Climate policy uncoordination

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With the stringency of climate policy varying from one country to the next, how are banks taking advantage of this lack of coordination? Research and analysis by Emanuela Benincasa, Gazi Kabaş and Steven Ongena.

As climate change threatens the human way of life, banks share the responsibility to drive investments to support a climate-resilient economy. Green financing through bank lending is crucial to re-engineer firms’ business models towards climate-friendly production processes.

One important yet often neglected challenge that green financing faces is the differences between countries’ climate policies. While some countries have been pursuing a low-carbon economy, others are not so eager. 

These differences are an important factor in the fight against climate change and can impact bank lending decisions, especially regarding how to adjust lending in one country as a reaction to conditions in other nations. For instance, we know that the monetary policy of one country can influence another via banks that operate in both countries. This suggests that the climate policy of one country can affect another through banks’ activity too.

The climate policy/lending relationship

We studied this relationship in detail by investigating how banks alter their cross-border lending as the climate policy of their home country changes. Exactly how domestic climate policy affects banks’ cross-border lending habits is not obvious, however. 

On the one hand, stricter climate policy facilitates the transition into a low-carbon economy, which requires firms to make investments. This green investment, in turn, can increase domestic firms’ loan demands. Banks may react to this higher loan demand at home by reducing their cross-border lending. 

On the other hand, the risks that emerge as a result of the transition into a low-carbon economy – known as transition risks – may lower firm profitability. Thus, a stricter climate policy can threaten banks’ domestic loan portfolios. To protect their loan portfolios, banks may increase their cross-border lending. 

To find out which effect dominates, we collected a sample of global syndicated loans from the 2007–2017 period. Syndicated loans are an essential tool for cross-border bank lending, and importantly they make it easier for smaller banks to engage in lending across national borders. Our sample covers banks located in 42 countries that supplied credit to companies located in 40 countries. 

Quantifying the stringency of countries’ climate policies

This is not an easy task for two main reasons. First, stringency is a combination of many aspects, such as energy consumption, emissions and regulations. Second, each country may have different types of measures in place.

However, there exists a comprehensive measure of climate policy stringency, the Climate Change Performance Index (CCPI). The CCPI was developed by Germanwatch (an environmental non-governmental organisation based in Germany) with the purpose of enhancing the transparency of countries’ climate protection action. We employed this index as it summarises country differences with a single metric, facilitating a comparison between countries with different backgrounds.

Testing the hypothesis

Let us now consider a hypothetical example of a cross-border syndicated loan where one bank is located in Germany and another in the US, and the borrowing company is in a third country, Poland. Let us also consider one specific year, say 2015, where Germany has a more stringent climate policy by six index points compared to that of the US.

Our results – based on the data we collected – indicate that Germany’s six-index-point policy lead in 2015 guides the bank to finance a 6% higher loan share for the same loan compared to the US bank.  This is not driven by the borrowing company’s higher demand for bank credit from the German bank, but rather by the German bank’s decision to increase its credit supply due to the more stringent domestic climate policy. 

Additional interesting results arise too. The cross-border credit supply is higher when originating from banks located in countries where bank supervisory authorities have low independence from the government, or low power to take actions to prevent and correct problems. The relative increase in cross-border lending is larger for banks that are more experienced in cross-border lending activities, have a high non-performing loans ratio and are larger in size.

Making sense of the results

Why are banks increasing their lending activity abroad? Could this be race-to-the-bottom behaviour, whereby they can circumvent the higher costs induced by stricter climate policy at home?

Our results suggest so. The increase in the cross-border credit supply occurs only if the bank’s home country has a more stringent climate policy than the borrowing firm’s country. Furthermore, we found strong evidence that banks increase their credit supply to foreign polluting firms while decreasing their lending to similar polluting firms operating in the domestic market. 

All of these results suggest that banks manoeuvre around the lack of global coordination in climate policies by increasing cross-border lending to polluting firms in polluting countries.

To prevent such circumvention, it seems that coordination among countries is essential to minimise leakages in the fight against climate change.

 

Emanuela Benincasa is a PhD student and Gazi Kabaş is a postdoctoral researcher at the University of Zurich. Steven Ongena is a professor of banking at the University of Zurich and CEPR Research Fellow. In collaboration with the Centre for Economic Policy Research and VoxEU. Read the full study here.

 

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