LONDON (Reuters Breakingviews) – 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.
Wind turbines are pictured at Swisswinds farm, Europe’s highest wind farm at 2500m, before the topping out ceremony near the Nufenen Path in Gries, Switzerland, September 30, 2016.
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 risk-weighting 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%, while fossil fuels receive a 120% 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,…