{"id":35852,"date":"2023-09-01T10:00:00","date_gmt":"2023-09-01T08:00:00","guid":{"rendered":"https:\/\/frankfurt-main-finance.com\/?p=35852"},"modified":"2023-08-30T15:17:57","modified_gmt":"2023-08-30T13:17:57","slug":"risks-in-loan-pricing","status":"publish","type":"post","link":"https:\/\/frankfurt-main-finance.com\/en\/risks-in-loan-pricing\/","title":{"rendered":"Climate-related and environmental risks in loan pricing"},"content":{"rendered":"\t\t
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European banks need to integrate climate-related and environmental (C&E) factors into their loan pricing by the end of 2023,and to meet all the European Central Bank\u2019s (ECB) C&E expectations by the end of 2024. This requires a whole-bank, top to bottom transformation. Specifically, the ECB expects banks\u2019 loan pricing frameworks to reflect their credit risk appetite and business strategy for C&E risks, and for loan pricing components to be C&E sensitive.\u00a0<\/p>

Time therefore is short, and many European banks still have a long way to go. In the first half of 2022, more than 40 percent of Significant Institutions (SIs) and Less Significant Institutions (LSIs) still had taken no action to implement C&E risks into loan pricing (see Figure 1). A recent KPMG survey on ESG risk in May 2023 shows that while further banks are envisioning to work on this topic, some do not have any plans in place yet.<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t

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Figure 1 - Level of maturity of C&E in loan pricing\n<\/h3>\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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Note: The figure shows the level of maturity of banks\u2019 of integrating C&E aspects in loan pricing, covering 107 significant banks under the direct supervision of the ECB and 79 less significant banks supervised by their national authorities.<\/figcaption>\n\t\t\t\t\t\t\t\t\t\t<\/figure>\n\t\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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The new requirements for integrating C&E in loan pricing are drawn from the EBA\u2019s Guidelines on loan origination and monitoring and the EBA report on the management and supervision of ESG risks. The ECB also identifies C&E risks as a key supervisory priority. This is in line with the EU\u2019s policy focus on its Fit-for-55 green finance package, which aims to reduce EU emissions substantially by 2030, while being mindful of the resilience and capacity of the financial system required to achieve this goal, as \u2018green\u2019 does not necessarily mean less risk. Investment, including C&E-sensitive lending, will play a crucial role in achieving this goal.<\/p>

So, what do banks need to do?
Loan pricing framework and banking strategy<\/h3>

Banks\u2019 business strategy and risk strategy need to be updated in line with banks\u2019 C&E vision (e.g., each bank\u2019s targets on reducing financed emissions and increasing green finance) that reflects banks\u2019 impact and risk-driven motivations. These C&E-related updates need to then be integrated in loan pricing frameworks. In fact, C&E-risk-sensitive differentiation in loan pricing is a tool that banks can use to operationalise their C&E vision – and align their portfolio composition accordingly (see Figure 2). The challenge for banks is to commensurately reflect this impact and risk-driven motivations in loan pricing frameworks, since adopting solely an impact-based malus\/bonus approach may be dangerous from a risk point of view.<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t

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Figure 2 \u2013 Reflecting C&E strategic choices in banks\u2019 operations\n<\/h3>\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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Note: Banks have various tools to operationalise the integration of C&E considerations outlined in their business strategy and risk strategy. C&E-differentiated loan pricing is one of these tools.<\/figcaption>\n\t\t\t\t\t\t\t\t\t\t<\/figure>\n\t\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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With that in mind, it\u2019s also essential for banks to consider their competitive environment. Business units have discretion to alter the margin component of loan pricing in response to market conditions. To remain competitive, some business units are offering financing to ‘green’ borrowers or specific ‘green’ assets at a discount. Some may also charge a premium to \u2018brown\u2019 companies or when financing \u2018brown\u2019 assets.\u00a0<\/p>

However, in the process of growing their green market share or reducing their financed emissions, C&E differential pricing \u2013 if not done properly – could lead banks to take on excessive through-the-cycle risks, or ceding market share to competitors still willing to finance companies making a slow (or no) transition from \u2018brown\u2019 to \u2018green\u2019. Therefore, it is essential to get loan pricing right \u2013 allowing banks to build market share without compromising their long-term profitability.<\/p>

Finally, the interest rate environment<\/b> needs to be considered. In recent years, low interest rates and fierce competition left banks with little room for price differentiation, but the current higher interest rate gives more scope for banks to adjust their loan pricing \u2013 presenting an opportunity not seen in a decade.\u00a0<\/p>

Loan pricing components\u00a0<\/h3>

To explore how to reflect the different cost impacts of C&E risks into loan pricing as expected by the ECB, it is important to look closely at the margin and costs components of the interest rate of a bank loan (see schematic illustration in the Figure 3). Each component poses its own challenges when it comes to integrating C&E factors.<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t

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Figure 3 \u2013 Loan pricing components (simplified)\n<\/h3>\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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Note: Simplified, client\u2019s interest rate includes Margin and Costs components, whereas Costs can be further differentiated between Credit risk costs, Capital costs, Funding costs and other (e.g. administrative) costs.<\/figcaption>\n\t\t\t\t\t\t\t\t\t\t<\/figure>\n\t\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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Profit margin<\/b> is the component which most institutions with differentiated loan pricing frameworks focus on, by providing tailored pricing for green loans (which ring-fence loan proceeds for environmental objectives) or sustainability-linked loans (which typically offer reduced interest charges to borrowers that achieve specified sustainability-related or transition-related targets) (see Figure 4). Also, the offering of products such as sustainability-linked loans may reflect lower funding costs that result from a funding advantage passed through to green assets linked to a green funding source.<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t

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Figure 4 \u2013 Illustration of a sustainability-linked loan pricing mechanism\n<\/h3>\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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Note: The figure illustrates the mechanism of a sustainability-linked loan with a client receiving a more beneficial loan interest rate when achieving predefined green targets (e.g., GHG emissions reduction rate is above predefined threshold). When the green target is not achieved, the interest rate returns to the basic level.<\/figcaption>\n\t\t\t\t\t\t\t\t\t\t<\/figure>\n\t\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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Funding costs<\/b> need to reflect the cost of liabilities, such as deposits, issued stocks and bonds, and interbank borrowing. Banks\u2019 Funds Transfer Pricing (FTP) frameworks typically quantify funding costs based on estimates of liquidity risk and interest rate risk. However, as banks make greater use of green deposits and sustainability-linked liabilities to fund green and sustainability-linked loans, FTP frameworks will need amending to introduce new \u2018green pricing curves\u2019 that reflect the benefit of funding green asset with green liabilities (see Figure 5). This shall lead to a reduction in the funding cost component in the loan pricing (see Figure 3).<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t

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Figure 5 \u2013 Illustration of FTP pricing curve<\/h3>\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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Note: Banks may introduce new green pricing curves, that, in terms of spread levels, may tend more towards existing unsecured or secured curves. Source: KPMG International, 2023<\/figcaption>\n\t\t\t\t\t\t\t\t\t\t<\/figure>\n\t\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t
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Credit and capital costs need to reflect a range of novel C&E risks. Banks use various performance metrics in loan pricing, such as return on equity (ROE), risk adjusted return on equity (RAROE) and risk adjusted return on risk adjusted capital (RARORAC). These metrics typically incorporate credit risk and capital-related elements, such as:<\/p>\n