UC San Diego

This dissertation consists of three chapters focusing on the effect of an unexpected climate shock on liquidity and systemic risk in the Indian Economy. The causal effects are identified using the exogenous nature of the shock, spatial variation in exposure, and the granular dataset I constructed.

Chapter 1. Unexpected climate shocks are increasing in frequency and magnitude. However, there is limited evidence on quantifying the impact of these shocks on firms and the interlinkages with the financial sector. This is augmented in Emerging market contexts that are more vulnerable to this shock and can face additional market constraints. In this chapter, I estimate the effect of an unexpected flooding shock on firm liquidity and explore the mechanisms through which they smooth their liquidity needs. I find firms located in the flood zip code face a net decrease in their sales driving the contraction in their operating cash flow. However, the increase in overall cash flow for these firms indicates they are obtaining external financing. While they have access to different margins for adjustment, I document the lack of insurance use and a limited use of Deferred Tax Assets. Credit is the most significant source as exposed firms almost double their volume of new loans compared to unexposed firms. Exploring the credit supply channel, I find branches of local credit institutions are providing credit by lending larger loan volumes, despite being exposed to the shock as well. But there is an there is an intermediation channel from Banks via Non-Bank Financial Institutions to firms, that emerges to provide liquidity after the shock. These results emphasize the necessity of external financing for firms impacted by climate shocks amidst liquidity contractions. While traditional macro-development papers emphasize financial frictions in emerging markets, this chapter demonstrates the presence of external liquidity and firms' diverse access to it.

Chapter 2. Aggregate local shocks impact agents differently, especially in the presence of financial frictions. Analyzing these heterogeneous effects can reveal if the allocation of resources is going to the firms that have a higher credit need. Chapter 1 finds the average firms exposed to the unexpected climate shock face a contraction in their liquidity and increase their borrowing from credit markets. This chapter examines examines how vulnerability to climate shocks varies for different types of firms, and what that implies for their access to external financing and credit risk. Manufacturing and younger firms are more susceptible to these shocks and face a liquidity crunch, thereby needing more external financing. Credit markets allocate larger loan volumes to them. High-credit-risk firms also face a reduction in their liquidity and can access more credit. These firms also restructure a significant number of these loans issued in future periods. The results show that the firms with characteristics that make them more vulnerable to this climate shock require larger loans. Credit markets are working well on this dimension: they are allocating loans to the firms requiring it most. Surprisingly even the high-risk firms are not driven out and can increase their borrowing.

Chapter 3. After the 2008 Great Financial Crisis, Bank Regulators increased capital requirements to make the banking sector more resilient to economic shocks and reduce their impact on the real economy. A key Basel requirement was Bank Capital Adequacy Ratio (CAR) to build in the buffers. In Chapter 1, I find credit institutions exposed to an unexpected climate shock increase their lending to the real economy. In this chapter, I evaluate if more capitalized Banks, i.e. those with better buffers, are better able to supply credit after a climate shock crisis. I find bank branches with higher capitalization increase lending overall, particularly to firms in the real sector. Decomposing the CAR into its components, Tier 1 capital i.e. the bank's core capital and its primary safeguard against losses, is driving these results. Tier 2 capital i.e. the supplementary capital, has no effect. Exposed branches with lower core capital (Tier 1) and higher supplementary capital (Tier 2) increase lending to Non-Bank Financial Institutions (NBFIs) to maximize their risk-adjusted returns while responding to market liquidity needs. Thus, credit flowing from stronger capitalized banks to the real sector during a crisis aligns with macro-financial risk mitigating policies: banks with greater loss absorption capacity are providing liquidity after a shock. However, this capital play by banks that is catalyzing the intermediation channel via NBFIs can potentially augment risk in the system. NBFIs have been documented to reach for yield in their lending practices, which is supported by the relatively less stringent regulatory framework they are subjected to.