This article is one in a series of thought leadership pieces written for Responsible Investor by members of the European Commission’s High Level Expert Group on Sustainable Finance. To see other HLEG coverage, see here, or to comment, visit our discussion page.
The aim of establishing the Hight Level Expert Group on sustainable finance by the European Commission was to put into practice the UN Sustainable Development Goals, the Paris Climate Agreement and the EU’s 2030 Agenda for Sustainable Development.
As a starting point, it is worth noting that the level of investment in EU countries is significantly lower than in the years before the financial crisis in 2007. This, at least in theory, should provide an opportunity – and some kind of room for manoeuvre – to include new targets for funding of sustainable development. However, we do not observe this taking place. To the contrary, the status quo understanding is that there has been no significant increase in the share of environmental and social management in new investments. As, a result of some tactics in the construction of balance sheets – interpreted as a consequence of constraints from capital and liquidity regulations – the average asset retention period has been considerably shortened. Merely this one fact may explain the lack of interest of banks – the main financing providers in Europe (they provide 80% of the financing of the economy) – in sustainable and infrastructure investments, which usually require long-term commitment.
One of the biggest anti-stimulus of ESG financing by European banks is the rigorous risk-weighting system based on Basel III
Thus, there is a need for in-depth analysis and reassessment of banking supervisory regulations in the EU. One of the biggest anti-stimulus of ESG financing by European banks is the rigorous risk-weighting system based in principle on Basel III regulation. Under these conditions, increasing banks’ participation in sustainable development financing can be truly difficult and slow moving. What is necessary to achieve this is to integrate sustainable development targets within both financial and investment objectives, which are primarily pursued by the private sector.
We are talking here about instruments at the level of the so-called ‘second pillar’ in regulatory provisions, which is at the disposal of national supervisors: introducing or reducing buffers and capital gains. Such an approach does not dismantle the precise Pillar I structure (CRDIV and CRR) – designed to neutralise the worst effects of banks exceeding safe levels of risk and transferring them to Member States budgets. Transferring this to local supervisors better aligns some regulation with the level of actual risk in a particular credit institution in a given Member State; and these can vary considerably in this respect.The only exception to those not-very-flexible rules (i.e. Pillar I of supervisory regulations), may be the use of a supporting factor for the assets preferred for sustainable development. Such a solution was applied to financing for small- and medium-sized enterprises, where banks could apply a 25% risk weight reduction to assets that meet a certain criterion. It is worth taking into consideration the application of a parallel solution as an incentive to boost sustainable development financing.
Another issue is the strengthening of fiduciary duty for those who invest in deposited funds or savings. An adjustment or extension of protection guidelines should be implemented here. Important EU regulations, such as AIMFD, pension insurance regulations, MiFID II, CRD V, wage regulations and others, covering not only banks but more broadly also other financial sectors, should more strongly emphasize the trustee’s liability, based on responsible buyer principles, highest diligence and best practices, with a clear inclusion of ESG factors. The disclosure of important non-financial disclosures is strongly linked.
Disclosure of information in accordance with relevant standards and principles is a basis for assessing the compliance of a bank’s credit policy with its declared objectives. This is a form of social control in those areas where the precise measurement by supervisors or formal audit rules are insufficient or incomplete. One of the examples of development of this process is the 2014 EU Directive on reporting non-financial information and the Bloomberg Report for the Basel Committee on Financial Stability.
Many of the above-described activities are aimed at creating clear conditions and principles for the pursuit of goals of a different nature than before, engaging with precisely-regulated sectors such as banks. But the use of overly general concepts such as “sustainable development” and “ESG” is far from sufficient: a new toolbox is necessary in this case, and it should be extensive. These processes are taking place – new definitions are set, such as “green bonds”, and standards for “green” covered bonds and their securitisation. On the basis of those, new appropriate and quantified measures and reference levels shall be developed. The practice of benchmark-use is essential here.
Moreover, there is a need to adjust Accounting Standards and International Financial Reporting Standards (IFRS). The main direction of changes in the extensive catalogue of accounting standards and IFRS is to adapt them to take into account long-term sustainability factors. This includes, inter alia, the development of capital standards for long-term investments and the addition to the basic valuation methodology of fair value based assets with a total value approach that is more friendly to long-term investors.
Dr Mieczysław Groszek is a member of HLEG and the former Executive Vice President of the Polish Bank Association.
Piotr Gałązka is a barrister, EU affairs expert and Director of the Representation Office of the Polish Bank Association in Brussels.
To give feedback on the group’s interim report, published in July, see here.