Building green fortresses

Should banks' climate-friendly assets be ring-fenced?

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Fortification-based metaphors are popular in high finance.

Jamie Dimon, chief of JP Morgan, often touts his bank’s ‘fortress balance sheet', a moniker reflective of its huge equity base, which acts as a bulwark against economic strife.

Bank capital is often described as a ‘buffer’; a means to protect lenders from financial losses — like those inflicted by today’s coronavirus-inspired recession.

Regulators are also fans of this phrasing. Post-financial crisis, watchdogs touted the merits of so-called ‘ring-fencing’ rules, which require banking groups to cordon off certain parts of their businesses to protect them from losses incurred elsewhere at the firm.

Usually, these rules require lenders to lock-up specific amounts of equity and easy-to-sell assets in the ring-fenced entities, so that they have their own dedicated loss-absorbing resources that can’t be plundered by other businesses in the same group.

On paper, these rules look eminently sensible. The retail unit of a banking group, for example, provides a socially important function, and should have enough resources to function even if the investment banking or capital markets divisions of the host run into trouble.

Breaking up is hard to do

The dynamics of green finance appear to be borrowing from the tenets of ring-fencing. Bank capital, liquidity, and balance sheet capacity is sectioned off to promote sustainable investment, and the assets and liabilities associated with these activities are given their own unique designation to set them apart from other activities.

Lenders are segregating their resources this way in order to effectively quantify their sustainable investments and mark progress towards specific targets — either imposed internally or in response of stakeholder pressure.

However, this ‘green ring-fencing’ has its limits.

Take BBVA’s issuance of a €1 billion ‘green CoCo’ [contingent convertible] bond on July 7. Unlike vanilla bonds, CoCos have the characteristics of both debt and equity. If an issuing bank stays healthy, then the bondholders will receive regular coupon payments and may see their principal investment returned in full after a predetermined ‘no call’ period. 

But if the bank’s core capital ratio falls below a certain point, a CoCo bond is ‘bailed in’, meaning the debt is transformed into equity and the principal is used to absorb losses. Because of this feature, CoCo debt is counted as additional Tier 1 (AT1) capital under European Union rules, and contributes to a bank’s minimum regulatory own funds requirement.

Now a green bond is structured and sold on the understanding that the proceeds will be used to fund climate-friendly activities only. BBVA has dutifully explained that the proceeds of its new bond will be used to back a stable of sustainable investments. But the €1 billion question is how the CoCo’s principal will be allocated if it is bailed in.

Would the green debt be transformed into green equity, and only be allowed to cover losses on BBVA’s green assets? Nope — that’s not how a CoCo works. You can’t brand something as loss-absorbing but be picky about what losses it can take on. 

In practice, if BBVA’s green CoCo were bailed in, debt that had been used to finance climate-friendly projects could be written down to swallow losses caused by climate-aggravating assets.

Essentially, BBVA is trying to have it both ways — saying the debt proceeds are ring-fenced for green activities while insisting any bailed-in equity be freely used across the firm as a whole.

Branding a bond ‘green’ is a canny way to acquire climate-conscious investors. But the dual nature of this CoCo may deter some who don’t like the idea that their green capital could underwrite non-green assets.

Of bubbles and bulwarks

Though the BBVA CoCo does not represent a true ring-fencing of green resources, it does shine a light on an emerging dynamic that could threaten financial stability in the future.

Today, banks are churning out new climate-friendly products, such as sustainability-linked loans and green mortgages, that are funded using quasi-segregated ‘green’ resources — like the proceeds of green bonds. 

Often, though not always, these funds are acquired at a discount to their non-green counterparts. The Climate Bonds Initiative’s recent survey of corporate treasurers found that 70% said demand for their green bonds was higher than for vanilla issuances, with about one-in-five saying they secured cheaper funding this way.

The funded products themselves are also frequently issued at favourable terms. For example, Crédit Agricole allows climate change projects to benefit from lower internal funding costs, making it possible to “offer attractive conditions to investors”.

The idea may be to expand the allocation of capital to sustainable investments, but such discounts also skew the risk-adjusted returns of these projects — meaning they make less money for the banks than their riskiness warrants. 

How could this be a threat to financial stability? Well, if you give banks cheap financing to invest in assets with yields that don’t compensate for their risks, they could build up shaky piles of loans which, if they imploded, would likely eat up more capital than they generated — forcing them to draw on precious reserves.

As it stands, prudential safeguards mean green bubbles like these are unlikely to form. Regulatory capital requirements are climate-agnostic, meaning it doesn’t matter if a bank charges less for a green loan than a non-green equivalent with the same risk profile — the rules say both have to be backed by the same amount of equity.  

However, plans to cut risk-based capital requirements for green assets may be in the works. In a 2018 report, an expert group sponsored by the European Commission said a “green supporting factor”, lowering the regulatory charges assigned to climate-friendly assets, “could give a strong policy signal to re-engage the banking sector in its lending function for the economy after years of tightening capital regulation.”

It’s a noble goal, but cutting capital requirements so they understate the riskiness of certain products would remove a key obstacle to the formation of green bubbles. Green portfolios would then be both low-yielding and undercapitalised. If these blew up, a bank’s capital buffer would then have to be tapped to cover the losses — leaving less behind to deal with non-green assets, which are themselves vulnerable to physical and transition risks. Not the outcome financial regulators should be aiming for. 

True ‘green ring-fencing’ may be a better solution.

Troubled lenders often split up their operations into ‘good’ and ‘bad’ banks to separate toxic assets from healthy ones, thereby giving investors clarity as to the capital-intensity of the different portfolios. Deutsche Bank is in the process of winding-down its own ‘bad bank’ today.

Could a lender, then, split its balance sheet into ‘green’ and ‘non-green’ entities, and capitalise them separately?

If the two were legally separated, then each could raise equity on their own terms — with the green bank perhaps able to secure this on a more favourable basis than its non-green counterpart, if investors correctly perceived the climate-related risks of the latter to be a long-term threat to their capital.

If both green and non-green banks stayed under the same roof, they could still be ring-fenced via regulatory intervention. Watchdogs could maintain the same risk-based capital requirements for assets in each entity, but could lower buffer requirements, such as Pillar 2 charges and AT1 quotas, for the green assets that are less vulnerable to climate-related risks. 

The green bank would therefore have a lower all-in solvency requirement, reflecting how it no longer has to cross-subsidise the climate-related risks present in the non-green unit. This would mean it would have more capital available to make climate-friendly loans.

Losses incurred in the non-green bank would also be prevented from spilling over to the green counterpart, or vice-versa, meaning each unit would be free from contagion risk.

A ‘green ring-fenced’ banking group would also be incentivised to grow its green unit and shrink its non-green unit, considering the greater capital burden of the latter. The green unit would also be able to continue to benefit from cheaper funding through the issuance of dedicated bonds.

Yes, ring-fencing has its risks, too. After all, if capital and liquidity is compartmentalised across a banking group, then the whole cannot be drawn upon to stave off a firm-wide collapse.

Still, it may provide a simpler and safer solution than adjusting capital requirements for climate-friendly assets without segregation.

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The views and opinions expressed in this article are those of the author alone

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