As we detailed earlier this week, the Bank for International Settlements’ opus on green finance takes central banks far beyond monetary and regulatory policy, imploring institutions that already have their hands full defining financial markets, rules, and even wealth distribution also to become arbiters of social values. Reflecting these lofty ambitions, the BIS also wants central banks to reset risk-based capital, urging a new “brown-penalizing” capital requirement. However, climate change is not the only woe that befalls us. Sexism is an evil that suppresses economic growth and might even lead to financial risk – Goldman Sachs tells us that IPOs without women are riskier than all-boy’s deals. Do we need a “man-penalizing factor?” What about a “youth-penalizing factor?” BofA’s CEO said earlier this week that many of his employees were too young to have learned the hard lessons of the great financial crisis. Why not slap them around with a higher capital charge for loans made by or to millennials?
In its report, the global central banks espouses a wide array of actions premised on a “learn by doing” approach, pressing hard for climate-change stress testing that would create strong capital disincentives against environmental risk atop a specific Pillar 2 penalty for “brown” projects and a Pillar 2 supervisory whack that raises brown capital costs still higher on a case-by-case basis at recalcitrant banks. All this would lead to a “brown-penalizing factor.” However, the rationale laid out by the BIS is puzzling: green projects may not necessarily pose lower financial risks just because they are green – true – but exposures to brown projects “can increase financial risk.” Of course, they might not – some oil companies do repay their loans – but the BIS isn’t buying capital rules based solely on financial risk regardless of whether a project is green, brown, or just a muddy shade of ochre with wholly uncertain climate-change impact.
Indeed, some passages in the BIS report reflect a bit of worry on this score. Prudential rules should not, it is said, seek to “reconfigure the productive structure of the economy,” with the BIS here citing a failed effort by the EU to do so by lowering risk-based capital charges to encourage lending to small and medium size enterprises (SMEs). SME incentives might well have worked because lots more is known about SME risk, but this case study leads the BIS to fear that capital incentives aimed at “decarbonizing” the world will fare far worse.
Where does the penalty zone start and stop? Would capital charges rise only for loans to companies deemed too brown for comfort or, as the BIS’s principles suggest, would banks also take it on the chin for lending to a consumer who wants a Hummer, not a smart car? What about penalizing construction projects that are not suitably sustainable, or for that matter, pretty enough to make a neighborhood nicer and thus make its inhabitants healthier?
It’s always been true that risk-based capital rewards borrowers engaging in activities favored by political consensus – see for example the steep capital discounts still accorded high-risk mortgages such as cash-out refinancings and leveraged home-equity loans. However, cooking the capital books didn’t work out all that well in 2008 no matter the putative contribution to the American dream of home ownership. Now, we have the global dream of a zero-emissions planet and a lovely thought that is. However, rewriting finance to serve a pipedream may not work any better now than it ever has.
Indeed, given that even the BIS is flummoxed by how much real financial risk green or brown projects pose, it seems certain that capital standards that reward projects based on color will quickly prove capital rules that reward astute arbitrageurs and profit-hungry banks. Been there, done that, probably shouldn’t do it again.