Financing sustainable development and regulatory reforms: the right balance?

Fostering sustainable finance requires leadership

Improving the risk-return ratio of economic growth versus environmental impact is on the top of the agenda of many conferences and seminars. The Paris Agreement on climate change and the 2030 Agenda for Sustainable Development committed to developing more sustainable growth within a sound and transparent financial system to avoid an unsustainable increase in global temperatures of 4°C or more in the coming decades. According to estimates presented at the World Economic Forum in Davos back in 2013, over US$100 trillion is needed by 2030 to finance infrastructure needs worldwide.


Stephen van Mello, Project Consultant at TriFinance Financial Institutions and Rudolf Sneyers, Practice Leader of the Risk Management and Compliance Practice, focus in this contribution on the review of risk measurements in the banking and insurance sector to better align regulatory reforms with long term objectives in sustainable finance.


Financial Institutions have an important role to play

The High-Level Expert Group for a greener and cleaner economy with less carbon and fewer natural resources have given several recommendations:

  • Clarifying the expectations towards asset managers and institutional investors to take sustainability into account in the investment process.
  • Incorporating sustainability in prudential requirements considering that banks and insurance companies are an important source of external finance for the European economy.

Financial institutions are a key stakeholder in financing sustainable development. Consequently, the impact of Banking and Insurance regulatory reforms can play an important role in reaching the climate change objectives. Institutional investors might indeed demonstrate increased interest for this kind of transactions in their search for yield following the persisting low-interest environment. The search of long-term investors for ‘sustainable labelled’ assets is a second important driver for additional market supply.

Did you know that?
French banks have long-standing experience in Infrastructure Finance. They are well presented in the League tables of Mandated Lead Arrangers with Crédit Agricole Group, Société Générale, BNP Paribas and Natixis being part of the top 10 both in terms of deal count and transaction value. Other names in the League tables are ING Group, HSBC, Santander, NordLB together with the large Japanese banks.


In December 2018, the EU ambassadors endorsed the Council's position on two proposals aiming at making finance greener and more in line with the objectives of the Paris agreement on climate change. The first proposal is a new category of financial benchmarks aimed at giving greater information on an investment portfolio's carbon footprint. The second proposal requires institutional investors to disclose:

  • The procedures they have in place to integrate environmental and social risks into their investment and advisory process;
  • The extent to which those risks might have an impact on the profitability of the investment;
  • Where institutional investors claim to be pursuing a "green" investment strategy, information on how this strategy is implemented and the sustainability or climate impact of their products and portfolios.

Internal Rating Based Approach in Basel III: Better incentivization required

The EBA’s regulatory review of the Internal Rating Based Approach (IARB) focused on the main sources of unjustified variability of capital requirements identified in the studies on comparability of Risk Weighted Assets (RWA). The overall objective was to restore credibility in RWA calculation and to improve comparability of the capital ratios of banks. The sources listed in the study include the calibration of Probability of Default (PD), Loss Given Default (LGD) and the treatment of low default portfolios (including specialized lending).

The recent consultation report of the Financial Stability Board states that regulation is not expected to have a significant effect on the behaviour of banks because all the Basel II IRB approaches will remain available under the finalized Basel III agreement with limited additional constraints.

Major adjustments have been made in the Basel III proposal since the March 2016 consultation about specialized lending. The most qualitative project finance transactions remain however penalized in terms of risk-weighted assets compared to the Basel II framework. This is due to the lack of risk sensitivity in the Basel III approach by the application of standard eligibility criteria for collateral, the LGD floors and the RWA output floor. Haircuts will be based on the corporate asset class which are subsequently less granular and risk sensitive.


For this reason, banks might have the tendency to apply regulatory arbitrage by underwriting less solid project structures to get a higher return on equity for a similar risk weight. This kind of arbitrage would not only conflict with the ECB’s objective of the resilience of banks but would also be in contrast with the G20 objective to mobilize more private sector financing for infrastructure investments.


Solvency II for insurance undertakings: a first step in the right direction

According to Assuralia, the Belgian Federation of Insurance undertakings, the Solvency II regulation provides strong disincentives for long-term investments. In a survey of Insurance Europe, 48 % of the insurance companies stated that they have invested less than optimally in the real economy due to Solvency II capital requirements. Insurance companies were often reluctant to invest in infrastructure because prudential requirements oblige them to hold a high level of capital against these investments. However, infrastructure investments are from an Asset Liability Management perspective almost a no-brainer for insurers, where long-dated assets can be placed against long-dated liabilities.


The amendments to the Solvency II delegated regulation aim to create better incentives to invest in these projects and was a first step in the right direction. The risk profile of qualifying infrastructure corporates is better reflected under the new rules and improves the return on risk-adjusted capital for the insurers compared to other corporates. The increased exposure to non-traditional asset classes, such as infrastructure, improves asset diversification but also demands new risk management capabilities from insurers and closer supervisory attention. This clearly is a first step in the right direction, but further actions can be taken to boost sustainable investments in our economy.

Did you know that?
Infrastructure corporates must fulfil strict criteria. The list can be found in Delegated Regulation (EU) 2016/467 art. 164.



Fine Tuning Needed

The recent Financial Stability Board (FSB) consultation report estimates that the increased investors’ appetite for infrastructure investments will create additional market support from institutional investors such as insurance companies and pension funds. This viewpoint passes however completely over the lifetime cycle of project financing with very different risk profiles (medium-term construction risk versus long-term investments) as highlighted in several comments on the FSB consultation document. We believe that institutional investors will not be interested in financing ‘greenfield’ projects as opposed to ‘brownfield’ projects because of a lack of technical expertise together with a lack of risk management expertise in project finance.

Did you know that?
Greenfield project – Infrastructure that is built from scratch and lacks constraints of prior work.
Brownfield project – Existing infrastructure that is currently lying vacant, idle or underutilized and can be modified or upgraded.

The difference in risk profiles between banks and insurers could lead to an increased number of partnerships in infrastructure investments. There are already examples of partnerships where banks and insurers develop optimal strategies leveraging on each other expertise and split desirable risk characteristics between them. Evolutions in capital requirements in Basel III and Solvency II should, therefore, be looked at in conjunction, steering institutional investors in the right direction.

Reaching the right balance between regulatory reforms and sustainable finance will require additional re-thinking from both EBA and EIOPA. The upcoming review of Solvency II and the monitoring of the Basel III impact by the Basel Committee on Banking Supervision (BCBS) will be outstanding opportunities to ‘fine tune’ this balance between supporting long-term sustainable finance and the resilience of financial institutions as put forward by the European Commission and the G20.



Sources

  • Consultation report on the evaluation of the effects of financial regulatory reforms on infrastructure finance – FSB, July 2018
  • Counsel of the EU, 2018, Green finance: Council agrees position on low carbon benchmarks and disclosure requirements
  • Delegated Regulation (EU) 2016/467 of the European Commission of 30 September 2015 amending Commission Delegated Regulation (EU) 2015/35 concerning the calculation of regulatory capital requirements for several categories of assets held by insurance and reinsurance undertakings.
  • Final Report 2018 by the High-Level Expert Group on Sustainable Finance, Secretariat provided by the European Commission.
  • Solvency II Conference – Two years on and two reviews, Olav Jones, Insurance Europe.
  • The review of Solvency II – Belgian Financial Forum, 2018.
  • The EBA’S Regulatory Review of the IRB Approach - Review of the IRB Approach Conclusions from the consultation on the discussion paper on the future of the IRB Approach – EBA 2015

About Rudolf Sneyers
After holding a wide range of management functions within BACOB Bank and Artesia Banking Corporation, Rudi Sneyers joined the market and operational risk management division of Dexia Bank Belgium (currently Belfius) in 2002 as Deputy Head of the division. In 2004, he became Director of the Credit Risk Management division. He was appointed deputy Chief Risk Officer of Dexia Group in May 2007 – a challenging journey in view of the emerging banking and sovereign crisis of 2008 and 2011. From May 2014 until mid -January 2018, he held the position of General Auditor of Dexia Group also in charge of internal model validation and the ECB Office. Rudi joined TriFinance in 2018 to lead FI’s Risk Management & Compliance Practice. He is also Executive Director at Arvestar Asset Management since mid-2018.

About Stephen van Mello
Stephen has a Master in Commercial Sciences, a Master of Science in Financial Economics and a Master in Fiscal Law and earned several project management certifications. He performed several missions mainly in an M&A environment in both finance and risk departments of several financial institutions. He is a member of the TriFinance’s Risk Management & Compliance Practice and his main expertise domains are ALM, capital management and financial regulations.

About TriFinance’s Risk Management & Compliance Practice
The TriFinance Risk Management & Compliance practice is supporting banks and insurance undertakings in anticipating and addressing the tighter regulatory standards relating to risk management, compliance and internal control by monitoring the different European and local regulatory and supervisory bodies. Simultaneously, TriFinance can help banks in all kinds of transformation processes of the Risk Management and Compliance function to be better prepared for the rapidly evolving external environment.
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"Now that climate marches have put sustainability high on the agenda, we still observe some important discrepancies between the sustainable growth ambitions and the financial regulation."