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Sustainability Improvement Loans

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In the context of the EU Action Plan on Sustainable Finance, the European Commission plans to explore the introduction of a Green Supporting Factor (GSF) under capital requirement frameworks, which would incentivize banks to lend to ‘green’ activities.

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Key Findings

1

This working paper suggests an alternative pathway to the Green Supporting Factor that satisfies both the objective of using capital requirements for risk reduction and the objective of shifting capital towards improving sustainability outcomes.

2

Sustainability Improvement Loans (SILs) involve conditionality related to the sustainability performance of the borrower. In these instruments, the borrower receives a lower interest rate if they improve the performance on a sustainability indicator. As we shall see, these aspects of sustainability performance can reduce environment-related risks and thus credit risk, some of which can be passed on to the borrower in lower interest rates.

3

Supporting factors on SILs could reflect the lower risk of the instrument as a function of reduced environment-related risk (including climate-related risks), while supporting the scaling of these instruments and thus the shifting of capital to sustainability.

This takes capital requirement frameworks away from their risk-based origins and this move is widely contested, including by many financial supervisors.

This paper suggests an alternative pathway that satisfies both the objective of aligning capital requirements as a way to shift capital towards sustainability, while preserving their core role of supporting risk management in the financial system and avoiding the drawbacks of a GSF. The paper introduces the concept of Sustainability Improvement Loans (SILs), which could merit lower capital charges as they are lower risk. We define SILs and how they could incentivize sustainability practices and reduce risk. The potential pathway to policy application and its estimated effects on banks’ capital and profitability is then discussed, as well as the extent to which the policy is aligned with the financial stability prerogative of financial supervisors.

Independent, non-profit think tank working to align the financial sector with international climate goals.

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