China Should Lower Risk Weights for Green Assets

2018-11-01　 　

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 China Should Lower Risk Weights for Green Assets

Ma Jun[1]

Developing green finance has become a national strategy in China, and will serve as an essential tool to promote ecological civilization, advance the green economy, and combat climate change.In 2016, sevenMinistries and Commissionsjointly issued the Guidelines for Establishing China’s Green Financial System. Many of the policyincentives developed in these Guidelines have already been implemented. Examples includethe PBOC green re-lending facility, the incorporation of green performancemetrics into the Macro-Prudential Assessment (MPA), as well as interestrate subsidies and guarantees for green projects provided by local governments. However, the implementation of these incentives is still limited in intensity and scope, and the number of green companiesbenefiting from them remains quite small.In light of the mounting environmental and climate challenges, we need more aggressive policy innovations to speed up the development of green finance.

I believe that lowering the risk weights for green assets (including green loans and green bonds) in the calculation of banks’ capital requirement will allow for a significant reduction in financing costs for green projects, thereby making a substantial breakthrough in green finance development. According to our preliminary estimation, if the risk weight for green loans is reduced from the current 100% to 50%, it can reduce the financing costs by about 50 basis points (0.5 percentage points) for all green projects funded by green loans in China. Given the fact that bank loans are the primary source of funding for green projects in China, this measure could lower the financing costs of all green projects by 0.4-0.5 percentage points in the country. In addition, the “saving” of capital requirement for banks with substantial green asset exposure could allow these banks to extend more green credit. The “stimulus” impact of this measure alone could potentially outweigh the totalimpact of all green finance incentives introduced so far.

Internationally, discussionshave already started around the idea of reducing risk weights for green assets and/or increasing risk weights for brown (polluting) assets. The European Banking Federation has made such a recommendation to the European Union, while the Action Plan on Sustainable Finance adopted by the European Commission in March 2018 also proposed a study of such “green-supporting factors”. The Central Banks and Supervisors Network for Greening the Financing System (NGFS), consisting of central banks and financial regulatory bodies from 19 countries including France and China, established a supervision workstream. The workstream, which I chair, has also initiated discussions on this topic.

A growing consensus from these international discussions is that if the default rate of green assets is proven to be lower than for non-green assets, it will then justify the consideration of lowering risk weights for green assets and potentially raising those for brown assets. Such evidence-based measures will align with risk-based prudential regulatory frameworks, and the overarchinggoal of financial regulations to enhance the resilience of the banking sector and maintain financial stability. Unfortunately, most countries have not yet developed explicit definitions for green finance (including green loans) and thus have not collected data on green loans/assets, and are not able to conductstatistical analyses of the default rates and compare the difference between green and brown assets. As China is the first in the world to establish a green loan definition (in 2013) and has collected statistics on green loans for five years, it is now able to analyze empirically the performance of green loans.

Statistics from the China Banking and Insurance Regulatory Commission showed that as of June 2017, the non-performing loan ratio (NPL) of green loans was only 0.37%, far lower than the NPL ratio of 1.74% for the entire loan portfolio at 21 major banks. Statistics from 2013-2016 also showed similar patterns. The same conclusion can be drawn from data provided by a few large and medium-sized banks. For instance, statistics from a large Chinese state-owned commercial bank show that the NPL ratio of green loans is lower than that of its entire loan portfolio by 1.3 percentage points. Data from another large joint-stock commercial bank also showed that, at the end of June 2018, its NPL ratio for green loans was 0.35%, lower than the NPL ratio of all corporate loansby 1.74 percentage points. Sectoral data from this joint-stock bank also demonstrates that in 13 out of 14 sectors, the NPL ratios of green loans were lower than industrial averages. The only exception is from a sector where the number of loans is very small.

Research findings from academia and the financial industry have also provided supportive evidence. An empirical study led by Professor Haizhi Wang at Illinois Institute of Technology and myself at Tsinghua, using data of 5,612 global loans from Thomson Reuters DealScan as well as ESG data from MSCI, demonstrates that banks are willing to offer lower interest rates to companies with better environmental performance, suggesting that these banks view “green” loans as having lower default probabilities. A recent study from Moody’s show that the 10-year cumulative default rate for green infrastructure loans is 5.7%, lower than that of 8.5% for non-green infrastructure loans. Evidence from the UK also suggests that the NPL ratio of green mortgage loans is lower than regular mortgage loans. Additionally, many studies showed that green or ESG equity indices perform better in the long term than traditional stock indices. The rationale behind these is that green index investing can help investors avoid financial losses due to environmental and climate risks. From a bank or bond investor’s perspective, “green” lending can also help it avoid similar downside risks, thus improving its credit quality.

As China is the only large country that has established a green loan statistic system and has been keeping a record of green loan default rates, ithas the chance to be the first country tobetter calibrate the risk weights for green assets. As Chinese data has already shown lower default rates for green loans (and green bonds have zero default rate so far), reducing risk weights for green assets will be in line with the macro-prudential principleto enhance the stability of the banking industry. It will also deliver the important co-benefits of scaling up the green finance market and fostering a faster green transition of the economy. It may also inspire some other countries to establish green taxonomies, collect data on green/brown assets, and consider the introduction of “green supporting factors/brown penalizing factors” in their policy initiatives.

(Dr. Ma Jun is a member of the Monetary Policy Committee of the People’s Bank of China --China’s central bank, Chairman of China Green Finance Committee, and Director of the Center for Finance and Development at Tsinghua University.)