We uncover a robust positive relationship between a bank’s share of retained mortgages and subsequent bank performance. This relation is time-varying and depends on the business cycle. During crises, when house prices decline and delinquencies increase, high-retained- share banks report higher profitability than other banks. The relation is reversed during expansion periods when house prices rise and delinquencies are typically low. We provide evidence that banks’ internalization of fire sale externalities acts as a main channel with important real effects: high-retained-share banks originate higher loan volumes at more favorable terms and indirectly affect the performance of banks active in the same region. Further evidence confirms that this channel is different from alternative explanations based on market power, relationship effects, diversification, or informational benefits.

I quantify the costs of realized flood disasters for banks and create a novel measure of bank-level flood risk exposure using expected flood risk estimates and mortgage lending data. I document that banks with large shares of mortgages in affected areas experience lower profits and capital ratios following flood disasters. In the cross-section of stock returns, small banks with high exposure to flood risk underperform other banks, on average, by up to 9.6% per year; this implies that exposure to flood is not fully priced. Underperformance persists when controlling for the negative effects of disasters on realized returns and adjusting for investors’ climate change concerns. The findings support regulatory concerns that bank equity is exposed to physical risk from climate change.

This paper examines how banks’ incentives to internalize the negative spillovers from natural disasters affect their credit lending. Using data on small business loans and damage estimates from natural disasters, I find that banks with a large lending share in a local market provide more credit to small firms during the recovery periods than other banks. This finding implies that banks recognize the benefits of alleviating liquidity constraints for distressed borrowers, which lowers the default risk and preserves their future business opportunities. Furthermore, I document that disaster-affected local areas with high-lending-share banks experience higher employment growth than other disaster-affected areas. The paper underscores the importance of bank lending in disaster recovery and resilience.