Climate-Friendly Banking Might Be a Risky Thing

(Bloomberg Opinion) -- As part of Europe's promise to become the first “climate-neutral” continent by 2050, the region is emerging as a leader in creating standards for green investments. But the push to get its banks to back sustainable assets needs careful scrutiny.

At the core of the European Union's project is the creation of a single set of definitions to determine what economic activities are sustainable and should count as green. To take just one example, for a transport project to be labeled green the passenger trains would have to have no direct emissions or they must be below a certain threshold. The initial aim is for these classifications to form the basis for framing green bond issues, but they will go beyond that: They might well shape government spending and central bank stimulus programs.

In the world of finance, Brussels is especially eager to encourage green loans as well as bonds. The European Commission is examining whether banks should be encouraged to fund sustainable industries via a potential softening of the EU's rules on capital charges on their lending. In Europe, where businesses use bank credit (rather than bond and stock markets) for much of their financing, addressing where these loans go will be critical in tackling global warming.

But anything that encourages European banks to increase their risky lending will have industry regulators fretting, and rightly so. The wounds of the financial and sovereign debt crises are still fresh.

Banks have, of course, become more resilient to shocks in recent years, By some metrics Europe's lenders have more than doubled the capital they hold against their assets, when the latter are weighted by their riskiness. But negative interest rates, sluggish economic growth and the need to spend on technology mean profitability is still lackluster.

Europe's bankers are already chasing risky lending to try to boost returns, the European Banking Authority warned last week. This explains a headlong rush into commercial real estate, small and medium-sized businesses (SMEs) and consumer credit.

So it's no surprise that the idea of setting aside less capital for green loans is a red flag for supervisors. While it might improve short-term returns, it could stoke the return of excessive leverage. “Any capital relief for green assets must be based on clear evidence that they are less risky than non-green assets,” Andrea Enria, Europe's chief banking regulator said last month.

Valdis Dombrovskis, a vice-president at the Commission, favors a similar mechanism for lowering capital charges on green loans as is used for lending to SMEs. Recent data show such relief does spur credit expansion. Bank lending to smaller companies has increased by more than 20% since 2014, while loans to large companies have dropped 9%, according to EBA figures.

But lending to SMEs is a risky endeavor, while banks' vulnerability has yet to be tested by a sharp economic downturn. Incentives for green loans would add another source of potential weakness by adding exposure to new types of assets.

And banks cannot yet be fully trusted in how they judge the riskiness of their assets, which isn't subject to external audit. Rules drafted by the Basel Committee on Banking Supervision will tackle some of this by limiting how far lenders can reduce their capital needs by using their own internal models, but they won't be implemented fully until 2027.

Lenders' reporting of metrics including capital adequacy have shown worrying signs of fragility recently. In Britain, regulators found that Citigroup Inc. underestimated its risk-weighted assets in part because of governance failings, leading to a $57 million fine. The U.K. has now asked all deposit-taking institutions for details of any interpretations in their numbers and how they oversee reporting.

While the climate emergency is naturally at the top of the EU's agenda, loosening rules for the region's lenders should not be done lightly. A stable financial system is essential too for a transition to a greener economy.   

To contact the editor responsible for this story: James Boxell at jboxell@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News.

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