Green finance in an IRB world – How can Banks and Regulators cooperate towards more environmentally friendly lending using the capital requirement framework?


Societies and governments across the world are searching for ways to promote environmentally friendly activities and discourage the environmentally unfriendly. Governments have used direct measures such as carbon taxes and air quality rulings, however their approach to the economy as a whole tends to be more general “nudging” and steering businesses towards achieving society’s aims.

All sectors are being called on to make positive changes.  In the finance industry, funds have responded to investors’ concerns by offering funds which promote green investments. Governments have also certified some bond issues as “green”, however there is currently an increased pressure to evaluate the role of bank loans in promoting environmental awareness and action.

Several banks have included environmental concerns into their lending policies which may already have had a positive effect, however questions remain regarding to which extent banks are implementing environmental aspects in their lending actions. Two recent articles from Bloomberg and Financial Times cite bank lending remain unchanged to sectors deemed less socially or environmentally friendly[1][2] which show the difficulties for financial institutions to balance environmental pledges against their duty to lend profitably to long term customers.

The question to be answered is: How can the finance industry play a clearer role in nudging/steering more environmentally friendly business activity and investments? Specifically, can the worldwide framework of bank capital assessment be used to steer more environmentally friendly bank lending? If so, how could this be achieved in the most time efficient and effective way?

Banking regulation

Current banking regulations aim to promote a competitive and efficient finance market which enables businesses and households to conduct purchases/sales and make savings work through channelling them to investments, with minimal risk of economic disruption through bank failure.

International bank regulations are in place to ensure banks do not support illegal activities (e.g. anti-money laundering regulations) while other regulations try to ensure a fair and balanced system for consumers and businesses by limitations on predatory lending and ensuring complaints are dealt with by the banking ombudsman.

Bank regulations does not usually cross the boundary of directing banks on which type of business they should or should not lend to, even if for important political purposes. It would be tempting for a government with a “buy domestic production” ambition to regulate banks to lend more favourably to exporters than importers. However, this is not done. Instead, governments set up their own specialist export credit agencies and development banks to support this ambition without disturbing commercial banks.

Directing and nudging of bank business apart from the criminal activity and fair play rules is usually based on ensuring that banks fully account for long term risks, where there might be market pressure not to. A rule setting maximum Loan to Value (LtV) for housing loans could be viewed as a political attempt to slow a house-price bubble, but in most countries these rules have the stated purpose of ensuring that banks do not take on too much risk in their home loan books.  A risk which has been proven to cause damage to the bank and the economy in a downturn.

In theory, every bank can self-regulate a stricter maximum LtV compared to market practice to meet its own risk appetite needs. However no such actions are taken since it could result in a significant loss of business for the individual bank to move in such direction. To quote Citibank CEO Chuck Prince in 2007 just before the sub-prime lending crisis: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”. This feature of the ultra-competitive banking market makes it difficult for banks to take individual action and thus support the need for regulation which requires all banks to recognise the same risk in the same way.

The key bank regulations restricting bank growth, leverage and hence profitability are called the “Basel Rules” named after the international governmental group headquartered in Basel (Basel Committee on Banking Supervision). The Basel Rules require banks to estimate the risk of losing money in their loan portfolios and hold sufficient capital to avoid bank failure, focusing on higher capital for higher risk loans. These rules are also known as IRB (Internal Ratings Based) as they rely on larger banks to each build their own (internal) model of the default and loss risk for customer loans.

Environmental risk is a very long tailed risk which is hard to quantify and therefore difficult for the banking sector to estimate correctly. The ECB consider this (risk) as real and quantifiable, and which it is assessing by stress tests.[3] In addition, in its annual sustainability report the Swedish Financial Supervisory Authority also consider this as a key risk for banks.[4]

However, real data on bankruptcy and recoveries for “green” and “brown” businesses which could be used to build models will take years to collect, and indeed, the changing attitude of the public to “brown” and “green” goods makes it difficult to use historical data to predict this risk. Therefore, long term, the industry may benefit from bank regulators setting an arbitrary risk increase for “brown” business and a corresponding risk decrease for “green” business, justified by likely future risk developments. As no individual bank has the market power to be an early mover while maintaining its market share, a coordination of timing and amount by regulators could be helpful.

Such a direction to recognise environmental risk could be made through adjustment to the Basel / IRB rules. An adjustment requiring banks to recognise and hold more capital for environmentally unfriendly loans (as opposed to banning or taxing them) would have immediate consequences for new lending which regulators want, while not cutting off credit to long term businesses which need time to adjust.  The effect of increasing the required capital percentage a bank must hold against a certain loan is that the bank’s return on capital is reduced and they are inclined to search for more capital friendly alternative business and/or increase the price to the affected borrower. In the current low interest rate environment, a distinction between business loan rates of 2% for a neutral investment loan and 3% for an environmentally unfriendly investment loan would likely change the return to the investor so much that they would do all they could to mitigate their environmental impact.

Nudging consumer lending

The bulk of consumer lending is for housing loans (mortgages) as shown in the figure below from an EBA report[5], with over €5 trillion in mortgages outstanding in September 2019.

The environmental friendliness of the existing house or apartment being financed could be measured in a rather simple way by using existing metrics such as energy usage, type of heating/cooling installed, insulation rating, etc. For new buildings, standards already exist across Europe which measure the environmental sustainability. However, for already existing homes an appropriate simple metric could be an energy efficiency measure which combines heating/cooling method with insulation. More energy efficient dwellings should hold their value better and be easier to sell long term.

This environmental factor could be mandated by regulators as a key component in the “house value” part of IRB capital modelling called “Loss Given Default” (“LGD”) which mean the size of the outstanding loan the bank estimate to lose if the borrower defaults. An increase in house value will reduce the LGD, if all remaining components are unchanged. A simple increase in LGD for environmentally unfriendly houses combined with a decrease for environmentally friendly houses would immediately feed into the banks’ minimum capital requirement in a multiplicative way. For example, moving a mortgage from LGD from 20% to 25% requires the bank to hold 25% more capital for that loan and would certainly see the bank re-pricing such loans upward, with a direct effect on consumer ability to buy such houses.

Banks would be expected to pass on any increases or decreases in interest margins to customers. By doing this, customers would receive a signal that upgrading their insulation or adding solar cells would not only make them feel better for the environment but also result in a monthly loan repayment saving.

Nudging the environmental friendliness of new-build houses and major upgrades is perhaps even more urgent than the slow effect on existing customers. Here there would be a strong justification for not only a capital benefit but a strong capital add-on for environmentally unfriendly buildings.

Targeting the “LGD” makes sense from a risk estimation viewpoint and fits with the current risk-based capital approach of regulators.  The environmentally friendly houses (which often cost more to build) should be easier to sell in the future as environmental concerns tighten and hence are a lower risk to the bank doing the lending, justifying the lower LGD, and vice versa.  An analogy is homes with a large asbestos component, which did not originally affect their value, but which eventually have become difficult to renovate and sell due to the strong health and safety rules imposed by governments.

Nudging business loans

Businesses are financed through equity and debt and these channels could both be used to steer business activity in a greener direction.  Businesses are already being softly encouraged to take an environmentally friendly route via ESG reporting, with the hope that equity investors will reward/punish to achieve this end.

Debt is provided to business through bonds and bank loans. Green Bonds have already been mandated with rewards to investors which encourage lower cost to the issuer (the business). Smaller businesses are funded by private equity and bank loans and typically turn to the banks for finance needed to take on more environmentally friendly investments.

As the previous figure shows, business loans to Small and Medium Enterprises (“SME”), Commercial Real Estate (“CRE”) and Large Corporates (“LC”) make up around half of all bank lending in Europe, an amount of over €6 trillion.

Bank loans to businesses are currently priced on the basis of their risk as measured by the two main components in the IRB formula:

  • The borrower’s likelihood of default (Probability of Default or “PD”). This is set for each borrower and is the same for every loan the bank makes to that borrower.
  • The LGD, i.e., the size of the loss the bank estimates it would suffer if the borrower did default, as described earlier. LGD is set by the bank distinctly for each “deal” or loan the bank makes to that borrower.

Banks have quite sophisticated PD models, which usually consider the near-term industry and technology risk, and may in the future even consider the added risks that operating in an environmentally unfriendly way could bring. Some banks rely on external ratings for default risk and apply a supervisory formula to determine capital (the Standardised Approach).  In many cases where external ratings do not exist banks simply accept a 100% risk weight, without being able to identify risky vs less risky loans.

Banks who estimate PDs internally can either accept supervisory LGDs, based mainly on collateral types and values (the Foundation Approach) or build internal models for LGD (the Advanced Approach). Banks’ LGD models, regardless of sophistication, still heavily depend on collateral types and values.

Overall, regardless of which approach the bank adopts for LGD, their risk and capital estimates will be heavily affected by risk weightings, collateral values and/or LGD rules set by the regulator, which the regulator could adjust in relation to the loan’s environmental sustainability.

As in the consumer lending example, a change to the LGD percentage would have an immediate, multiplicative, and easily measurable and predictable effect on the capital a bank needs to hold to make or hold that loan. Combined with the specificity of LGD for each deal this could result in the bank being able to offer the customer lower interest rate products for loans to fund its environmentally sound investments or businesses and higher interest rate products for so called “brown” business.

Just as for housing lending, mandating an extra amount of capital via an LGD impost for environmentally unfriendly loans fits with the risk-based capital assessment, where it is likely that future values of “brown” assets or businesses will decline over time or be harder to sell in default situations which is also likely to be in a downturn. Again, as for housing loans, the transition could be made by applying small LGD adjustments to existing portfolios but requiring higher LGD imposts/reductions for new loans/investments.

For banks adopting the standardised approach, there would be an extra effort in being required to split their deals by environmental impact and apply the same increase/decrease to the underlying inherent (implied) LGD producing a direct risk weight outcome. Investors and regulators will increasingly require banks to identify the environmental impacts of their lending as part of their day-to-day ESG compliance, so a specific rating of individual loans should not add a burden.

Applying an adjustment to LGD for different grades of environmental impact makes sense as LGD is relevant to the risk and has a clear and simple effect. If regulations force IRB banks to record an increase in LGD by 10% units (e.g., 30% to 40%) for environmentally unfriendly deals, the same group of deals where the standardised approach is used should get an equivalent increase in risk weight to make sure that a level playing field applies. With this simple approach there is no need for re-estimating the more difficult parameters such as correlations or PD curvature, knowing that any change to LGD has a constant proportional change to capital and hence cost.

Changes could be risk sensitive, capital neutral and achieve a level playing field

Any capital model changes would need to be carefully calibrated to ensure that the effect of risk weight additions/deductions are capital neutral at the start but then being progressively tightened over time. The goal would be that by the end of a transition period, for example ten years, a bank with a portfolio considered as “acceptably green” should have approximately the same capital as at the start of the process. Banks who moved faster to encourage their borrowers to “green” their portfolios would be rewarded by lower capital while banks who lagged in this process would have their capital progressively increased.

Banks’ lending in regions dominated by “brown” industries and environmental unfriendly houses would be negatively affected. Therefore, a well-planned transition would also be required to ensure the banks and their customers are not destabilised before they are able to affect their portfolios. To be clear, the role of the banks in this lending is as a conduit. In any given country it will take time for the population to transform and conduct appropriate changes to achieve environmentally friendly houses (insulation, solar cells etc.). The banks providing borrowers with housing loans can encourage them to make these changes and contribute to accelerate transformation. However, they cannot be expected to withdraw support for existing borrowers unfairly.

The initial phase of any implementation could simply be to target loans for new investments, buildings and projects, where the investors have the option to make them environmentally friendly or not. The second phase would then involve existing portfolios, with a ramp up of effects over a time frame which fits how borrowers can make the changes society demands.

Need for common metrics

It would be possible to demand that each bank determine for itself how each deal will affect the environment and how environmental change will affect each deal. This would need to be a lengthy process with much guesswork at the stage, made by thousands of institutions.  Alternatively, we would propose that the metrics of environmental risk and effect should be developed centrally and then applied consistently by each bank on their own portfolio. Already the European Commission has issued drafts of its Taxonomy for Sustainable Activities[6] which contains detailed environmental assessments by industry and activities. The EU is also looking further into more specific finance guidance in its Platform on Sustainable Finance[7] whose Transition finance report in March 2021 gives the current view on definitions of Green Finance and sustainable investments.

Banks themselves have already begun work at the industry level on identifying environmental effects of their loan books through the Partnership for Carbon Accounting Financials[8].  This work supported by over 100 banking institutions aims to “enable financial institutions to assess and disclose greenhouse gas emissions of loans and investments”.  A good loan by loan estimate of relative environmental impact would be an excellent input metric for IRB capital adjustment.

In summary, banks would need the EU taxonomy to be simplified but also made more relevant to their lending transactions and then bucketed into at least positive, neutral and negative groupings before applying them in their credit risk / capital measurement infrastructure.  This work could be done more quickly and safely as a cooperative effort by banks and regulators, especially by dovetailing with industry initiatives such as PCAF.

Summary and conclusions

Banks and regulators have an opportunity to use their long developed and expensive risk-based measurement processes to “nudge” borrowers into more environmentally friendly activities, with the simple expedient of a mandated addition/reduction of a key risk factor, LGD.

  • Bank loans are a critical component for both business and consumer investments and any “nudging” by banks could positively impact the environmental impact of such investments.
  • Banks are not currently seen as doing enough to discourage environmentally unfriendly investments or promote improvements to existing technology.
  • Regulators have the power to direct bank activities but western governments do not want to operate a “planned economy” by telling instructing banks where to lend and where not to. Instead, nudging banks to nudge investors and businesses could be a more palatable and effective way forward.
  • The activities of governments and society in restricting environmentally unfriendly activities through carbon taxes, pollution laws and investment pressure will have significant long-term effects on companies, which will affect their credit risk when they borrow from banks.
  • Banks could be asked to recognise the increased credit risk of lending to environmentally unfriendly businesses and even the reduced credit risk of lending to businesses which solve environmental problems or reduce harmful emissions. Risk increases require banks to hold more capital which reduces their profit on these loans. Banks could then reflect these risk and capital changes in their pricing of loans, which would have an immediate and strong nudge effect on borrowers.
  • Banks and regulators could use the use existing set of credit metrics (LGD and risk weights) to make implementation easier and connect the environmental risk to where it will have most impact on banks, the credit risk of the lending book. Banks and regulators have spent 20 years on improving the risk estimation and capital frameworks, so using this to highlight a new risk will build on the skills and techniques already present, also allowing backtesting of the set levels.
  • It is important for wide ranging changes to be done in a way which does not affect the healthy competition between banks, hence the need for central timelines and directives on coordinated risk calculation. This could be accomplished with a sensible transition period starting with full effect on new business and ramping up the effect on old business, allowing banks and their customers time to plan capital investments.

Philip Winckle, Christine Ehnström and Henrik Nilsson, FCG

[2] Global banks’ $750bn in fossil fuels finance conflicts with green pledges. Financial Times 24 March 2021.

Let's connect

Green finance in an IRB world – How can Banks and Regulators cooperate towards more environmentally friendly lending using the capital requirement framework? Green finance in an IRB world – How can Banks and Regulators cooperate towards more environmentally friendly lending using the capital requirement framework?
I want an Advisense expert to contact me about:
Green finance in an IRB world – How can Banks and Regulators cooperate towards more environmentally friendly lending using the capital requirement framework?

By submitting, you consent to our privacy policy

Thank you for connecting with us

An error occurred, please try again later