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Climate Change Regulations: Bank Lending and Real Effects

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Climate risks and climate policies are expected to have a major impact on the financial system. In recent years, financial authorities have required banks to embed climate risks into their risk management frameworks, including in their Internal Capital Adequacy Assessment Process, the so-called ICAAP. While some policy makers are exploring the explicit use of prudential measures to direct funds away from high-carbon activities and into green sectors, the main objective of prudential capital requirements is to enhance the soundness and stability of financial institutions. Whether newly implemented climate-related prudential measures affect bank lending and firm activity is an open empirical question with important policy implications. For example, negative effects on bank lending would imply that there are costs associated with bank capital that curb the ability of banks to support firms in climate-exposed sectors. It is possible that such outcomes, even if unintended, might be desirable to the extent that they promote the divesting in some high-carbon activities. However, constraining the supply of credit to firms with significant exposure to climate change risk might be detrimental as it limits their ability to finance the transition to a less carbon intensive economy.

In a recent paper (Miguel et al., 2022), we evaluate a 2017 policy introduced in Brazil requiring systemically important banks –with assets greater than 10% of Brazil’s GDP– to incorporate environmental risks in their capital adequacy assessments. We use bank lending data and a taxonomy of environmentally exposed sectors to examine the incidence of the policy on bank credit, firms’ economic activity, and on greenhouse gas emissions (GHG). We find that the introduction of the new 2017 ICAAP led to a lending reallocation by large banks away from exposed sectors. The change in credit to exposed sectors by large banks was also in the form of shorter loan maturity, as the ratio of short-term loans to such sectors increased substantially after the reform (see Figure 1). In contrast, banks that were exempt from the ICAAP exercise increased their total credit volume and loan maturity to firms in exposed sectors after the regulation.  In fact, we find that at the aggregate level, the lending expansion by smaller banks to firms in exposed sectors makes up for the contraction of credit by larger banks.

Figure 1. Lending outcomes of small and large bank groups

Side by side line charts Panel A. Share of lending to exposed sectors by small and large banks Vs. Panel B. Share of short-term lending to exposed sectors by small and large banks
Notes: Panel A displays the monthly aggregate share of corporate lending of small and large banks channeled to the 332 5-digit sectors classified as exposed. Panel B displays the share of lending to exposed sectors by small and large banks that has maturity of one year or less.

We also study whether firms in exposed sectors can switch lenders and fully substitute loans across banks, or if the credit contraction they experience leads to lower real outcomes, including their capacity to reduce their carbon footprint. To do so, we use the Brazilian census of the formal labor market (RAIS) and a comprehensive data set on greenhouse gas emissions (The Greenhouse Gas Emission and Removal Estimating System, SEEG). We find a moderate impact of the policy on real economic activity. For instance, we do not find any differences in the level of employment and total GHG emissions of exposed firms in municipalities where banks affected by the ICAAP exercise had the strongest presence (treatment) relative to municipalities with less exposure to systemically important banks (control). There is evidence, however, of some labor reallocation between small and large firms within exposed sectors. In particular, the results suggest than in treated municipalities, there is a decline in the number of formal firms, and the average firm size increases after the policy. Consistent with this finding, we show that the employment share and the share of micro firms within exposed sectors decline after the policy in municipalities with more incidence of large banks. Overall, the evidence suggests that the contraction in credit to environmentally exposed firms by systemically important banks is largely offset by the increase in supply from other banks. The negative effects from the contraction in credit appears to concentrate in smaller firms, those that are less able to substitute borrowing across banks.

Policy Lessons and Future Work

  1. The sharp contraction in the credit supply of large banks, is partially offset by banks not subject to the ICAAP exercise but at the cost of increased exposure to environmentally exposed sectors . The shift in exposure of environmental risks from large to small banks in our setting highlights the importance of safeguarding the entire financial system when implementing climate-related prudential measures.
  2. While many firms are insulated from the supply shock (as they can substitute credit across lenders), adjustment of bank portfolios in response to climate-related capital requirements may disproportionally affect borrowers that typically have limited access to credit , such as SMEs. An unintended consequence of prudential measures that should be closely monitored is the negative impact on financial inclusion.
  3. An ambitious research agenda would be to study the impact of climate-related capital in a multi-country setting. Since 2020, the Bank of England, the European Central Bank, and other supervisory agencies have introduced guidelines to climate-related and environmental risk management. It could be interesting to explore whether country specific features are an additional source of heterogeneity (alongside bank and firm characteristics) in the impact of climate-related capital requirements on credit supply.


Faruk Miguel Liriano

Financial Sector Analyst, World Bank

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