Green stress tests sound like a paper tiger. When the Bank of England, European Central Bank and European Banking Authority next year examine whether lenders’ balance sheets are robust to climate change, no one will be named and shamed or be forced to hold more capital. That doesn’t mean bank chief executives should chill out.
Unlike some previous European stress tests, the green ones are no joke. The BoE, which outlined its methodology on Tuesday, will test the sector’s resilience against a $1,000 per tonne cost of carbon – compared to around $60 now. Bank of America analysts reckon the ECB’s exercise could imply a 35% increase in the risk-weighted assets for BNP Paribas’ corporate exposures and a 10% jump at the group level, as polluting customers become riskier credits. And the EBA is proposing that banks disclose a new metric called the Green Asset Ratio (GAR), to show what proportion of their assets count as “sustainable” under the European Commission’s new definitions.
The BoE will initially just divulge sector-level information, and Europe’s 2022 version won’t see laggards having to raise equity. But that’s not the point. After the global financial crisis investors demanded that banks hit new “Basel III” capital targets quickly, even though regulators gave them almost a decade. The same could happen with green metrics.
Regulators may see all this as a virtuous circle. Under pressure from investors, chastened banks will strive to improve their GARs and stress-test scores by phasing out loans to heavy polluters. That will then incentivise those polluters to clean up their own operations.
Central bankers should be wary of what they wish for, though. If lenders go all-in on decarbonising their loan books, they may hold off from funding transitional energy sources, like lower carbon gas, even though regulators like the BoE want them to. When bank capital requirements jumped after 2008, major banks lost 15 percentage points of market share to non-banks as they shrank lending in some markets, BofA reckons. ECB data shows that for capital-market lenders like bond investment funds, heavy carbon emitters already account for 40% of total exposures, compared with 20% for banks. If asset managers drag their feet, even more polluter financing may flow out of banking system – and further away from regulatory oversight.