The risks of getting green finance wrong - Editor's Blog -

As the UN Climate Conference takes place in Madrid, policy-makers are busy coming up with anti-climate change proposals. However, writes Brian Caplen, not all of them are good. 

When the European Commission starts talking about easing bank capital rules for green finance, alarm bells should start ringing. Remember that it was doing something worthy – encouraging subprime borrowers to get on the US housing ladder – that led to the last financial crash.

Since then banking has been through a massive reregulation exercise so that, hopefully, banks now hold sufficient capital to cope with a downturn in any part of the market. The thinking behind risk weighting is that capital weights reflect the likelihood of a loan type to go bad. They are not supposed to be used as a policy instrument as proposed by (of all people) the commissioner for financial stability, financial services and the capital markets union, Valdis Dombrovskis.

In an interview with the Financial Times, he said the proposal would encourage banks to finance green investments including energy-efficient homes and zero-emissions transport by lowering capital requirements.

But it would also change the risk calculation for doing this kind of lending, even though the actual riskiness of the loans has not changed. Borrowers would strive to get themselves into the ‘green’ category as this would make them more likely to get loans and on better terms.

It is not difficult to see where all this could end up, with a market awash with so-called green loans that are then rolled up into securitisations and given AAA ratings until it all comes crashing down. The result would be bad for the banks but also bad for the environment and the regulatory response would then be to clampdown hard on green lending.

By contrast to this rather poor idea from the commission, the proposal from the German finance minister, Olaf Scholz, to end the zero-rating of eurozone sovereign bonds is a very good one. Clearly these bonds do not carry zero risk as the sovereigns in question cannot print money to repay their debts. The power to do this was removed as part of the currency union.

But politics has a nasty habit of triumphing over good economic sense. On that basis, the current enthusiasm for anything with a green label, regardless of merit, and the pushback we have seen from Italy for which holding capital on sovereign bonds would cause government financing problems, means that we could end up with the wrong result on both fronts. 

Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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