, for most lenders in the study, less than 30% of their loan portfolio is tied to properties located in flood zones.
• Concentration of lending on residential properties—Credit unions and small and medium-sized banks generally have a higher proportion of their loan book tied to the housing market than large banks do. Therefore, they tend to be more exposed to flood risk on residential loans.
• Probability of household default—The more likely households are to default on their debts, the more lenders are exposed to flood risk. The risk of default declines if a borrower has any of the following: insurance coverage, equity, liquid assets, ability to work and generate an income, or access to government support programs following severe flood events.
• Flood insurance coverage—Flood insurance reduces flood risk for lenders, but it is not mandatory in Canada. Across all homes with property insurance in our sample, the take-up of flood insurance coverage is around 38%.
• Level of borrower equity—As discussed above, a borrower’s probability of defaulting on their mortgage decreases as their home equity increases. At the same time, if that borrower does default and the lender assumes the loan, becoming the owner, the loss is smaller than it otherwise would have been. In the study sample, mortgaged homeowners had on average about 65% equity in their home as of the second quarter of 2023.

How does climate change affect the assessment of flood risk?

The number of severe weather events has increased in recent years because of climate change. In the past decade or so, Canada has experienced a series of very large and costly floods, including in Calgary in 2013, Montréal in 2017, Ottawa–Gatineau in 2019, Vancouver in 2021 and Nova Scotia in 2023. The severity and frequency of such events are expected to grow, which would increase losses for financial institutions.

To account for the effects of climate change, staff considered scenarios with a rapid warming of global temperatures. In particular, the study revealed that climate change is expected to:

• expand the number and size of flood-prone areas, exposing more properties to severe flood damage
• increase the overall costs of damages to houses

In an extreme scenario with global warming of around 4˚C by 2100, a severe flood event could result in a loss rate that is 2.5 times larger than the loss rate expected during a typical flood year in Canada—an average increase of about 0.6 percentage points of the overall loan book of the average lender.

Endnotes