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Lower capital requirements on green lending could meet regulatory opposition

A push by European banks to have their capital requirements reduced if they increase lending to environmentally friendly projects would encourage them to take a larger role in the financing of a green economy, but could come up against opposition from regulators, market participants say.

The European Banking Federation, or EBF, a lobby group, in September set out measures that it said would help increase the role of the banking sector in the transformation of the economy toward sustainable and "green" financing projects. One of its recommendations was that capital requirements be reduced for green investment, an idea originally proposed by the French Banking Federation, or FBF, in September 2016 and known as the "green supporting factor."

SNL Image

Heads of state arrive on the Seine River before boarding a boat to a climate summit Dec. 12 in Paris.
Source: Associated Press

The European Commission appears to be taking the suggestions seriously: Valdis Dombrovskis, the EU commissioner for financial stability, financial services and capital markets union, told a climate summit Dec. 12 in Paris that the EC would set out a plan in March 2018 to support green financing and was looking at proposals to lower "capital requirements for certain climate-friendly investments, such as energy-efficient mortgages or electric cars."

Green financing covers investments and lending in projects such as solar power and wind farms, and although the market remains very small, at less than 2% of overall bond issuance, it is expected to grow in the coming years amid concern over climate change and as countries begin working to meet commitments under the 2015 Paris climate agreement.

Wim Mijs, CEO of the EBF, said that because Europe's economy relies heavily on direct bank financing, lenders would have a key role to play in financing a green transition. That meant, he said, that regulatory frameworks must be flexible enough not to constrain such investments.

The EBF in its September report highlighted the potential for easing requirements on liquidity, given that the long horizon for many infrastructure investments can put liquidity ratios under pressure.

"There are sometimes different financial key numbers for green investment and you want to stimulate it, and it cannot be that your supervisory system or your capital adequacy system stops you from doing this transformation," Mijs said in an interview.

The CEO of the FBF, Marie-Anne Barbat Layani, told French financial newspaper La Tribune on Dec. 11 that the federation's plan was designed not to create "prudential loopholes like tax loopholes, but to encourage banks to reduce climate risk in their balance sheets."

"Climate risk in a bank's balance sheet is much more spread out than that of an insurer," she told the newspaper. "It is in the interest of the authorities (to ensure) that the balance sheets are less risky."

No need for large concessions

The scale of any concessions need not be large, added other market observers.

"It is a classic way to move your banking system," said Sean Kidney, CEO of the Climate Bonds Initiative, a not-for-profit organization that aims to increase green bond investment. "You don't need a lot of differentiation ... give it 25 basis points benefit to green bonds for your capital ratio requirements ... and banks will shift, they will be hunting green loans everywhere, " he said in an interview.

But Kidney added that regulators are hardly likely to warm to the idea of loosening regulations that they have spent the best part of a decade implementing and fine-tuning in a bid to prevent a repeat of the global financial crisis.

"Regulators aren't going very fast on that in Europe; you have seen a pretty strong pushback," he said.

The recommendation "will get a lot of attention but it is wishful thinking at this stage," agreed Lars Eibelholm, vice president and head of treasury at the Nordic Investment Bank. "Risk weights and capital go hand in hand and there is no evidence at this stage that green projects and greenness are related to lower risk," he said in an interview.

Anne Le Lorier, first deputy governor of the Bank of France, said at a climate finance conference Dec. 11 in Paris that green financing and lower capital did not necessarily go hand in hand.

"Prudential regulation is about the robustness of the financial sector, i.e about the risks of the financial sector; the idea to address risks is not to offer incentives, to take unknown risks," she said. "In the area of the green finance, you have to make a distinction between the risks on assets and the risk on issuers."

Dombrovskis said the EU could model its proposals on existing reductions in capital for investments in small and medium-sized enterprises or high-quality infrastructure projects. The EU currently awards capital reductions of 23.81% to lenders for investments below €1.5 million to small and medium-sized businesses.

But Le Lorier said regulators simply did not have the data on green financing that they have on SMEs and suggested it may be more effective to penalize lenders that continue to invest in projects that are not environmentally friendly: "We do not have such basis in the area of green finance so I will offer a counter proposal — what about a handicap on brown assets?"

Clear standards

Other observers, though, said it was key to find a way of encouraging banks to take a bigger role in green financing, such as setting a clear European standard on what constitutes green investment.

"Whether it is that tool, or another tool, we need to find a mechanism to encourage banks, notably encouraging banks to tell the difference between green assets and other assets," Philippe Zaouati, CEO of Paris-based responsible investment manager Mirova, a unit of Natixis Asset Management SA, said in an interview.

And although the idea of favorable capital treatment for green investment may not gain much traction for now, it may yet be a possibility as climate change grows in significance, Kidney said.

"As people get to know how big the stakes are ... you will see a much greater willingness to tackle everything," he said. "But in the short term ... people will be looking for other ideas rather than risk weight differential because that has been such a battleground for economists for the last 20 years."

"The debate is not yet closed," said Tanguy Claquin, head of sustainable investing at the investment banking division of French banking group Crédit Agricole SA. "The discussions are ongoing. If something was in place ... it would encourage banks to invest more in green projects."