Giacomo Calzolari

1. Introduction

That environmental sustainability should gradually become strictly interrelated to financial activities is a widespread and entirely accepted principle, pursued through financial regulation, supervision, and banks’ and financial institutions’ voluntary actions.

But it is not so obvious why this is the case. If markets were able to internalize environmental costs and risks fully, these should be adequately priced by financial institutions and banks. The allocation of credit and other financial resources would then reflect such costs and risks. And if there were, as there are market failures, these should be addressed by policy instruments targeted explicitly to reducing emissions, like carbon pricing or other fiscal tools, so that financial institutions could then face and respond to adequate pricing signals.

Moreover, by affecting the allocation of assets in terms of their environmental intensity, financial regulations also influence their risk mix. Polluting activities or activities potentially exposed to climate change face physical (environmental damage) and transitional (change in regulation) risks. But green assets are frequently based on new and untested technologies. Hence they are also risky. The ideal mix between these two types of risk should in principle be identified by the objective function of policy makers or social planners, not necessarily by financial regulators.

So, why is there a need for an environmentally-focused action in financial and banking markets? This is one of the two questions addressed in this issue of European Economy. The other one, is how this should and is being done, especially through regulatory and supervisory frameworks, voluntary actions and standards for measuring and disclosing climate and environmental risks.

As for the why, a simple argument is that climate-related risks could impair the ability of central banks to achieve their mandated objectives, for example because climate change and mitigation policies may affect inflation dynamics and also financial stability, as discussed by Campiglio and Lamperti in this issue. Consequently, central banks could directly target green financial instruments in their asset purchase actions.

At the same time, central banks, along with other mandated authorities, could affect the market behaviour of banks and financial institutions through regulatory and supervisory tools. Four other arguments support this type of action.

The first one is that environmentally stringent regulation for financial institutions is less politically costly to be put in place than fiscal instruments affecting the generality of businesses and consumers. Paradoxically, even though nowadays no political party could be elected without a platform explicitly addressing climate change, fiscal tools raising the prices of fossil fuels can give rise to massive political resistance and turmoil, see for example the uprising of the Gilets Jaunes movement in France following a fiscally induced slight increase in fuel prices. At the same time, an effective carbon taxation should be global and fully harmonized through border adjustments. In this respect, a coherent global policy alignment is difficult to implement and faces a lot of resistance, as shown by the recent, pretty generic commitments reached during the United Nation Conference on Climate Change, Cop 26 conference. These policies are necessary of course, but they are not there yet.

Financial institutions are easier to regulate. There is consensus on the need to reduce the riskiness of financial markets in itself, and on the fact that climate change raises high physical risks (e.g. environmental disasters) and transitional risks (e.g. changes in regulation and consequent stranded assets). In that respect, especially banks, have an issue of legacy stranded assets that regulators are bound to face, for example in fossil fuels. Investors are also increasingly sensitive to the pursuance of ESG objectives and are in favour of stringent environmental targets. The risks of investing in green technologies are certainly sizeable and frequently uncertain, but the pressure toward the environmental transition partly reduces the perception of such risks.

A second reason for targeting financial markets is that since fiscal tools are not yet (or are just partially) in place, or in the end they cannot be fully enforced, and consequently market prices do not adequately internalize environmental costs and risks, there is a need for a rapid action, which can more easily be taken by directly targeting financial markets. The mitigation of both physical and transitional risks in asset allocation can more effectively be achieved through financial regulation in the short/medium term. The following section of this editorial discusses this issue at length.

A third one, is that the financial effort required to achieve environmental targets and mitigate climate change is enormous and all resources must be mobilised towards this goal as soon as possible, pressing financial markets in this direction even beyond what would be achievable with mere fiscal incentives.

Fourth and finally, as discussed below, there are failures that cannot be targeted by fiscal instruments and directly pertain to financial markets and interact with pure environmentally induced market failures. For example, credit constraints induced by asymmetric information. Also, De Haas and Beyene et al. in this issue discuss at length how banks generally price environmental risks less than capital markets and how this is also related to the limited perception that depositors, in contrast to direct investors, have on the allocation of banks’ assets. The last part of this editorial will discuss the role of banks vs. capital markets in financing the environmental transition.

As for the how, several contributions in this issue discuss the regulatory and supervisory frameworks adopted or planned (Beyene et al., Mikkelsen et al. and Marullo Reedtz). These, in general, pertain to several domains. First the definition of shared criteria for the measurement and disclosure of the environmental risk, both concerning assets with implicit physical riskiness and those involving transitional costs. Second, the evaluation and inclusion of such risks by financial institutions in their risk appetite frameworks and in supervisory actions and stress tests and the provision by supervisors of clear guidelines. Third, a balanced use of regulatory tools like capital requirements, on the one hand to favour asset allocation towards sustainable investments and, on the other hand, to reduce the risk of rapid divestment from established fuel intensive assets.

The issue focuses especially on the actions of EU institutions, initially triggered by the EU Commission Action Plan on Financing Sustainable Growth in March 2018 and which involves the European Central Bank (ECB), the European Banking Authority (EBA).

Also important are frameworks which imply a voluntary action by financial institutions. In particular, the Task Force on Climate-related Financial Disclosures (TCFD) was established by the Financial Stability Board (FSB) for climate related disclosures and the Net-Zero Banking alliance, which now involves all major financial players. There is an open issue of how far these voluntary arrangements should become compulsory in the longer term.

In what follows, we develop the arguments for why financial regulation should address environmental issues and discuss the different position of banks and capital markets as recipients of such regulatory frameworks.

2. Why financial regulation?

Problems of sustainability of economic decisions are inherent problems of adverse external effects: “the negative effect of production, consumption, or other economic decisions on another person or party, which is not specified as a liability in a contract” (Core, 2017) and therefore is not taken into consideration by a selfish profit or utility maximizing economic agent.

Consider the most debated one: emissions of greenhouse gases causing global warming (Stern and Stern, 2007). Like any other type of pollution, it is a negative externality. Negative externalities have been thoroughly analysed in the economic literature. Two leading solutions have been proposed: limits to production and taxation. Indeed, the most obvious solution in front of a polluter is to force him to stop. But this is an oversimplification because the social costs of completely halting the activities of a polluter can often be higher than the benefits (if Pfizer were marginally polluting to produce vaccines, we would probably be unwilling to force its closure). Welfare maximization requires comparing costs and benefits and set any quantitative limit to production at the level that equates the marginal social costs of production with the marginal benefits. However, this is more easily said than done, especially when producers are in large numbers – coordination on quantity limitations is complex among countries, let aside among single firms – and when the adverse external effects are not instantaneous but delayed in time, as in the case of global warming.

Fixing precise limitations to any activity that generates external effects and imposing them on each economic agent is clearly infeasible. A first option to circumvent this problem is cap and trade policies, i.e. to define a measure of the negative external effect (e.g., tonne of carbon emissions) and price them (see Campiglio and Lamperti in this issue). Once this is done, these policies can go a long way in solving the coordination problems of quantity limitations by allowing firms to trade the right to emit among themselves. Although the decision on how to initially allocate these rights is not obvious, the outcome is efficient, because those firms who incur the lower costs to reduce emissions have the higher incentive to do so. At the same time, the total amount of rights to emit that are granted allows to control the aggregate level of emissions.

Taxation is the alternative to impose quantitative limits, directly or through cap-and-trade policies. Set a Pigouvian tax equal to the marginal external cost – the difference between the (possibly delayed) marginal social cost and the private social cost – and profit maximizing firms will automatically choose the socially optimal production level. Taxation allows to force economic agents to internalize the external effect of their actions, leading to an optimal aggregate level of carbon emissions. According to this view, the optimal strategy to limit greenhouse gas emissions – or any other external effect in production or consumption – is to levy a Pigouvian tax. As such, there is no need to adopt indirect strategies, such as regulations in the financial markets making the cost of funding dependent on how “green” an investment is, so as to “reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth” (EU Commission, 2018).

However, there are at least two main problems with this prescription. One is the interaction of the external effects with other features of the economic system, such as imperfections in financial markets. The other is the evaluation of the joint riskiness of both the impact of the negative external effect (e.g., global warming) and the actions addressing it.

The case of imperfections in the financial markets is relatively straightforward. Consider two firms that must decide whether to invest in adopting a greener production technology. To simplify the analysis, assume for the moment that such technology is readily available, and its cost and benefits are known. One incurs lower costs to adapt to the new technology, but due to credit constraints, it faces high borrowing costs and prefers to renounce investing. The other firm has low borrowing costs, but it is also unwilling to invest since it faces high adaptation costs. Taxing carbon emissions would increase the costs for both firms if they did not invest in acquiring the new technology. The firm facing high adaptation costs may be forced to make the investment, despite the higher adaptation costs, while the credit constrained one may still find unprofitable to invest. An alternative policy, introducing incentives to finance green investments, would instead reduce the borrowing costs for the credit constrained firm, making it more likely to invest in green technology. For reasonable ranges of the differences between the costs of adopting the new technology and the borrowing costs for the two firms, it is possible that financial market regulation allows to achieve a lower level of emissions with the same impact on production. Regulations favoring investments in greener productions or technologies may thus be more effective than directly taxing emissions.

The issue of riskiness is two-faceted (on this theme, see also Campiglio and Lamperti in this issue). On the one side, there is a legacy problem: economic activities started when the global warming problem was underestimated (and therefore Pigouvian taxes were not introduced) can suffer significant losses, causing a surge in the riskiness of the existing portfolio of investments. On the other side, there is a perspective problem because the development and adoption of environmentally sustainable technologies require large investments, typically involving a high riskiness of both private and social returns.

The consequences of the permanent increase in average world temperature caused by greenhouse gas emissions are the object of an intense debate among scientists. Their economic effects are also the focus of a growing body of research (Cruz Álvarez and Rossi-Hansberg, 2021). It seems unquestionable that exceptional risks loom ahead.

From a portfolio management perspective, the problem is whether these risks are priced correctly by investors, particularly by financial intermediaries. If global warming led to extreme events causing radical changes in the economic system – from severe weather conditions to substantial relocations of economic activities – the value of assets held by financial intermediaries would collapse. If provisioning to face these risks was insufficient, a financial crisis would likely unfold. As already seen with the global financial crisis of 2007-2008, this may cause monetary policy problems, calling for radical interventions by central banks.

Provisions may be inadequate for two main reasons. First, investors may be unable to collect and process the vast amount of information required for a sound assessment of the risks caused by global warming. A possible solution would then be to elaborate and provide information on the risks caused by global warming to economic activities, to help investors accounting for their effects in their decisions. As argued by Degryse et al. in this issue, this is already happening, at least in part.

Second, the investors and especially financial intermediaries may not have the right incentives to set aside adequate provisions if they believe that the effects of global warming will be so pervasive to require in any case an intervention by public authorities. We can dub this as a “too-pervasive-to-face” problem. The obvious response to such a scenario is to introduce specific regulations of financial markets forcing intermediaries to cover the risks caused by global warming adequately.

In principles, the rationale for such interventions is not to sustain the funding of investments in greener technologies but to cover the risks caused by greenhouse gas emissions. In fact, such risks may even be unrelated to the production of negative external effects, depending only on how much the existing economic activities are exposed to the consequences of such effects. In practice, requiring higher provisions to cover the risks of the activities more severely affected by global warming will also impact on the allocation of portfolios towards greener investments. First, corporations such as airlines both produce negative external effects and are affected by events extreme weather events caused by global warming. Second, the likely introduction of a Pigouvian tax on polluting corporations is itself a risk that regulations will ask to cover, making it less profitable to conduct these economic activities.

The second type of risk is related to developing and adopting “green” technologies, which is an effective alternative to reducing the level of production in industries that negatively impact the environment. The question is how much shall we invest in this endeavour? Welfare maximization requires comparing the cost of developing and adopting these technologies with the benefit that they guarantee in reducing the external costs. However, both costs and the benefits entail significant risks, which are difficult to evaluate, making it difficult to find the funding required for such investments (as in the well-known cases of R&D financing) especially by financiers like banks and traditional investment funds. In complete and perfectly working financial markets, a Pigouvian tax increases the costs of production, providing an incentive to reduce its levels and, therefore, those of greenhouse gas emissions.

However, Pigouvain taxation may be more challenging to organise, and it can create an additional layer of uncertainty, related to its application through time, relative to a financial regulation that favours financing the development and adoption of greener technologies. As discussed in more detail in the next session, differences in risk aversion across financiers can also impact the adoption and development of green technologies.

Banks vs. markets

Finance and investments are necessary ingredients for a swift green transition. This observation naturally begs the question about the most effective ways to finance the investments that the green transition requires. This question has no unique answer, as it depends on the characteristics of the investing firms and the type of investments. The heterogeneity of firms and investments relevant to the green transition explains some of the mixed results identified in the academic literature and discussed in the articles in this issue of European Economy. We identify three critical factors for financing investments in general and the green transition in particular.

First, to understand the role of finance in the green transition, one needs to move away from the ideal world of the Modigliani and Miller theorem, where the source of finance does not matter for firms (value). In a realistic realm, the “pecking order theory” for finance (Myers and Majluf, 1984, for its adverse selection incarnation and Jensen and Meckling, 1976, for the cost-of-agency one) provides a first helpful step in understanding how firms finance different investments. Ample empirical evidence shows that to address issues of asymmetric information and reduce the cost of financing, firms first rely on retained earnings as the cheapest source of funds and then on external finance, first debt and then equity, with increasing financing costs that reflect the higher associated risk for the external parties.

A second relevant element is that the mentioned hierarchy of financing sources adapts to the “financial growth cycle” of the investing firm and its characteristics, such as size and actual and prospective growth. For example, small start-ups with high growth potential and high risk very often rely on venture capital and private equity.

A third key point is the nature of the investments needed for the green transition. Simplifying and relying on the articles on the present issues of the European Economy, we can identify two types of investment: one aiming at drastic innovations and another helping polluting firms start coping with and reducing their emissions using existing technologies. These types of investments are different. The former is much riskier as it aims at delivering new technologies with a long investment span. The latter is less so and could be seen as “retrofitting” or adapting existing production activities with abatement technologies. Also, the output of the former type of investment is typically intangible, such as with intellectual property rights and trade secrets. Instead, that of the latter is incorporated in production assets, such as renewable energy generation. As we further explore below, these critical differences in risk, investment span, and intangibility have material implications for funding different parts of the green transition.

Combining all these factors, the hierarchy in cost of finance, the characteristics of the investing firms, and the types of investments offers a rich picture to understand how and to what extent sustainable finance can contribute to the green transition. In particular, we are interested in understanding which type of finance is better suited to provide funds for the green transition. Given our three key elements, it is clear that the answer to this question depends on the possible matches between the alternatives, in particular (i) the source of funding, e.g., banks or financial markets, (ii) the characteristics of the investing firm, e.g., established firms or high-growth potential start-ups, and (iii) the type of green investment, e.g., new technologies or existing abatement technologies. The possible matches of the factors (i)-(iii) provide 2x2x2 combinations, some of which are more apt to finance the green transition than others.

In particular, in light of these observations, banks may face relevant issues in financing green investments when associated with certain matches combining points (i)-(iii) discussed above. A first specific problem often mentioned is that the green transition operates in a pre-existing environment where banks provide funds to firms, typically relying on debt contracts and associated collaterals. The green transition is intended to shift activities from pre-existing ones to more environmentally friendly ones. This transition tends to reduce the value of pre-existing technologies and associated assets that banks hold in their accounts. Banks may thus prefer not to contribute with their actions that may accelerate this devaluation of assets and collateral related to dirtier technologies. This observation, also discussed in Degryse et al. and De Haas in this Issue of the European Economy is reminiscent of what we have observed with the Non-Performing-Loans(NPL) crisis a few years ago, where banks avoided for quite some time the write-down of bad debts (see the European Economy 2017 issue n. 1). Although unilaterally, the fear of the risk of an adverse market reaction was understandable, collectively, keeping NPL in banks’ balances contributed to a general instability of the whole sector and required prompt policy interventions.

The problem of pre-existing lending to non-clean investments shares some similarities with NPL and some significant differences. In particular, although NPL banks had clear individual incentives to keep inflated asset values, with the green transition, it is difficult to imagine that each bank individually anticipates and fears the devaluation effects in legacy portfolios and hence perceives the risk of the transition of its lending to innovative green technologies. For example, Beyene et al. (2021) show that banks continue to underprice the risk of asset devaluation for traditional investment due to the green transition, which seems odd with a bank’ strategy of limiting entry green innovative firms with credit rationing. Relatedly, other banks’ characteristics contribute to their attitude towards green investment. Since banks tend to have a shorter investment time horizon than equity markets, they consequently tend to care less for possible future devaluation of assets associated with a high-carbon footprint. In this respect, capital markets seem more apt for prompt corrective action incorporating the increasing environmental risks.

Traditional banks also perceive less pressure to adapt to changing needs and preferences of ultimate funders, in their case depositors, as compared with investment funds. Although attention toward cleaner activities and investments is increasing, traditional banks offer a bundle of many different services to depositors, which may dilute the perception by depositors of the greenness of banks’ asset allocation. Relatedly, the actual exposure of banks towards polluting activities and or the fossil fuel sector is not readily available to banks depositors, as emphasized in Beyene, Delis, and Ongena in this Issue of European Economy. On the contrary, when investors patronize investment funds, the link between the funded projects and the investors’ preferences is more direct and visible. Relatedly, the universal-service characteristic of traditional banks makes it more difficult for banks’ management to keep track of the specific technologies adopted by the firms they lend to. This limited knowledge may ultimately weaken banks’ ability to invest in environmental-friendly innovations.

The different technologies relevant to the green transition can more or less fit what banks can effectively offer and handle. Banks can play a significant role in funding transition investments that allow firms to “retrofit” and adapt their production process towards cleaner approaches. In these cases, borrowers’ traditional assets can offer collaterals that banks can rely on for lending. Instead, financing the developments of drastic innovations for new green technologies may be problematic for banks because these types of innovations typically produce intangible outputs such as patents and trade secrets. As with any type of R&D intense investments, when the outcomes of the investments are intangible and thus non-pledgeable, banks can provide limited funding sources, and capital markets are more apt to address these environments. This is also convincingly emphasized by the papers of De Haas and Degryse et al. on this Issue of European Economy, which illustrate that green patented innovations expand faster in countries where equity finance is more prominent compared with bank lending. This observation is particularly relevant for bank-centric Europe that should channel as much as possible equity funding towards environmental innovations, possibly also rebalancing tax biases in favour of equity rather than debt.

How effective are banks dealing with polluting firms? There is some evidence that banks can price loans incorporating environmental impact. Chen et al. (2021) show that firms that emit more pay higher interest rates than banks, primarily when emissions are associated with more risky borrowers and weak governance. However, the question is whether banks are better able than capital markets to price environmental risks correctly. As discussed by De Haas in this Issue of European Economy, access to credit per-se favours investment in cleaner technologies, although the most relevant factor seems instead the quality and attitude of firms’ management towards environmental issues. Moreover, since banks continue to underprice the risk of asset devaluation for traditional investment, firms relying on carbon-heavy technologies are currently moving away from bonds to bank credit, as documented by Beyene et al. (2021b).

Interestingly, both De Haas and Degryse et al. in this Issue of European Economy have shown that the best outcomes from the credit markets obtain when “green-meets-green,” when banks explicitly commit to green lending match with environmental conscious borrowers that effectively disclose their attitude. In these cases, mutual commitment and disclosure on the two sides of the credit market allow for a cheaper lending cost. An immediate policy implication seems thus that of facilitating credible disclosure of the environmental attitude of both sides of the credit market.

Overall, banks’ difficulty in correctly pricing environmental risks combines several elements, as argued above. The articles in this issue of European Economy provide several policy actions that could redress this problem. Essential in this direction will be improving transparency and disclosure requirements about actual exposure to polluting industries and environmental risks. Moving from a voluntary approach (prone to manipulation and cherry-picking, as shown in Bingler et al. 2021) towards mandatory requirements, such as recently announced by New Zealand, the United Kingdom, and Switzerland seems a fundamental step.

3. Conclusions

In principle, Pigouvian taxation could fully internalize environmental costs and risks, making it useless to introduce ad hoc financial regulations (see Cochrane, 2021, for a view along these lines). But to attain a more sustainable equilibrium in the presence of other market failures, policy interventions in the financial markets can be an effective complementary tool to Pigouvian taxation.

Two main types of interventions have been proposed and are being put in place (see, in particular, Marullo Reedtz and Mikklesen et al. in this issue for a comprehensive analysis). First, the provision of rigorous and standardized information to investors, through the definition of criteria for the measurement and disclosure of environmental risks (e.g., the Taxonomy Regulation of the EU, the Sustainable Finance Disclosure Regulation, the Regulation on European green bonds), and the requirement that large public-interest entities publicly report on sustainability issues (e.g., Directive 2014/95/EU). Second, the explicit inclusion of environmental risks in the bank supervisory framework, including capital requirements and stress tests (e.g., EBA’s Implementing Technical Standards on Pillar 3 disclosures on ESG risks), and in central bank’s analyses (e.g., ECB’s Guide on climate-related and environmental risks).

The ample set of policies proposed in the financial sector will be paralleled by more traditional interventions addressing the effect of negative externalities through taxation and quantitative limitations. These will also impact investment returns (see also the discussion in Giovannini and Tamburrini, in this issue). Overall, the impact on the entire financial industry will be pervasive, affecting the choices and performance of banks, investment funds, insurance companies, and retail investors.

A natural set of questions thus arises. What objective function is driving this process? Who has chosen this objective function? Who is controlling that, when enacted simultaneously, the selected policies point in the right direction to achieve the desired goals?

The answer to the first question is apparently easy: the objective of all proposed policies is to internalize the adverse external effects that make individual choices unsustainable. But this goal requires a precise quantification of the social surplus to be maximized, a daunting task in any welfare analysis. In the absence of a unique solution, the objective function to be maximized should be chosen by citizens, following a democratic process. This observation leads to the answer to the second question that elected governments should determine the objective function to be maximized. While it may be largely agreed that the mandate of financial regulatory authorities reflects the government’s will for financial stability and the general working of financial markets, that such a mandate also reflects government choices on environmental issues is not so obvious. This may call for stricter directives from governments to financial authorities on environmental issues so as to enhance their accountability.

The last question has apparently no answer. Different bodies define different sets of rules, often with a large degree of autonomy. But a body or a framework coordinating the different policies and controlling that their decisions are not contrasting is absent. Given the large number of proposed and implemented interventions, the risk of a lack of coordination is substantial. This calls for a coordination table on environmental issues among all interested bodies. This framework should be set at the European level. In addition, given the global scope of environmental issues, it should be organized at the world level (see also Panetta, 2021).

References

Beyene, W., Delis, M., and Ongena, S. (2021a). Disclosure of Bank Fossil Fuel Exposures. European Economy – Banks, Regulation and the Real Sector, this issue.

Beyene, W., de Greiff, K., Delis, M., and Ongena, S. (2021b). Too-Big-To-Strand: Bond to Bank Substitution in the Transition to a Low-carbon Economy, Swiss Finance Institute, Mimeo.

Bingler, J. A., Kraus, M., and Leippold, M. (2021). Cheap Talk and Cherry-Picking: What ClimateBert Has to Say on Corporate Climate Risk Disclosures, University of Zürich, Mimeo.

Bowles, S., Carlin, W. and Stevens, M. (2017). ‘Market, efficiency, and public policy’. Unit 12 in The CORE team, The Economy. Available at: https://www.core-econ.org. [Accessed on April 17th, 2022].

Campliglio, E., and Lamperti, F. (2021). Sustainable finance policy-making: Why and how. European Economy – Banks, Regulation and the Real Sector, this issue.

Chen, I-Ju, Iftekhar Hasan, Chih-Yung Lin, Tra Ngoc Vy Nguyen, 2021, Do Banks Value Borrowers’ Environmental Record? Evidence from Financial Contracts, Working paper.

Cochrane, J.H. (2021). Testimony of John H. Cochrane to US Senate Committee on Banking, Housing, and Urban Affairs. Available at: https://www.banking.senate.gov/download/cochrane-testimony- [Accessed on April 17th, 2022].

The CORE Team (2017). The Economy: Economics for a changing World, Oxford University Press.

Cruz Álvarez, J.L. and Rossi-Hansberg, E. (2021). The Economic Geography of Global Warming. NBER Working Paper Series, No. 28466. Cambridge, MA: National Bureau of Economic Research.

De Haas, R. (2021). Finance and firms on the road to net zero. European Economy – Banks, Regulation and the Real Sector, this issue.

Degryse, H., Goncharenko, R., Theunisz, C., and Vadasz, T. (2021). The green transition and bank financing. European Economy – Banks, Regulation and the Real Sector, this issue.

European Commission (2018). The Action Plan for Financing Sustainable Growth.

Giovannini, A., and Tamburrini, F. (2021), Sustainable Finance: Three Questions in Search of an Answer. European Economy – Banks, Regulation and the Real Sector, this issue.

Jensen, M.C., and Meckling, W.H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3: 305-360.

Mikkelsen, D., Viscardi, S., Montes, M., and De Amicis, F.P. (2021). Climate change regulation and supervision in Europe and implications for commercial banks. European Economy – Banks, Regulation and the real Sector, this issue.

Marullo Reedtz, P. (2021). Financing the environmental transition in Europe. European Economy – Banks, Regulation and the real Sector, this issue.

Myers, S.C., and Majluf, N.S. (2021). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13: 187-221.

Panetta, F. (2021). A Global Accord for Sustainable Finance. Available at: https://www.project-syndicate.org/commentary/sustainable-finance-global-taxonomy-agreement-by-fabio-panetta-2021-05 [Accessed on April 17th, 2022].

Stern, N., and Stern, N.H. (2007). The economics of climate change: the Stern review. Cambridge University Press.

Authors

Giorgio Barba Navaretti^[1]University of Milan., Giacomo Calzolari^[2]European University Institute., Alberto Franco Pozzolo^[3]Roma Tre University.

 

1. The function of banks in emergency

“This time banks are not the problem but part of the solution.”^[4]Statement by the General Manager of BIS Agustín Carstens in his interview with Martin Wolf at Financial Times – The Global Boardroom 2nd Edition: Shaping the recovery, 13 November 2020 and … Continue reading This is a statement with several implications and inherent meanings, that we explore in-depth in this issue of European Economy (EE).

First, the absence of wrongdoing. This is an economic crisis that started as an exogenous shock (the pandemic) and not because of financial mismanagement by banks and financial companies: the plaintiff is empty-handed this time. In the aftermath of the great financial crisis (GFC), the leitmotif was that banks’ profits were private and their losses public, as many had to be bailed out by taxpayers. The subsequent reforms in regulation and supervision, the steep rise of capital requirements, and the restrictions on public bailouts were precisely based on the principle that also losses had to be private, borne mainly by shareholders and junior creditors with the ultimate aim to reduce moral hazard in lending and financial allocations. This time, not only the initial shock was exogenous to the banking sector, but it also happened at a time when the industry was acting in good health on safe grounds, as clearly emphasised by Campa and Quagliariello in this issue.

Second, the solution. Banks were crucial in channeling funds to firms and families, indeed so in Europe. Loans to non-financial corporations and households rose substantially in most EU countries during the first half of 2020, as firms needed working capital to withstand a steep reduction in sales and started amassing liquidity as a safety measure, given the remarkable rise in uncertainty (as thoroughly reported by Falagiarda et al. in this issue). Moreover, banks granted moratoria and considerably extended the duration of outstanding exposures. Bank loans also increased in the US, even though firms relied more on the issuance of corporate bonds than their European counterparts. According to Darmouni and Siani in this issue, both investment-grade and high-yield markets reached historical heights after March 2020. Yet, small firms still relied on bank loans. No other economic or financial, or public institution would have been equally pervasive to reach the broad public of firms and households like banks while being thoroughly regulated and supervised to assure the correct implementation of a centrally coordinated nation-wide and EU-level action.

Third, being able to afford to be the solution. As argued, banks were sufficiently capitalised, liquid, and well managed at the outburst of the pandemic (at least a large number of them) to be able to expand their assets without an excessive depletion of prudential capital. Also, because of the restrictions in distributing dividends and because of the moratoria extended to loans, Tier 1 capital, liquidity ratios, and the share of non-performing loans all improved during the crisis (as all the tables and figures reported in the Number section clearly illustrate, and as also argued in the papers by Angeloni and Campa and Quagliariello in this issue).

Fourth, this was possible because banks are subject to strict regulations, in Europe under a common regulatory framework. This had a double advantage. First, the quality of banks’ balance sheets and the extent of their ability to act were well known to the authorities. Second, regulatory authorities knew there were sufficient margins to release many of the prudential provisions of the pre-COVID-19 regulatory framework (e.g., capital buffers) and to introduce some ad hoc prudential measures, such as the restrictions in the distribution of dividends. And also, there was political consensus to do so. Consequently, it was possible to launch a public-private joint action between supervisory authorities, central banks, governments, and the banks themselves, which were at the forefront as the final actors and the enablers of the support operations. Banks would not have been able to act on similar grounds and to a similar extent in a pre-2009 environment. A tighter prudential regulatory framework was essential in creating the preconditions for banks’ “social” action. Also, this could not have happened in Europe if there had not been a Banking Union (although yet to be completed). Ring-fencing and uncoordinated supervisory procedures would have prevented a swift action under comparable conditions within the Union.

Fifth, being part of the solution. For well capitalised and healthy that they were, banks could have never been a solution without several levers of extensive public support: massive liquidity from central banks; extensive public guarantees on new loans; comprehensive regulatory responses, allowing banks to use their capital, liquidity, and countercyclical buffers; suspension of State Aid rules. In Europe, no such action could have been carried out in a pre-2009 environment and in the aftermath of the financial crisis. Governments could not have enacted expansionary measures of support and increased public debt without a massive program of purchase of government bonds by the ECB. At the time, there was no, and there would not have been political consensus for the ECB to carry out a quantitative easing (QE) program first and then the Pandemic Emergency Purchase Program (PEPP). Also, without a Banking Union, it would not have been possible to carry out a coordinated action throughout Europe and also construct sufficient political consensus to soften the prudential requirements set up after the GFC and the Sovereign Debt Crisis and use them countercyclically.

But the next critical challenge is to avoid the solution becoming a problem. For banks to act as responsible social actors during the pandemic, it was necessary, as argued, to considerably smooth the existing regulatory framework. Yet, such a framework was essentially designed to avoid moral hazard, when the banks were indeed the problem: i.e., to provide the right incentives to avoid irresponsible economic behaviour and potential episodes of insolvency. Future problems will be less likely if banks during the pandemic have acted as both economically and socially responsible actors. For example, if the standards applied to the allocation of loans backed by a state guarantee have been adequately stringent. Or if credit forbearance has been granted only to solvent borrowers. Hence at the moment we do not know if banks have carried out economically responsible actions even in the absence of adequate regulatory incentives to do so.

Clearly, to avoid the solution becoming a problem, a crucial aspect is the timing of the steps to go back to normality, which needs to be phased with the evolution of the pandemic and the uncovering of its effects. The legacy of the crisis, the exit strategy, the long-term impact on the banking and financial sectors, and what we have learned from a regulatory perspective are the main issues discussed below.

 

2. The legacy of the crisis and the exit strategy: notes of caution

The aftermath of the pandemic.  

The legacy that the pandemic crisis will leave on the banking sector cannot be underestimated. As argued above, the size and scope of policy interventions have been pervasive, including: (i) monetary policy measures, such as ECB’s Targeted Long-Term Refinancing Operations III (TLTRO III) and Pandemic Emergency Purchase Programme (PEPP); (ii) fiscal policy measures, such as national public guarantee schemes; (iii) prudential and supervisory measures, releasing capital and liquidity buffers, easing the classification of loans and their risk provisioning, and allowing for moratoria on lending. While these measures have been crucial to contrast the effects of COVID-19, they will also have substantial short- and long-run consequences on the banking sector and the economy as a whole.

The moral hazard problems at the core of the debate after the GFC appear not to be an issue in the current situation. Schnabel (2020) explicitly said that “the pandemic has not raised concerns of moral hazard.” Of course banks had no bearing in the economic crisis triggered by the pandemic and were instrumental in supporting households and firms. However, it is not clear whether credit allocation has been biased towards riskier creditors by lifting several prudential conditions. At the same time, cheap credit, moratoria on bank loans, and government guarantees are helping firms to survive, but at the cost of increasing their indebtedness. When support measures will finally be lifted, many borrowers will find themselves more indebted and in a direr condition than before the crisis.

Expansionary monetary policies and government guarantees make it very easy for banks to grant credit, as it is necessary to contrast the pandemic. But they also raise the risk that banks lend to zombie firms, which most likely will not be able to pay back their debts, and the survival of which causes significant distortions in the allocation of economic resources. This would hamper the reorganization of economic activities necessary for an effective process of creative destruction to unfold (Beck et al., 2021). Not all banks have the same incentives to lend to zombie firms, and the available evidence shows that the weaker and less capitalized banks are precisely those that are more likely to do so (Dursun-de Neef and Schandlbauer, 2020; Schivardi et al., 2021 ).
Like all crises, also the pandemic will have a cleansing effect. The acceleration of some trends that were already unfolding will cause a substantial reshaping of profitability across and within economic sectors. Strong firms will sail such rough waters and possibly strengthen their position, while weaker firms will be in trouble. Entrepreneurs should base their decisions on realistic assumptions about their business perspectives, avoiding leveraging on the availability of easy credit to bet for resurrection.

Public spending has increased substantially all over the world in the last year. According to the IMF, the ratio of government debt to GDP in advanced economies has soared by 16.3 percentage points between 2019 and 2020, to 120.1 per cent (by 12.9 per cent in the euro area, to 96.9 per cent). Contingent liabilities related to the guarantees offered on bank loans (see Figure 10, in the Numbers section) may cause a further increase in the coming years.

Expansionary fiscal policies were needed to contrast the effects of the pandemic, and they will undoubtedly be effective in the short run, given the large output gap and the depressed aggregate demand. But government policies need to have a sufficient long-term perspective and the recovery must be sustainable, protracted and sizeable enough for firms to pay back their debts without triggering government guarantees. Adding further concerns to this scenario, moratoria are more widespread in countries with a higher debt-to-GDP ratio (see Figure 17, in the Numbers Section). If government spending during the pandemics and the recovery programs in the aftermath had no impact in the longer term, the unfolding of a new doom-loop between banks and sovereigns might become a possible scenario in the coming years.

Closely related is the issue of NPLs. While their level is still low, they might rise substantially. As reported by Campa and Quagliariello in this issue, the volume of loans classified under IFRS 9 stage 2 – those that are still performing but for which there was a significant increase in credit risk – increased by 24% in 2020. As argued by Angeloni in this issue, banks should set aside adequate provisions to cover for credit risk and keep screening their clients even when government guarantees cover the loans they grant. This is even more so because of the link between NPLs, moratoria, capitalization and profitability: the country share of loans under moratoria which are classified as Stage 2 is higher than the average share of loans classified as Stage 2 (see Figure 12, in the Numbers section), the share of loans under moratoria is larger in countries with higher NPL ratios (Figure 16) and where banks have lower Tier 1 capital ratios (Figure 18) and profitability (Figure 19). Careful attention must thus be paid that banks do not postpone uncovering their losses.

To this aim, asset management companies can be an effective tool to make it easier to sell NPLs at a fair price, avoiding inflated losses because of thin markets or fire sales (which, in turn, could hamper the incentives to uncover them), as suggested by Campa and Quagliariello and Beck in this issue (building on the proposal made by Enria, 2017, in a previous issue of this journal).^[5]Although NPLs which will derive from the pandemic are not a legacy of past misbehaviours by bankers, as in the case of GFC, the proposal is nonetheless encountering some opposition at the European … Continue reading

The pandemic crisis also leaves us with a less stringent regulatory framework than what was agreed after the GFC. While this was necessary, an exit strategy must be devised. As argued by Beck in this issue and Beck et al. (2021), the right balance must be found between acting too soon, thus causing a credit crunch during the recovery phase, and acting too late, thus increasing the risk of moral hazard. To help banks and firms make credible budget plans for the coming years, a “forward regulatory guidance” should be provided, setting a clear path ahead. Given current and future uncertainties, such guidance would be more credible and effective if it were state-contingent (i.e., based on economic conditions) rather than time-time contingent (i.e., based on fixed dates in the future).^[6]Andrea Enria (2021) in a recent speech suggested a mixed strategy. He argued for the need to move ahead as planned for completing and implementing the Basel III framework on capital requirements, and … Continue reading

Long-run implications  

All the measures described above aim at tackling the short-run legacies of the pandemic crisis, setting the road for a stronger recovery and a sounder financial sector. But long-run legacies of the crisis will also unavoidably affect governments, banks, and firms alike.

Many governments will need to find a way of reabsorbing their massive debts, especially when central banks will phase out the QE. Firm over-indebtedness, especially with banks, will also be a major problem in the medium-run, since it will harm their investment ability. Even more so in the highly productive but riskier activities necessary to reach sustained economic growth.

During the pandemic, some firms have found easier access to the bond market than in the past, as shown by Darmouni and Siani, in this issue (partly thanks to the effects of central bank purchases). Also, in Europe, the number of firms issuing bonds has increased and their average size has declined (Darmouni and Papoutsi, 2020). Bond financing may become a problem if firms cannot roll-over their debt when the next crisis comes.

For firms to have more extensive access to arm-length financing, a larger number of investors should be willing to change their preferences towards higher risk-return strategies. This would be a crucial step to foster the reallocation of activities needed to recover from the COVID-19 pandemic and face future challenges, such as environmental problems. While all obstacles should be removed to facilitate firms’ access to equity markets, including SMEs, a renewed cultural approach to financial investments is also needed. Policies helping firms to switch from government guaranteed bank debt to equity financing, for example along the lines of the proposal made by Boot et al. (2020), would help in this direction. Set within the Capital Market Union framework, their effectiveness would be further enhanced (see Barba Navaretti et al., 2019).

Banks could also play a more active role in helping firms to access the financial markets directly. Margins on traditional banking activities are shrinking due to the current low-interest environment and increased competition from non-bank financial intermediaries, such as in the payment business.^[7]As suggested by the results of Bolt et al., in this issue, competition in the payment business is likely to increase in the coming years, due to the acceleration in the diffusion of digital payments … Continue reading A large amount of liquidity available in the financial markets may give way to fintechs to increase lending, for example, through peer-to-peer platforms. Since investment banking has higher margins than traditional lending, underwriting services should be seen by banks as a profit opportunity, rather than as an activity that reduces their loan portfolios’ size.

Also, the evolution of the entire financial intermediation sector, with new players such as fintechs and bigtechs, will undoubtedly push pressure on banks’ profitability. Fintechs had apparently a temporary step-back during the pandemic. This is partly related to the fact that many of these new players like peer to peer landing platforms had no access to relief measures and funding sources and that the public preferred to fly to safety in hardship (see Davies in this issue).

Possibly this has been a temporary accident, as fintechs were not ready yet and diffused enough in Europe to act pervasively during the crisis. But they may come back soon, given the earlier observed speed in the expansion of their business. Also, not all activities faced a set-back. Bolt et al. in this issue have shown that within a few months in lockdown individual payments’ habits have changed and probably permanently at a speed that usually would have taken several years.

The low profitability of traditional banks cannot last forever, with very low, if not still declining, book-to-value records for European banks.^[8]Market capitalization of Apple in 2018 was roughly half the combined European listed banks’ capitalization. In 2020, the situation is reversed with Apple now valuing more than the double of the … Continue reading The articles in this issue of European Economy have discussed how banks can regain profitability (see Davies). Overall, there are not so many options available. A combination of traditional approaches, such as cost containment, national and cross-border M&As, and more transformative changes are the likely outcomes.
Excess capacity is still a characteristic of some, although not all, domestic banking sectors in Europe. In some countries, the concentration in the banking sector is already high (notably Spain), and there are narrow margins for other M&As. In others, there are options, notably in Germany and Austria, and also in France and Italy.^[9]See https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200608_ssi_table~3054d55051.en.pdf But in this period of uncertainty with an unclear picture on the extent of future NPLs, the value of banks’ assets is uncertain and difficult to assess.

Also cross-country M&As could help to boost banks’ efficiency, and they would be an interesting way forward also in light of the hopeful completion of the Capital Markets Union. But, as highlighted by Davies in this issues, also, in this case, the uncertainty in the value of assets, the yet uncompleted Banking Union (a still missing European Deposit Insurance Scheme) and some potential political opposition, higher than usual in these COVID times, may hamper this pattern in the short/medium term.

Another source of efficiency can come from the adoption of digital technologies, especially for customer engagement applications and the use of artificial intelligence and Big data that can help in credit allocation and asset management modelling. Adopting transformative digital technologies not only opens different sources of profitability but also a re-organization of the banking activities, with a rebalancing of revenues towards non interest based sources (fees and commissions), a useful shift in a negative interest rates environment.

Financial intermediaries would be more of a matching entity, that gains when a transaction takes place. Bigtechs have a similar business model where in many cases profits come from flat-rate subscription fees and the ability to retain customers. The current banking business model is very far from all this, but it could be now the right moment to move more in this direction. Yet, the pace of adoption rate of these technologies by traditional banks is not of the speediest. In this respect, as argued in an earlier issue of this journal on fintechs, banks may rely on third parties such as cloud computing for data storage and analysis rather than developing these technologies.

For regulation and supervision, this will be a process to monitor closely. If regained profitability may stabilize the banking sector, a new business model may come with different risks. It has been shown, for example, that relying more on fees enhances the operating risk of banks.^[10]See DeYoung and Roland (2001) and more recently Köhler (2014). Also, as regulators have already noted, outsourcing crucial banks’ activities to third parties implies new risks.

 

3. What have we learnt? Rules as an anticyclical tool and the need for more European integration

Drawing conclusions on the effects of the pandemic on banking and financial markets at this stage is too early. However, the papers in this issue of European Economy help us identify some early observations about what we have learned.

The COVID is an unfortunate and prolonged stress test for the European banking sector and the regulations approved after the GFC, although the presence of unprecedented market interventions confound the test. We have learnt that rules have to be implemented with sufficient flexibility. They can work as powerful anticyclical measures. Using the available margins for releasing capital, liquidity requirements and State-aid rules has been essential to shelter as much as possible companies and households from the worst consequences of the pandemic.

As argued in the papers by Campa and Quagliariello, by Davies, and by Falagiarda et al., adequate capitalization levels were effective in fostering banks’ resilience. However, different banks in different countries will sail through the crisis in very different conditions. How they will exit it will depend not only on the quality of their loan portfolios and on their level of capitalization, but also on how their domestic countries have been hit by the pandemic: the severity of the lockdowns, the sectors of exposure, the effectiveness of the support measures, the state of the public finances etc.

In this framework, it will be difficult not to consider that the process of recapitalization initiated after the GFC was still incomplete. Rescuing banks in a post-COVID-19 banking crisis, if needed, will be just an act of realism: as it turned out to be necessary after the GFC, it would be even more so when the cause of the banking crisis is an exogenous shock like the pandemic.

In light of this, one could try to understand what would have been the COVID-19 crisis had it taken place before the Banking Union, and also what are the challenges ahead for the architecture of European banking supervision and regulation.

A first issue concerns the Single Resolution Mechanism. This was meant to reduce the risk of bail-out and the vicious cycle between banks and sovereigns. However, the bail-in of 8% of a bank’s balance sheet (contained in Banking Recovery and Resolution Directive, to access the Single Resolution Fund) has never been applied, de facto. Several reasons can explain why this Mechanism has not been used so far (see among other Dewatripoint et al. Vox 2021).^[11]https://voxeu.org/article/urgent-reform-eu-resolution-framework-needed

What will happen now, in the aftermath of the COVID-19 crisis? In principle, hard hit and undercapitalized banks in need of recovery would face the 8% bail-in rule. However, given the current post-COVID-19 conditions, governments would likely invoke the financial stability exemption to rescue their banks. Especilly if the pandemic evolves into a systemic rather than an idiosyncratic crisis involving more than a small number of banks, as argued by Beck in this issue. Paradoxically, this could lead to a claim of the irrelevance of the Single Resolution Mechanism  – aside from the ex-ante disciplining effect on banks of the threat of its application. This would be an ill-judgement, given the extreme and exceptional conditions we are sailing through, yet it would certainly call for some deep rethinking on how to use public funds in rescuing banks in troubles within a common European framework.

A different perspective emerges if we instead consider jointly the Single Supervisory Mechanism and the Single Rulebook. If these two critical elements of the Banking Union had not been available, then probably the current situation, and the future, would be definitely darker. As we have seen, the increased capital requirements are now paying off. We can claim that, at least so far, even in the case of undercapitalized banks, they allowed for buying time for the public hands to support the economies, without having to worry too much for the banking sector, as far as the lockdowns will not continue in 2022. Also, the banking Union offered a framework for coordinating actions for granting the necessary flexibility in prudential requirements across the Union.

From the COVID-19 crisis we have also learned that it is not true that the only missing piece in the Banking Union is the European Deposit Insurance Scheme. There is still a lot to do in terms of coordination. As mentioned by Campa and Quagliariellio, payment moratoria and public guarantee schemes were launched from governments in a not sufficiently coordinated manner and significantly differed in terms of deadlines, coverage, and conditionality, notwithstanding the efforts of the ECB. This lack of coordination will impact the post-COVID-19 life of banks in Europe.

We also lack a functioning European AMC to deal with NPLs, as mentioned by Angeloni. The current European plans will most likely not materialize in time, and, retrospectively, we missed an occasion in the last phase of the GFC to introduce this tool. Had it been available now, this tense period when NPLs haven’t realized yet, but everybody predicts they will, would have been less haunted by uncertainty.

And we further lack a convincing framework for cross-border banks. This is not a detail. As we argued above, these banks could be a solution for the current situation as a driver of the efficiency of the European banking sector. However, cross-border mergers are unlikely, given the current conditions. Political pressure might oppose such mergers for fear of losing control of national banking systems. Also, the highly uncertain environment in case of resolution of a pan-European bank is a formidable impediment for a cross-border merger. As in the past, the difficulty here is to a conflicting interest of home and host jurisdictions. The Single Supervisory System has made cross-border European banks more likely, but it has not yet lifted several still existing impediments.

As we have argued many times in this journal, a further and stronger integration of European banking and capital markets is a crucial way to improve the banking sector in Europe and certainly for a rapid recovery from the dreads of the pandemic.

 

References

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Avgouleas, E., Ayadi, R., Bodellini, M., Casu, B., De Groen, W.P., and Ferri, G. (2021). Non-performing loans – new risks and policies? What factors drive the performance of national asset management companies? European Parliament. Available at: https://www.europarl.europa.eu/thinktank/en/document.html?reference=IPOL_STU(2021)651386 (Accessed on May, 6, 2021).

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Boot, A., Carletti, E., Kotz, H.H., Krahnen, J.P., Pelizzon, L., and Subrahmanyam, M. (2020). Corona and Financial Stability 4.0: Implementing a European Pandemic Equity Fund. VOXEU – CEPR. Available at: https://voxeu.org/article/implementing-european-pandemic-equity-fund (Accessed on May, 6, 2021).

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