Fiddling with bank capital can help the planet
Climate change could give fiddling with bank capital a good name. Regulators have spent much of the last decade trying to stop lenders massaging their solvency to boost returns. Yet that same sleight of hand could make a big difference in the fight against global warming. The main job of prudential regulators is to stop lenders going bust. They do this by ensuring banks hold enough equity capital relative to their loans, weighted according to how risky they are. These risk-weighted assets (RWAS) calculations appear highly mechanistic. Each loan is adjusted according to chances it will go bad, and how much the bank will recover if it does. This is based on decades of historical data. Assuming the regulator approves, the formula determines the minimum amount of capital a bank must maintain.
In practice, RWA calculations are intensely political. In the euro zone, for example, sovereign bonds issued by member states famously had a riskweighting of zero, encouraging banks to load up on government debt which proved anything but risk-free.
Climate change-conscious regulators like the Bank of England are pondering how this system can help fight climate change. There are two considerations: first, historical data is a poor guide to whether loans sour in future because of global warming. Second, tilting the scales could encourage the financial system to favour projects which help avoid a catastrophic outcome.
Imagine a bank has a choice between lending 100 million euros to a wind farm project or a carbon-heavy oil exploration scheme. Now assume wind farm loans are weighted at, say, 80 per cent, while fossil fuels receive a 120 per cent weighting. Lending to the oil project would require the bank to allocate 1.5 times as much capital as to the wind farm — pushing up the interest rate attached to the loan.
It’s not so simple, though. Regulators need to ensure that lending decisions are still driven by risk criteria rather than political objectives.
As the European Central Bank pointed out in May, the data does not conclusively prove that loans to green assets are less risky than polluting “brown” ones. Oil major Royal Dutch Shell consistently generates vast quantities of spare cash, while numerous solar panel projects have gone bust in the past 15 years.
Governments, regulators and banks are waiting for someone else to take the lead. The European Commission has asked the European Banking Authority to work out how to apply an RWA discount for green projects and a premium for brown ones, but this is not due to report back for six years.
The Basel Committee on Banking Supervision, which sets global capital rules, has yet to deliver a verdict. Meanwhile, big banks have been told they will have to provide more green finance data if regulators are to feel comfortable incorporating climate risk into RWA models.
Into this vacuum has stepped Natixis. The French bank’s “Green Weighting Factor”, launched this week, is an attempt to devise a classification system for sorting climate-friendly projects, and a riskweighting protocol. Natixis will divide 127 billion euros of loans on its investment bank balance sheet into seven buckets, from dark green to dark brown, depending on how seriously the borrowers take alignment with Paris Agreement global warming targets.
The greenest loans will be charged at 50 per cent of their normal risk weighting, while the most polluting ones will attract a risk premium of up to 124 per cent.
Say the Natixis credit committee faces the same choice between lending 100 million euros to a wind farm, which attracts the lowest risk-weighting, or an oil project which receives the highest score. The latter would require almost 2.5 times as much capital as the former.
At first sight, Natixis seems to be taking capital calculations into its own hands. Yet the Green Weighting Factor does not change the amount of regulatory capital the bank must allocate to its loans. Instead, it’s an analytical tool designed to shove management into more sustainable behaviour. The downside for Natixis shareholders is that it will encourage the bank to approve green loans with a low return on regulatory capital, while rejecting more profitable projects.
The scheme is little more than a start. Still, the more it catches on with other banks, the more regulators might feel comfortable incorporating green RWA measurements into regulatory models. The upshot could be a virtuous circle of increased green lending, lower emissions — and a reassessment of the merits of fiddling around with bank capital.
IN THE EURO ZONE, FOR EXAMPLE, SOVEREIGN BONDS ISSUED BY MEMBER STATES FAMOUSLY HAD A RISK-WEIGHTING OF ZERO, ENCOURAGING BANKS TO LOAD UP ON GOVERNMENT DEBT WHICH PROVED ANYTHING BUT RISK-FREE.