Increasing regulation must not restrict banks’ ability to finance the carbon neutral transition

The financial crisis triggered a tidal wave of financial sector regulation that is showing no sign of stopping. This regulation has aimed to improve banks’ resilience, liquidity and stable funding and curb over-indebtedness. Requirements for the quantity and quality of banks’ own funds, for example, have grown stricter.

As a result of the new requirements, the European banking sector’s resilience has improved markedly. A testament to this are the supervisory stress test results from recent years and the sector’s good operational capability throughout the Covid-19 pandemic (see e.g. the Finnish Financial Supervisory Authority’s press release from 28 July 2023).

Although the crisis is over, the amount and specificity of banking regulation has continued to grow.

A case in point is the regulation on sustainable finance, which no longer focuses on improving bank resilience but on promoting sustainable economic growth.

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Regulation on financing the carbon neutral transition
must not restrict banks’ ability to finance companies that
are still in the process of making their transition.
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A successful green transition to carbon neutrality cannot take place without the private sector. With the new regulation, the EU aims to accelerate sustainable finance. A key goal of the European Commission’s sustainable finance strategy is to strengthen banks’ resilience to environmental, social and governance (ESG) risks.

The EU has also created green investment rules with the aim of directing the flow of money into investments that are sustainable for the climate and environment.

A much-debated aspect of green finance is transition finance. Transition finance refers to financing that banks offer to companies for decarbonising their operations and products.

The transition plans of banks and their client companies play a key role in the carbon neutral transition. They allow banks to identify and track their clients’ transition towards a more sustainable economy and make it easier to identify risks and different financing options.

It is vital that the rules for the carbon neutral transition do not restrict banks’ ability to finance companies that are still in the process of making their transition. These companies are abundant.

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As legislation becomes increasingly detailed,
thorough law-making and extensive impact assessments
become more and more important.
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The European Central Bank (ECB) directly supervises the largest banks in Europe and has issued a guide on climate-related and environmental risks that sets out supervisory expectations relating to risk management and disclosure. The ECB expects banks to incorporate climate-related and environmental risks as drivers of existing risk categories into their risk management framework, with a view to managing, monitoring and mitigating these over a long-term horizon. The ECB also expects banks to identify and quantify these risks within their overall process of ensuring capital adequacy and to review their arrangements on a regular basis.

Banks must take climate-related and environmental factors into account in their credit risk management at all stages of the credit granting process. They must also monitor the risk development of their credit portfolios. This viewpoint was included in the European Banking Authority’s (EBA) public consultation on the draft guidelines on the management of ESG risks (see the EBA’s press release from 18 January 2024).

The ECB guide’s supervisory expectations and the EBA’s draft guidelines reinforce the view that there is a need for transition finance. A controlled transition is possible as long as risks are identified and monitored appropriately. This approach makes it possible for companies to develop their operations in a way that allows the achievement of Finland’s and the EU’s goals of carbon neutrality in the long term.

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The Finnish financial sector considers it important that
regulation treats sustainability risks in a way that reliably reflects
the financial risks borne by the credit institution.
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As legislation becomes increasingly detailed, thorough law-making and extensive impact assessments become more and more important. Legislative work has been extremely busy in recent years, which has led to solutions whose impacts have not been thought through.

In financing the carbon neutral transition, transition risks play a key role.

Transition risks refer to financial losses that result to credit institutions from the transition towards a low-carbon and environmentally sustainable economy. These losses can be direct or indirect and stem from climate-related and environmental policy decisions, technological advances or changes in market confidence or market behaviour.

When creating new regulation in the future, it is important to ensure that the new requirements aim not only to improve banks’ resilience but also to finance economic growth and promote a carbon-neutral economy while taking into account Finland’s national specificities.

Moreover, the new requirements must be established and implemented responsibly based on an overall assessment, and enough time must be reserved for stakeholder consultations.

The Finnish financial sector considers it important that regulation treats sustainability risks in a way that reliably reflects the financial risks borne by the credit institution.

In order to effectively target financing and prevent bottlenecks, dialogue between legislators, supervisors and supervised institutions is of utmost importance. As the ECB’s report Risks from misalignment of banks’ financing with the EU climate objectives published in January shows, a lot of work remains to be done.

Regulation must not stifle banks’ ability to promote companies in their transition away from pollutant activity and towards more sustainable solutions. Instead, it must support and improve banks’ ability to finance the carbon neutral transition.