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Here’s a funny thing. Banks are in the business of selling loans, but a lot of the time they have no clear idea what they’re being used for. It’d be a strange business model in any other context. In fact, it would prevent many other businesses from building a customer base and developing new products if they had no clue what their patrons needed and why they needed it.
But money isn’t a product, it’s a medium of exchange, and banks aren’t in the habit of asking too many questions about what the money they loan out is being used for. Yes, there are obvious exceptions. Mortgages, for one. After all, it would be hard to get one if you didn’t plan to buy a house. But when it comes to unsecured lending to corporates, the use of proceeds is often a mystery.
Many business loans are provided for “general corporate purposes”, a roundabout way of saying “for anything as long as it’s legal”. They’re a favourite of big businesses with myriad financing needs, as the paperwork is simple and they don’t require a line-by-line explanation of every good and service they intend to buy with the proceeds. These kinds of loans suit banks, too, as there’s no need to set up expensive, time-consuming monitoring and audit processes to make sure the money is going where it’s supposed to.
Fuzzy loans are fussy to classify
However, general corporate purpose loans are black boxes from a climate risk perspective. This makes it hard for lenders to count up their financed emissions — essential for tracking transition risk — and complicates the monitoring of geographic exposures, which is important for gauging physical risks.
Furthermore, they frustrate efforts to understand climate risk differentials between different types of financing. The Network for Greening the Financial System (NGFS), in a report on financial institutions’ experiences working with green, non-green and brown assets, wrote that general corporate purpose loans are “difficult to categorise in a [green/brown] taxonomy framework” as they have “a weaker direct link to a physical asset or a project”.
This is a problem, as it undermines efforts to understand whether or not climate risks adversely affect an asset’s creditworthiness. If they do, then brown assets should attract heightened due diligence, tighter covenants, and larger capital requirements to reflect this.
Climate risk conscious banks, therefore, could do themselves a favour by paring back general corporate purpose loans in favour of single purpose loans — those extended to fund a clearly defined activity. These kinds of loans allow banks to “follow the money” and assign discrete risk factors to each asset.
Take the example of an automobile manufacturer. A loan to such a client could fund a wide variety of activities, from building an SUV factory to developing technologies that increase fuel efficiency. The former would likely be considered a climate-harming activity; the latter a climate-friendly one.
With a general corporate purpose loan, a bank would not know what activity they actually funded. Yet with a single purpose loan, they get far more visibility. In the case of the automobile manufacturer, its lender may opt to hike the interest on a loan to build an SUV plant, out of concern that emissions standards may tighten and render such vehicles economically unpalatable. On the flipside, they may offer more favourable terms on a loan to bolster fuel efficiency standards. A number of lenders are already doing the latter through the issue of sustainability-linked loans (SLLs).
Ratcheting up the issuance of single purpose loans would also allow banks to dispense with crude exclusion policies that could choke the supply of funds to brown industries trying to make the transition to green. Certain industries, like thermal coal mining, may be beyond redemption, but how about an energy major that wants to become a net-zero emissions company, like BP? Yes, today it is predominantly a fossil fuel producer. But in order to fulfill its promise to become carbon neutral by 2050 it will need to invest massively in non-oil and gas products. It will need debt financing to do so. A bank that bars all financing of fossil fuel companies will, in this case, be effectively impeding progress on climate change.
Single purpose loans also make it easier for banks to tot up their financed emissions, helping them identify carbon intensive portfolios that are subject to transition risk. Right now, lenders are assessing different approaches to accounting for their financed emissions, including those promoted by the Partnership for Carbon Accounting Financials (PCAF), a coalition of 62 banks working on open source methodologies. The PCAF approach rests on the principle of “follow the money”, meaning funds should be tracked “as far as possible to understand and account for the GHG [greenhouse gas] emissions impact in the real economy”.
When it comes to business loans, however, the group relies on a sector-average calculation of carbon emissions, as “data may not be readily available in the aggregate at the loan portfolio level and could be too onerous to use as standard procedure for GHG accounting”. This makes PCAF user-friendly, but also reduces its accuracy — which is one reason why some larger banks are leery of the standard.
If banks made general corporate purpose loans the exception, rather than the norm, then the necessary data to run a loan-by-loan carbon footprint could be gathered at the point of origination, obviating the need to use sector averages.
A more granular understanding of the carbon intensity of individual loans would also aid supervisors. The European Central Bank’s latest study of the financial stability implications of an abrupt climate transition used two scenarios: one that assumed credit rating downgrades for all “climate sensitive” sectors on an equal basis, and another that calibrated downgrades in proportion to each firm’s emissions. Guess which approach the ECB favoured? Yes — the firm-level one. If future studies could assess the climate risk of loans at the use of proceeds level, imagine how much more detailed, and therefore helpful, these analyses could be for informing policymakers and prudential regulators.
The perils of specificity
What’s holding banks back, then? First of all, as indicated above, single purpose loans require banks to interrogate their clients on the intended use of proceeds. This makes the loan application process more onerous for both parties.
Second, single purpose loans hamstring a borrower’s ability to respond to risks and opportunities as they arise. After all, a client can hardly use funds loaned for a single purpose to invest in an exciting new startup that pops up after the terms are finalised, or cover the costs of a sudden breakdown in its supply chain. This desire for flexibility explains why so many corporates tapped their credit lines with big banks at the onset of the coronavirus crisis. They thought they’d need ready cash to weather the storm, but the kind of problems they’d face were unclear when the pandemic first took hold. Slapping conditions on these kinds of loans would have hampered firms’ liquidity, and could have led to avoidable business collapses.
But emergency situations notwithstanding, it’s unclear under what other circumstance a general corporate purpose loan could not be substituted for a single purpose one. In fact, prudent banks should want to issue more single purpose loans, not only to get a better grip of their climate risk exposures, but also to encourage proper long-term planning by their corporate clients. After all, a firm that puts borrowed money to work in a clearly defined, money-making project is much more likely to repay it than one that just takes the money and scatters it around haphazardly — the example of WeWork comes to mind.
Only by breaking norms can the banking sector tackle the specter of climate risk. Old, comfortable ways of doing business, like issuing general corporate purpose loans, have to give way to fresh approaches. Yes, there will be added costs and complexities. But the long-term payoff will be greater than the short-term pain.
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