Bankers Face a Dirty New Temptation

The many rules, metrics and disclosure requirements imposed on banks after the global financial crisis largely succeeded in their principal goal: making lenders safer. But a new gauge that aims to encourage lenders to do more good — by fighting climate change — may just inspire a renewed fascination with derivatives, one of the raciest parts of finance.

From as early as next year, European banks may be asked to calculate the “greenness” of their activities, or what share of their business is financing climate-friendly activities. The European Commission is drafting the final rules.

The so-called green asset ratio (GAR) measure is meant to help inform stakeholders — including investors, employees and depositors — of a bank’s commitment to disinvesting from fossil fuels by revealing what proportion of its assets are environmentally sound. Depending on its relative shade of green, a lender’s funding costs could be at stake, as well as its ability to retain talent and its attractiveness to customers. Unlike banks’ other complex financial metrics, a green label may resonate with a much broader public that’s increasingly conscious of companies’ role in society.

European banks’ lending practices are critical to the region’s efforts in curbing polluting businesses. Companies in the region tend to rely on bank loans far more than in other places. The total balance sheet of European Union lenders was about 200% of the bloc’s gross domestic product at the end of 2018. In the U.S. that metric has been closer to 80% over the past 15 years.

And yet, data on European lenders’ climate-friendly financing activities are at best patchy and inconsistent. A new set of EU definitions by which economic activities are weighed on their environmental impact, the so-called “green taxonomy,” is an opportunity to boost transparency and comparability across the financial sector. While criticized for deficiencies — from being too binary to being too strict — the taxonomy is a starting point that will give companies a single, comprehensive guidebook on going green.

Unfortunately, there is still a lot of uncertainty around what will be included in the GAR. Chuck in too many banking activities and some lenders may look unfairly brown, the finance industry argues. But if you include too few, there’s a danger of “greenwashing.” The banks look greener but they have more opportunity to shift dirty business to where it isn’t captured in the GAR.

The inclusion or not of derivatives is particularly troubling. Brussels has proposed measuring green assets against banks’ entire activities, including derivatives, even though they’re not covered by the taxonomy. The European Banking Authority disagrees. It favors excluding derivatives entirely from the calculation and reporting so-called “capital markets indicators” separately.

The EBA’s proposal could let banks off the hook on climate change by possibly flattering their green asset ratios. Derivatives are a significant (and somewhat risky) part of investment banking so their inclusion in the GAR would make a difference. Worse, some lenders might be tempted to take on greater risk by structuring non-green deals as derivatives to keep them out of the GAR calculations.

Regulators should be wary of doing anything that encourages banks to add more derivatives to their balance sheets. We don’t need to look far into the past for a reminder of the dangers posed by some of this business. Global banks are nursing more than $10 billion of losses after Archegos Capital’s equity swaps blew up in March.

In its first EU-wide assessment of banks’ exposure to climate risks earlier this year, the EBA didn’t include trading assets in its calculation but it still found its sample of banks had a green asset ratio of only about 8%. That’s not particularly encouraging, and including derivatives under the Commission’s methodology would make the number even lower, especially for large banks.

Still, transparency must be the best option to pursue. Yes, investment banking is a competitive global business and you don’t want to make European lenders’ funding costs too expensive. But the climate emergency requires honesty, and anything that quietens the siren call of opaque derivative deals can only be a good thing.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News.

©2021 Bloomberg L.P.

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