Bank capital requirements and the case for a macroprudential approach to climate risks

Vice President Dombrovskis of the European Commission recently raised the possibility of introducing a ‘green supporting factor’ (GSF) into the microprudential banking framework in order to “boost green investments and loans” by lowering capital requirements for certain climate-friendly investments. The possibility of introducing a supporting factor has also been mentioned in the recently published EU Commission Action Plan on sustainable finance. In this short note, Mireille Martini, Nina Lazic (both Finance Watch) and Ludovic Suttor-Sorel (Positive Money Europe) argue this would not be the best way to proceed and that attention should focus not on a micro but on a macroprudential approach to climate risks.

The introduction of a GSF would follow the precedent of the 25% SME supporting factor introduced in 2014 by the EU to bolster loans to SMEs. Microprudential risk weights are supposed to reflect the level of risks of a single credit and the SME supporting factor was adopted on the basis that credits to SMEs could be on average less risky than other credits. There was no decisive evidence of that (see EBA report), but SMEs were given the benefit of doubt. Is there merit in applying the supporting factor approach to green credits ?

We think not, for four main reasons.

  • First, risk weights are overwhelmingly determined by banks on the basis of internal rating models, as the regulation permits. The largest banks, with the biggest loan books, use the internal models approach which allows them to model their own risks – subject to internal controls and approved by supervisors. Therefore if some credits are considered by the bank to be less risky, nothing prevents a bank from lowering its capital requirements for particular credits.
  • Second, while credits to SMEs are a well identified category, with a long history, green credits are still to be defined and are a new area for lending. As such it would be impossible to empirically establish that green credits are less risky and to apply a reduced capital requirement on this basis.
  • Third, the proposed change comes down to reducing banks prudential capital. Even though the amount is likely to be small, this goes against the view of most experts, that to make a more resilient European banking sector banks should hold more prudential capital, not less.
  • Fourth, the case of green credits differs fundamentally from that of SME credit on one more crucial point. Whatever their future definition, the purpose of green credits should not be to pile up green finance on a brown economy. The transition to a sustainable economy does not mean simply investing more in renewable energy or any other „green sector“, but shifting financial flows so that zero net emissions can be achieved as soon as possible, at least by the end of the century.

If the Commission intends to consider introducing a green supporting factor, this option should be explored only if accompanied by a brown penalizing factor.

However, it needs to be noted that the risks of carbon intensive investments are not, in the current economic framework, risks to the credit worthiness of an individual credit. In a world where carbon emissions are generally not priced, sadly a single credit is no more prone to default if the borrower generates a lot of carbon emissions or not.

We understand that the issue of pricing carbon and other negative externalities is not in the remit of the HLEG or the DG FISMA. We cannot however but recall the simple fact that finance cannot be sustainable unless the assets it finances are sustainable: so, we urge the Commission to tackle this central issue, and show its leadership by embarking on a really green and sustainable economic  policy, of which sustainable finance is only one component.

We would also like to suggest that, while there may be no threats to the credit worthiness of a given carbon intensive credit in the current economic framework, there is a case that this credit may pose threats to the stability of the financial system at a macroprudential level. Physical, transition and liability risks have been outlined by Mark Carney (Governor of the Bank of England and Chairman of the G20’s Financial Stability Board) in his famous “Tragedy of the horizons” speech from December 2015, and have since formed a basis for the Task Force on Climate-related Financial Disclosures (TCFD).

Central Banks have started to look at the risks of climate change to their domestic financial systems, and a group of Central Banks has been set up to look transversally at the issue (Central Banks and Supervisors Network for Greening the Financial System). While the economic conditions may not warrant a clear understanding of the climate change threats and opportunities at individual credit level, there may be sufficient evidence in the making to address the transition issue at the macro- rather than microprudential level.

Rather than a green supporting factor that will weaken banks and fail to address the real issue, that is the amount of credit that contributes to raising CO2 equivalent emissions, we would favour the consideration of an additional transition risks capital buffer, covering the three risks outlined by Mark Carney, at the macroprudential level.

In order to adequately calibrate the size of this buffer, we would encourage Central Banks, as major holders of securities, to apply to themselves the recommendations of the TCFD, and to start measuring the current and future alignment of their securities portfolios with the Paris Agreement. Among crucial Central Bank’s policies are the ‘eligibility criteria’ of the asset purchase programs. Introducing progressively lower carbon and climate alignment criteria in these could also be a quite efficient way of ensuring a smooth transition, much better than relaxing capital requirements in the microprudential framework.

Finance Watch Bank capital requirements and the case for a macroprudential approach to climate risks

To discover all our cartoons, please visit the section

“Understanding finance”