What is the impact of bank loans on climate change? – 03/06/2023 – Pablo Acosta

There is an expectation that climate risks and climate policies will have a major impact on the financial system. For example, in recent years, financial authorities have required banks to incorporate climate risks into their risk management frameworks, including their Internal Capital Adequacy Assessment Process, the so-called ICAAP.

While some policymakers are exploring the use of prudential measures to direct funds from high-carbon activities to green sectors, the main objective of prudential capital requirements is to increase the soundness and stability of financial institutions. Whether newly implemented climate-related prudential measures will affect bank lending and business activity remains an open empirical question with important policy implications.

For example, these regulations may introduce costs associated with bank capital that constrain banks’ ability to support companies in weather-exposed sectors. It is possible that such results, even if unintentional, are desirable insofar as they promote disinvestment in some high-carbon activities. However, restricting the supply of credit to companies with significant exposure to climate change risk can be harmful, as it limits their ability to finance the transition to a less carbon-intensive economy.

In a recent article, the World Bank evaluated a policy introduced in 2017 in Brazil which required systemically important banks –with assets greater than 10% of GDP– to incorporate environmental risks into their capital adequacy assessments. Data from bank loans and a taxonomy of environmentally exposed sectors were used to examine the impact of the policy on bank credit, on the economic activity of companies and on greenhouse gas (GHG) emissions. The conclusion was that the introduction of the new 2017 ICAAP led to a reallocation of lending by large banks outside of exposed sectors.

The shift in credit to sectors exposed by large banks also came in the form of shorter loan maturities, as the proportion of short-term loans to these sectors increased substantially after the reform. On the other hand, banks exempt from exercising the ICAAP increased the total volume of credit and the maturity of loans to companies in exposed sectors after the regulation. In fact, it was noticed that, at the aggregate level, the expansion of loans from smaller banks to companies in exposed sectors offsets the contraction of credit from larger banks.

The study also found that companies in exposed sectors may switch lenders and switch loans entirely between banks or if the credit crunch they experience leads to lower real outcomes, including their ability to reduce their carbon footprint.

Furthermore, a moderate impact of this policy on real economic activity was detected. No differences were found in the level of employment and total GHG emissions of companies exposed in municipalities where banks affected by the ICAAP exercise had the strongest presence (treatment) versus municipalities with lower exposure to systemically important banks (control).

The study also presents evidence, however, of some labor reallocation between small and large firms in exposed industries. In particular, the results suggest that in the treated municipalities there is a decline in the number of formal companies and the average size of companies increases after the policy.

Consistent with this finding, the share of employment and the share of microenterprises within exposed sectors decrease after the policy in municipalities with a higher incidence of large banks. Overall, the evidence suggests that the contraction of credit to environmentally exposed firms by systemically important banks is largely offset by increased supply from other banks.

Finally, the negative effects of the credit crunch seem to be concentrated on smaller companies, those that have less capacity to replace loans from banks.

In conclusion, the shift in exposure to environmental risks from large to small banks in our environment highlights the importance of protecting the entire financial system when implementing climate-related prudential measures. While many firms are insulated from the supply shock (they can substitute credit among lenders), the adjustment of banks’ portfolios in response to climate-related capital requirements can disproportionately affect borrowers who typically have limited access to credit, such as small businesses. and medium-sized enterprises (SMEs). A possible unintended consequence of prudential measures that should be closely monitored is the negative impact on financial inclusion.

An ambitious research agenda would be to study the impact of climate-related capital in a multinational setting. Since 2020, the Bank of England, the European Central Bank and other oversight agencies have introduced guidelines for managing climate and environmental risks. It would be interesting to see whether country-specific characteristics are an additional source of heterogeneity (in addition to bank and firm characteristics) in the impact of climate-related capital requirements on the supply of credit.

_{This column was written in collaboration with World Bank economists Alvaro Pedraza, Faruk Miguel Liriano and Claudia Ruiz}

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