The ECB’s doublespeak on climate lending

The European Central Bank’s mandate states that it “shall support the general economic policies in the [European] Union” without prejudice to its primary objective of price stability.

Frank Elderson, Vice-Chair of the Supervisory Board of the ECB, wrote in a recent blog that “it is not for us supervisors to tell banks who they should or should not lend to.”

These two statements are at odds with one another. Let me explain why.

The EU’s “general economic policies” include its transformative Climate Law, which commits member states to achieve at least 55% emission cuts by 2030 relative to 1990 levels, and 90% cuts by 2040. The ECB’s mandate, as interpreted by Elderson among others, pledges the central bank to support this ambitious decarbonization plan.

As the EU’s monetary authority and primary supervisor of the bloc’s banks, the ECB has plenty of tools and influence at its disposal to coerce lenders to adopt certain behaviors. Indeed, it’s already making use of them in ways designed to change how they act and who they engage with.

Take the ECB’s plan to implement climate-related pool limits in its collateral framework. Put simply, this means the ECB will restrict the amount of bonds issued by high-carbon companies that banks can pledge in return for cash loans. Ostensibly, the limits aim to reduce climate risks in Eurosystem credit operations. The ECB doesn’t want to be sitting on a pile of high-carbon bonds freighted with transition risk, after all. But of course the limits are intended to have a secondary effect: to disincentivize EU banks from holding high-carbon bonds in the first place. All things being equal, a bank would prefer a bond portfolio that can be pledged for cash without restrictions than one with a cap.

Therefore, one consequence of the collateral framework changes should be to dissuade banks from holding bonds from high-carbon entities, and perhaps even make them think twice about acting as bond underwriters for them too, if they believe it’ll be hard to flip the inventory to investors. Bonds and loans being increasingly interchangeable, how can this ECB action not be considered an effort to “tell banks who they should or should not lend to”?

Then there’s the matter of bank oversight. Regulatory capital is a supervisor’s most powerful tool here. It can be deployed as either stick or carrot. At the outset of the COVID-19 pandemic, the ECB, in common with many other central banks, slashed capital requirements to make it easier for lenders to provide loans to desperate businesses, households, and (of course) governments. The idea was to encourage banks to continue lending even in the teeth of an unprecedented social, economic, and political storm. 

In a very different context, following the Eurozone Crisis, European policymakers legislated to lower the amount of regulatory capital banks would have to hold against loans to small and medium sized entities. In this instance, the motivation was political not existential. Lawmakers wanted to bolster lending to SMEs, a vocal and sympathetic constituency.

In the climate arena, the ECB is wielding regulatory capital as a stick, rather than a carrot – albeit as a rather floppy stick with little sting in its swipe. Back in 2020, the ECB finalized its expectations for banks on climate-related and environmental risk management. These include ordinances on climate risk identification and monitoring, and require the incorporation of climate risk into credit, market, liquidity, and operational risk management practices. The central bank has factored alignment – or misalignment – with its expectations into its annual health check of banks. Following the 2022 rounds, the ECB found shortcomings with a number of banks’ climate risk preparedness, which led to uplifts to their Pillar 2 capital add-ons. In a roundabout way, the ECB tightened capital requirements in response to poor climate risk management.

Punishing a bank for poor climate risk management is not the same as punishing them for lending to certain entities, you may argue. And again, the ECB is not saying that’s its intention. But I’d argue that the logic of the central bank’s climate risk management expectations – and increasingly strident pronouncements on the subject – should ultimately lead banks to cut loans to high-carbon companies, or at least those high-carbon companies that don’t have a plan to decarbonize. After all, risk management is about knowing what risks to accept, transfer, mitigate, and avoid. Expectation 4 in the ECB’s 2020 publication straight out says that “setting limits on lending to sectors and geographic areas that are highly exposed to climate-related or environmental risks” is a way to bolster institutions’ resilience to these risks.

A recent report out of the ECB hammers home this message. This explores the risks to banks of failing to align their financing activities with the EU’s climate objectives. The topline finding is that the majority of banks’ credit portfolios are “substantially misaligned with the goals of the Paris Agreement” leading to heightened climate transition risk for 90% of these lenders. Frank Elderson even spells out why this is the case: “transition risks largely stem from exposures to companies in the energy sector that are lagging behind in phasing out high-carbon production processes and are late in rolling out renewable energy production.”

The chain of logic here is clear. Banks want to avoid capital add-ons. Poor management of climate risks will lead to capital add-ons. Excessive exposure to transition risks may be considered poor climate risk management. Therefore, banks are incentivized to curb lending to high-carbon energy companies and increase credit allocation to those boosting renewables. 

Now this is a very roundabout way for the ECB to redirect lending flows. It may be that despite promoting the “general economic policies” part of its mandate in recent years, the central bank is still nervous of being seen as a policy actor, rather than as an indifferent steward of monetary policy and banking system stability. 

But personally, I wish the ECB would cut out the obfuscation. The way I see it, the ECB has a clear obligation to support the economic policies that the democratically elected (or appointed) EU policy making bodies decide to enact. It has to do so while striving to maintain price stability and the orderly transmission of monetary policy through the banking system. EU policies like the Fit for 55 plan are already changing, and should continue to change, the makeup of the EU economy so that climate-friendly sectors grow and fossil-fuel dependent ones shrink. This in turn means credit exposures to the latter will (generally) become riskier than those toward the former. If banks don’t amend their portfolios accordingly, then they will become more exposed to climate and macroeconomic shocks, and imperil the ECB’s overall mission.

If the ECB is sincere about the implications of its mandate and the EU’s climate policies, then it has no reason to be shy about being more direct with lenders. It can, fairly and defensibly, say that capital requirements will rise for banks that don’t curb exposures to high-carbon entities and transition refusers. 

This will be a clearer message than the one being put out today, and a more intellectually honest one to boot.