The concentration game: which EU banks hold the most transition risk?

The EU's transparency exercise offers a window to those firms with the most exposure to high carbon-emitting sectors

To topple a house of cards, only a few pieces need removing. Likewise, a systemic financial crisis can be sparked by the collapse of just one or two relatively innocuous firms.

In February 2008, hedge fund Peloton Partners liquidated a $2 billion asset-backed securities (ABS) fund after the value of its Alt-A mortgage portfolio plummeted. Though its balance sheet was tiny relative to the total size of the ABS market,  its collapse sent shockwaves across the financial system, as every firm had to mark down its own assets to reflect the implosion. Overnight, billions of dollars’ worth of value were wiped out, putting pressure on those firms loaded with similar mortgage assets. Eventually, some cracked — including Bear Stearns and, eventually, Lehman Brothers.

The lesson? Great collapses can start from humble beginnings, and the instigators will be those firms with highly-concentrated portfolios of risky assets. In 2008, these assets were mortgage-backed securities. In the near future, they will be loans to high carbon-emitting sectors. 

Exposures to these ‘carbon hogs’ — corporates involved in power generation, manufacturing and transport among them — are particularly susceptible to transition risk. Put simply, they could default suddenly and messily as the world economy moves towards a net zero-carbon goal.

Like with Peloton and its Alt-A portfolio, those institutions with concentrated holdings of these high carbon-emitting assets would be prone to collapse in the midst of this shock.

If they crashed under the strain, panic would spread like lightning through the financial system. All institutions holding similar assets to these unhappy harbingers would become suspect, just as every bank and broker-dealer holding mortgage ABS in 2008 was marked for failure.

Europe’s ‘dirtiest’ banks

Studies by European authorities show that transition risks are especially concentrated in a handful of high carbon-emitting sectors, and that exposures to these are piled up in a relatively small number of lenders.

The European Systemic Risk Board (ESRB) disclosed in a recent report that half of all emissions in a sample of 2,000 corporates were generated by just 15 polluters, and that exposures to these firms, while limited on average, “are concentrated in a few large exposures for some banks”.

It’s possible to estimate which lenders are the most exposed using the European Union-wide transparency exercise data, published on June 8. This includes information for 127 banks across the EU and European Economic Area as of December 31, 2019, representing €6.67 trillion ($7.51 trillion) of assets.

Importantly, their loan data is sorted by NACE codes, which are used to classify economic activities in the EU, thereby allowing insights into sector-specific exposures. Though NACE codes don’t enable identification of the most carbon-intensive exposures within these sectors, they offer a good enough proxy.

The five sectors with the highest average sector emission intensities, as identified by the ECB, are: electricity, gas and steam; mining and quarrying; water supply and sewerage; transportation and storage; and administrative and support services. 

Source: ESRB

Together, exposures to these sectors made up 17% of all loans held by European banks at end-2019. But at seven lenders they made up one-third or more of their total books. Norddeutsche Landesbank (Nord LB), a German state-backed firm, was the most exposed, with 46% of its portfolio allocated to these high carbon-emitting firms. 

However, the bulk of these exposures in euro terms are concentrated in just a handful of bulge-bracket lenders. The five banks with the largest loan portfolios in the sample — HSBC, BNP Paribas, Crédit Agricole, Santander and UniCredit — made up 29% of all exposures to the high carbon-emitting sectors.

What about exposures to corporates engaged in electricity, gas and steam production, the most carbon-intensive activity? Of the €290.5 billion loans outstanding, 27% were held by these top five — almost as much as the next fifteen largest firms combined.

Capital concerns

These giants’ nominal exposure to top polluters is also large relative to their Common Equity Tier 1 (CET1) capital — the layer of own funds they have on hand to absorb losses. In aggregate, these loans are equivalent in size to 80% of their CET1, and for BNP Paribas it’s a whopping 122%. This means if the bank realised losses of 10% on its carbon hogs, its capital would take a hit of almost €10 billion.

However, all five top firms are designated global systemically important banks (G-Sibs), meaning they are subject to higher capital requirements as a matter of course, and are therefore well protected in the event of transition risk related losses. Even BNP Paribas, the most exposed, would see its core risk-based solvency ratio reduced to 10.7% from its end-2019 amount of 12.2% in the event of a 10% loss — still above its regulatory minimum amount of 9.3% (assuming risk-weighted assets, the ratio’s denominator, stayed flat). Similarly, its leverage-based capital ratio would fall to 4.1% from 4.6%, well clear of the 3% minimum (again, assuming the denominator did not shift).

In fact, the French bank would have to lose one euro out of every five loaned to these polluters for its risk-based capital ratio to dip below this threshold, and about 66% to threaten its leverage ratio.

On the surface, then, it looks like those banks holding the most polluting exposures would be able to withstand a dramatic transition shock without succumbing to insolvency.

But what about those smaller lenders with the most exposure to high carbon-emitting sectors as a share of their overall portfolios? Here’s where the concentration risk gets scary. For example, Nord LB’s exposure to top polluting sectors represents 437% of its CET1 capital. Its exposure to the electricity, gas and steam sector alone is 207% its amount of own funds.

All it would take is a loss of 7% on these carbon hogs to blast a €1.8 billion hole through its CET1, shunting its risk-based capital ratio below its minimum requirement of 10.1% and its leverage ratio below 3%.

Similar vulnerabilities abound at Nord LB’s peers. The five banks with the highest proportion of their total portfolios invested in high carbon-emitting sectors had exposures 212% of their aggregate CET1.

Some of these banks are already on life support. Nord LB is a state-owned bank and received a capital injection in December to keep it solvent. Dexia is being wound down by the governments of Belgium, France and Luxembourg. Because of state bailouts, these firms may never have to face the full consequences of their high carbon exposures.

Others, though, may not be able to count of state largess. German giant Commerzbank — which is not a G-Sib — has high carbon-emitting exposures equivalent to 92% of its CET1. Would the German government be able to prop up this whale in a transition shock scenario, especially considering a number of other state-backed lenders would also be in distress at the same time?

How the dominoes could fall

What we know from the global financial crisis is that it only takes a few firms to spark a panic. In a sudden transition shock, a handful of banks most freighted with transition risk, and with exposures that exceed their own funds’ capacity to absorb losses, would be thrown into distress.

As a result, other firms would find similar exposures became instantly illiquid. Unable to offload these toxic loans to third parties at a reasonable price, they would have to divert earnings to cover losses over time — steadily undermining their capital positions.

Yes, banks would be unlikely to collapse overnight, as in 2008, since unlike asset-backed securities, most loans are marked at book value — meaning they don’t have to reflect market gyrations in their valuation.

Still, the accounting rule IFRS 9 means lenders do have to update their loan-loss expectations at frequent intervals, and put aside income to cover these each reporting period.

As these loss expectations are updated using projections part informed by the macroeconomic environment and part by their own observations of default risk, it’s not unreasonable to expect banks to take huge loan-loss provisions en masse in the event of a transition shock, much as they have done in response to the coronavirus crisis.

The multi-trillion dollar question, though, is whether a transition event that takes out a few banks could spread to obliterate the entire banking sector.

European authorities’ own rough simulations suggest a system-wide collapse would be improbable under a transition shock. As the ESRB notes:

An analysis of the impact of corporate rating downgrades for high polluters within sectors suggests that … diversified exposures should shield the banking sector from large losses if the highest-emitting firms within sectors at risk of climate change are downgraded.

However:

When shocks are applied that are proportional to each firm’s emissions rather than for a sector as a whole, losses in the banking system are estimated to increase by up to 10% for shocks corresponding to one-notch credit rating downgrades.

A 10% increase in losses could be enough to sink some of the highly-exposed firms mentioned above, and trigger the feedback loop that would force others into difficulty.

It’s important to remember, too, that a bank doesn’t need to realise huge losses to be plunged into crisis. Losing a few precious percentage points on leverage or risk-based capital ratios can be enough to get the sharks circling. Indeed, because a transition shock would deplete capital and increase risk-weighted assets at the same time, risk-based ratios could deteriorate very quickly after relatively few carbon hog defaults.

Stopping the rot

What actions could prudential regulators take to prevent the dominoes falling? Higher capital requirements for high carbon-emitting assets are one safeguard. Treating those banks larded with these exposures as systemically important — at the national or international level — are another.

But these measures are designed to help firms withstand losses once they occur. What watchdogs should aim towards instead is preventing large transition risk related losses happening in the first place. Intervening to limit banks’ exposure to carbon hogs would be one step towards this objective.

Monica Rebreanu, founder of IMPACTplus, a boutique consultancy firm focused on climate change and sustainability, says: "Considering the expectations set in the recently published ECB draft climate risk guide, supervisors may ask banks’ plans to reduce these exposures and may gradually impose Pillar 2 capital add-ons.  Regulators may also impose concentration limits or higher capital charges for these exposures given their riskiness.”

European regulators could, for instance, restrict banks’ exposures to the top five high carbon-emitting sectors to 10% of their CET1 capital. This would prevent losses being large enough to demolish banks’ capital cushions.

Still, concentration limits are blunt instruments, and watchdogs would have to be careful that these carbon hogs don’t just find new homes in non-bank entities outside their supervisory bailiwick.

They’d also have to develop a mechanism to identify those loans to high carbon-emitting entities that were sold to stimulate decarbonisation, perhaps through a green/brown taxonomy. After all, it would be unfair if banks were penalised for trying to assist corporates in their own transitions.

Still, with these caveats, concentration limits may yet save those lenders loaded with transition risks from detonating, and taking down the rest of the banking system with them.


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