Risk weighting adjustments for green/brown assets

Author: Cédric Merle

I. Recent recommendations on capital requirements for Brown / Green assets from the French national assembly

A report released on January 30, 2019[1],  from a Committee chaired by the “Whip” of the Finance Committee of the French National Assembly, contains 3 specific recommendations that drew our attention from a Green finance perspective:

1. Enact regulatory and technical changes to increase capital requirements for financial institutions who hold or propose “brown” assets that are unfavorable to the ecological transition (i.e. prudential malus).
2. After assessing the limits, symmetrically introduce a prudential bonus for green assets.
3. Explicitly integrate climate risk considerations into the annual bank assessment process (Supervisory Review and Evaluation Process "SREP")

In sum, the introduction of a brown penalizing factor (prudential malus) is endorsed both by the report from the Finance Committee of the French National Assembly and the Banque de France, albeit the latter expressed doubts about the green supporting factor (risk of creation of bubbles). Note that such doubts about the green supporting factor are shared by their German counterparts in the Bundesbank.

II. CHINESE GREEN FINANCE OFFICIAL ADVOCATES LOWER RISK WEIGHTING FOR GREEN ASSETS

 “China is the only large country that has established a green loan statistic system and has been keeping a record of green loan default rates, it has the chance to be the first country to better calibrate the risk weights for green assets.”. 

-- Dr. Ma Jun, Chair of China Green Finance Committee

Dr. Ma Jun, known as “the architect of sustainable finance in China”, is an influential opinion leader in green finance in China and abroad. A former Chief Economist of the People’s Bank of China, he currently serves multiple roles including the Chairman of China Green Finance Committee of China Society for Finance and Banking, Co-chair of G20 Green Finance Study Group, Director of the Center for Finance and Development of Tsinghua National Institute of Financial Research, as well as Special Advisor to the Governor of the People’s Bank of China (PBoC).

On October 24, 2018, he published an opinion piece on China Finance, a national journal managed by the PBoC, explaining why China should take the lead in lowering risk weighting for green assets (including green loans and green bonds) in the calculation of banks’ capital requirement.

The stimulus impact of the measurement alone is expected to overweight the total impact of all green finance incentives introduced so far, boosting substantial development in green finance, he writes.  According to him, current incentive initiatives are “still limited in intensity and scope” and “more aggressive policy innovations” are needed to speed up green finance in China.

One strong benefit of the proposed measurement is the significant reduction in the financing costs for green projects. He estimates a 0.5% of reduction in financing costs when the risk weight of green loans is halved from current 100%. In China where bank loans are the primary source of funding for green projects, the measure has the potential to lower 0.4-0.5% of the financing cost of all green projects, allowing banks to use the “saving” of capital requirement to extend more green credit.

He believes such evidence-based measure will align with risk-based prudential regulatory frameworks and create co-benefits such as strengthening the stability of the banking industry and promoting the contribution of financial services in industrial structure adjustment and the green transition. According to Dr. Ma Jun, China is the most qualified and well-prepared country to implement the measurement, as China has collected comprehensive statistics on the performance of green loans since the establishment of the world’s first green loan definition in 2013. The statistic records enable China to conduct empirical analysis on the performance of green loans and compare the difference between green and brown assets.

Already, many available empirical evidences from regulators and banks have echoed his notion. Two major findings are drawn from research. First, green loans demonstrate a much lower non-performing loan ratio and default rate. As of June 2017, the non-performing loan (NPL) ratio of green loans is merely 0.37%, far lower than the NPL ratio of 1.74% for the entire loan portfolio at 21 major banks in China. (The China Banking and Insurance Regulatory Commission, 2018)

Second, according to Dr. Ma Jun et Wang Haizhi, banks worldwide tend to offer lower interest rates to companies with better environmental performance, indicating banks’ view of lower default probabilities of green loans and that “green” lending can help avoid downside risks such as financial losses due to environmental and climate risks, thus improving credit quality

The notion is not a recent one. As early as August 2018, Dr. Ma Jun has started to advocate for the notion in various high-level conferences, including The Annual Conference Of The International Institute Of Green Finance hosted by the Central Finance University of China (September 2018) and The Climate Finance Day (November 2018). 

Note that this is only a proposal: The People's Bank of China (PBoC) has not yet lowered the risk weighting of green assets in China as of February 2019.

III. INTERNATIONAL SIMILAR INITIATIVES OR PROPOSALS, INCLUDING FROM EUROPE

The notion of lowering the risk weights of green assets is also placed in various regional and international regulator’s discussion. The European Banking Federation has already brought the recommendation of reducing risk weights for green assets to the European Union in 2017, followed by the “green-supporting factors” proposed by the European Commission in March 2018. The EU Action Plan on Financing Sustainable Growth (03/2018) indeed encompasses an Action 8 “Incorporating sustainability in prudential requirements. It states: “The Commission will explore the feasibility of the inclusion of risks associated with climate and other environmental factors in institutions' risk management policies and the potential calibration of capital requirements of banks as part of the Capital Requirement Regulation and Directive”. It says “The aim would be to take into account such factors, where this is justified from a risk perspective, to safeguard the coherence and effectiveness of the prudential framework and financial stability. Any recalibration of capital requirements, based on data and the assessment of the prudential risk of banks' exposures, would need to rely on and be coherent with the future EU taxonomy on sustainable activities”.

In addition, one of the three working groups under the Central Banks and supervisors Network on Greening the Financial System (NGFS) has also initiated the discussion. Dr. Ma Jun who chairs the working group reveals that, some European countries and Asian countries including China “has shown positive attitude towards the issue”.

Several empirical studies tend to evidence lower default payments risks of green loans:

• BPCE carried in on a study focused on specialized green loans for individuals, professionals and SMEs (for energy savings, refurbishment , clean vehicules) and compared their default rate with those of “classical” loans to the same type of clients (BPCE, 2017, Comparative study on the risks related to green and conventional loans). The study shows that green loans have a lower risk profile than standard equipment loans, by number (2.7% spread) and by outstanding amount (17% spread in relative value). The study was carried out in 2017 on a regional and national level.

• Project finance bank loans for green use-of-proceeds projects demonstrate a lower risk of default compared to project finance bank loans for non-green use-of-proceeds projects, particularly in advanced economies (10-year cumulative default rate of 5.7% versus 8.5% for non-green use-of-proceeds projects, Moody’s, 2018). In this study, green-use-of-proceeds project include: rail, tram, metro, bus rapid transit & other public transportation systems, clean water and waste water, and waste-to-energy. Overall, green projects had lower default rates than non-green projects in both the power and infrastructure industry sectors, although findings vary significantly across regional subsets.

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