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Should "brown" bank loans be penalized or "green" loans supported?

Antonio Carrascosa

Since 2018, the European Commission, as part of its action plan for a greener and cleaner economy, is analysing the possibility of recalibrate the capital requirements applicable to banks for sustainable investments. Following the recent review of the prudential financial regulation framework, the Capital Requirements Directive and Regulation (CRDV and CRRII), the European Banking Authority (EBA) was mandated to assess a special prudential treatment of exposures related to assets with sustainable objectives as components of the so-called pillar 1 (i.e. with possible impact on the minimum capital requirements for all banks). The topic of this article is therefore on the agenda of European banking regulators.

We can discuss two regulatory alternatives to contribute to the achievement of climate objectives: the penalization (more prudential capital) of "brown" credit exposures versus a green supporting factor (less prudential capital) for those credit exposures. The analysis will be general, as the features of the possible measures are not yet known.

First of all, it should be remembered that the final objective of these measures should be the reduction of the least sustainable activities and the increase of the most sustainable ones, with the variation of the credit for these activities (increase in their volume to green activities and reduction for brown ones) being an intermediate objective.

The final objective of these measures should be the reduction of the least sustainable activities and the increase of the most sustainable ones

A penalty to brown activities

First of all, let us focus on the capital penalty of exposures to brown activities and look at its possible effects on the supply of credit to those activities. The definition of green activities is more advanced (through the taxonomy of the European Union) than that of brown ones. CO2 emissions is a factor to consider, but it cannot be the only one. Therefore, it would be desirable to work on a brown taxonomy (as is being done with the social taxonomy).

The specific measure to be taken would be the requirement for greater risk weighting, which would increase the capital required for such financing. This makes the weighted average cost of capital of banks more expensive. Although the theory, in efficient markets, predicts that the weighted average cost of capital will remain unchanged after an increase in required regulatory capital, there is empirical evidence which argues that there would be an increase in that cost of capital. As a result of this increase, banks would be less willing to lend for each interest rate.

If we want our analysis to be more predictive, we need to include more realistic assumptions. It should be recalled, first of all, that this response of the supply of credit will depend on the level of capitalization of the banks before the adoption of the measures. There is evidence that a strengthening of capital (especially when it starts from an insufficient level) can favour credit by improving the stability of the banking system, which stems from better market financing alternatives for these banks.

The definition of green activities is more advanced than that of brown ones. CO2 emissions is a factor to consider, but it cannot be the only one

As banks consider multiple factors in the granting of credit (credit history of borrowers, guarantees offered, relationship with borrowers in other banking services, etc.) the aforementioned higher cost of financing for banks would not have to be automatically transferred to the brown borrower through an increase in the interest rate. In principle, the greater the volume of brown loans in a bank's portfolio (an assumption that is fulfilled in reality ), the higher the probability to transfer to these loans (via an increase in interest rates) the aforementioned increase in its financing cost (derived from the regulatory change that we are analysing).

Assuming that the increased capital requirement for brown loans ends up increasing their interest rate, does this necessarily mean a reduction in the volume of credit for those activities? No. This will depend on the elasticity of credit demand from these firms (i.e., the degree of response of demand to a change in the interest rate). Behind this elasticity we basically have the possibilities that these companies have to obtain alternative financing.

Companies that have more financing alternatives in the market (usually large ones) could to some extent replace their demand for bank credit. In this case, there may be no reduction in the volume of financing to those companies and, therefore, the regulatory penalty may not have an adverse effect on the production of goods (or services) of those brown companies, which is exactly what is sought with this regulatory change. In Spain , in the most polluting sectors (according to their CO2 emissions) there is more evidence of the presence of large companies than of small ones, that is, it is realistic that the conclusions of this paragraph are fulfilled.

Although, intuitively, one might think that securities issuance could be a substitute for bank financing (for companies with access to those markets), in some studies conclude that such substitution is not significant. If there is a substitution, it seems clear that companies would be better able to replace long-term credit with bond issuance than short-term (commercial/current) credit, not least because rating agencies require issuers to have bank credit lines.

In principle, the greater the volume of brown loans in a bank's portfolio, the higher the probability to transfer to these loans the aforementioned increase in its financing cost

Companies with fewer financing alternatives (generally small and medium-sized ones), i.e. with a more rigid demand for credit, would become more expensive to finance, but the volume of bank credit obtained would not vary significantly (its substitution is not possible). Moreover, if the demand for brown goods is relatively inelastic, the reduction in the production of that good may not be very significant (despite the increased financial costs of these companies). The result would be the opposite if demand is very elastic. This elasticity depends, among other factors, on the existence of substitutes for brown products.

Therefore, the requirement for more capital for brown loans does not guarantee the reduction of brown activities. Other regulatory measures could be needed, for example, quantitative limits on bank credit for these activities and similar penalties on other modalities of financing. As we suppose that affecting the demand for credit is an intermediate goal, it would also be necessary to affect the demand for the final goods (or services) produced by brown companies, supporting the existence of substitute products for brown ones. In short, by acting on the supply of bank credit, we cannot guarantee a reduction in the quantity of brown products on the market, not appearing to be this policy instrument more effective than the traditional "pigouvian" tax, which directly taxes brown products.

The implementation of these regulatory changes should be carried out with caution, since, regardless of their impact on the productive activities of brown companies, it can also affect the profitability of banks, through the impairment of loans to these companies (many of them with high outstanding bank debt). There is also a level playing field problem: if the penalty for this financing is extended only to banks and not to other financial intermediaries, the problem for banks could become even worse, affecting negatively to the global financial stability.

On the other hand, if these exposures are not penalized, we could be exposing banks to more environmental risks, both physical and transitional (for example, those arising from the introduction of the carbon tax and the like ). The lack of a carbon price that takes into account the negative environmental externalities it causes prevents financial markets from setting an appropriate price for these risks, which ends up underestimating the risks of banks and, in general, the risks to financial stability , especially in the long term. Very recently, it has been estimated that losses related to the most polluting companies could reach 10% of bank balance sheets in the event of a credit rating downgrade associated with a higher carbon price resulting from compliance with the Paris agreements. This impact is not evenly distributed among banks. For example, 25 European banks concentrate in their portfolios 70% of bank exposures to companies with high or increasing physical environmental risks in coming decades.

A supporting factor for green activities

A similar analysis can be made on measures to support bank financing for green activities (applying a lower risk weighting to such exposures). The conclusions would be: according to the theory, the willingness of banks to lend would be greater for each interest rate; in reality, this lower cost of financing would not have to be automatically transferred to the green borrower through a reduction in the interest rate, since, as we have mentioned, the bank can consider other variables: credit history of borrowers, guarantees offered, relationship with borrowers in other financial services, etc.; the increase in the volume of credit for these activities will depend on the elasticity of the credit demand of these companies (the greater the elasticity, the greater the increase in credit); and the impact on the production of green goods will depend on the elasticity of demand for these products (the greater the elasticity, the greater the increase in such production).

It is interesting to review a close experience: the European measure to reduce the capital required for the financing of small and medium enterprises (SMEs), which entered into force in Europe in January 2014. This measure increased, in Spain, credit for the largest companies in this group and did not serve to significantly reduce the credit restrictions suffered by smaller companies. This result confirms that banks, in addition to this capital relief measure, assess, among other factors, the probability of default on loans. If many green start-ups emerge with the sustainability boom, the impact of a relief on regulatory capital to financing could be less, as banks might consider those companies to be riskier because they do not have a credit history of such companies (or if they exist, it might not be very positive).

If many green start-ups emerge with the sustainability boom, the impact of a relief on regulatory capital to financing could be less

The requirement of less regulatory capital on a loan, without considering its expected loss (probability of default and loss given default), should lead banks to properly assess the relative risks of different exposures, since, if this is not done, it can lead to significant credit risk for banks. Analysing, for example, the default level in Spain, of the most polluting sectors versus that of the greenest, it is evident that it is greater in the latter, which may be due to the size of the companies in these sectors, with much higher relative weight of SMEs.

With regard to the credit risk of green activities, on the one hand, it does not seem clear that the ability of borrowers to pay is closely correlated with their preference for such activities. Therefore, in this way, it would not be appropriate to reduce capital requirements. On the other hand, the conclusion would be different if one considered that the collateral value of loans (green assets) is better because of more favourable long-term price expectations for these assets. The final conclusion will depend on both factors.

According to the European Central Bank , ineffective management of climate risks will eventually affect banks' long-term credit risk. For example, they conclude that losses arising from physical risks (associated with the most polluting companies) will show up significantly within 15 years if a disorderly environmental transition scenario prevails. In such scenarios, losses from credit risk could represent between 1.60% and 1.75% of risk-weighted assets over a 30-year period. These values are much higher than those recorded in the adverse scenarios of conventional stress exercises (with a shorter time horizon).

According to the European Central Bank , ineffective management of climate risks will eventually affect banks' long-term credit risk

Some authors have recalled that a basic objective of macroprudential policy is to limit systemic risk by increasing capital requirements to respond to speculative bubbles in some sectors driven by bank credit. In the case of green assets (not far from that possibility of a bubble), the regulatory response being discussed is just the opposite: reduction of capital requirements for such activities. A relevant issue is the duration of these measures (particularly relevant in the case of measures to support green activities).

To be effective, these measures should be permanent, otherwise banks will be less receptive to reducing their capital to replenish it later. An example of this behaviour has been the ability to free up capital buffers during the COVID crisis. The response from the banks has been very conservative, given its temporary nature. In favour of this permanence, we have that the European taxonomy of green activities does not have specific time horizons, but are transitions towards a state of sustainable balance of the economy.

Again, the increase in green activities is not guaranteed by this measure. As green loans in banks' portfolios are still in the minority, regulatory support for such financing does not appear to be sufficient to achieve the European Union's sustainability targets.

Other measures that may affect credit

Other measures that are under way can significantly affect bank credit, for example, the establishment of metrics for the homogeneous monitoring of how and to what extent banks' activities can be considered sustainable, from an environmental point of view, according to the European taxonomy. Among these indicators, the ratio of green assets stands out. In a recent pilot study of the EBA , the calibration of this ratio among the banks participating in the study has given a very low result (8%).

The pressure of these measures on the lending activity of banks will be increasing, given the strong reputational impact of unfavourable compliance indicators. In this case, the pressure from customers who are more sensitive to environmental issues could be as or more effective than prudential regulation in penalising brown lending activities and supporting green ones.

Conclusions

The financial regulator has a clear dilemma: if it penalizes credit by increasing capital requirements, it can negatively affect economic growth; if it does nothing, it may harm the future solvency of banks, which would not be internalizing the physical and transitional risks that climate change may pose.

It should be remembered that the basic purpose of capital regulation must be to ensure the solvency of banks. We have seen in this article possible problems of using this regulation to promote the energy transition. Specifically, on the banks' own solvency and financial stability (leaving aside the behaviour of these variables in the very long term).

If there is a political decision to promote measures to penalize or support credit for brown and green activities, respectively, we have seen that their effects are not unambiguous. First, it is not clear that in reality the effect on the weighted average cost of capital that the measure represents to the bank (change in regulatory capital) is automatically transferred to brown or green borrowers through a change in the interest rate, since the bank may consider other variables: guarantees offered, customer relationship with borrowers, etc. In principle, the greater the relative weight of such exposures in the bank's total loan portfolio (which is now the case with brown loans), the greater the likelihood that the interest rate will modify. Second, in the event of a change in the interest rate, the volume of credit for these activities will vary according to the elasticity of credit demand from these enterprises (the greater the elasticity, the greater the increase or reduction in credit). The elasticity of demand for bank credit depends on the possibilities of replacing that credit with alternative sources of financing. It seems clear that large companies have more financing alternatives than small and medium-sized ones. Third, the impact of a possible change in credit on the production of brown goods will depend on the elasticity of demand for such products (the greater the elasticity, the greater the variation in such production). This elasticity is explained by the possibilities of substitution between brown and green products.

It should be remembered that the basic purpose of capital regulation must be to ensure the solvency of banks

If we want to make progress on the commitment to climate neutrality and bank capital regulation must be used, it is not clear that these measures are sufficient. There are other measures in place that may be as or more effective than changes in capital requirements, such as the introduction of the performance indicators we have mentioned. Of course, even if they have a higher political cost, tax (and other non-banking) measures on brown products may be more effective.

We have already commented that doing nothing does not seem a desirable option, since it would expose us to a greater risk of materialization of climate change with the possibility that, in the long term, banks would be highly exposed to polluting sectors (for example, with a more severe potential impact on the credit portfolio of financial institutions after the introduction of a carbon tax). This is clear that in this transition process there will be losers and winners, which must be managed properly. Maintaining a reasonable level of economic growth is essential for that management to be a success.

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