Financial market regulation and transformation financing
Immense volumes of investment need to be financed for the transformation of the economy. For NRW, Fin.Connect.Kompakt No. 1 has calculated an annual sum of €80 billion for financing the climate-neutral transformation alone (Demary, 2024), the majority of which will come from the private sector. As the majority of companies are not active on the capital market but are financed by bank loans, there is very likely to be a high demand for credit from banks in the context of transformation financing. The following section calculates how large an equity gap may arise for banks as a result of financing the transformation. Such an estimate is relevant because the financing of the transformation is taking place at the same time as the implementation phase of the 2021 banking package, under which banks in the European Union will have to increase their capital anyway (European Commission, 2021).
Capital regulation in the form of the Credit Requirements Directive (CRD) came into force in 2006 with the aim of reducing the insolvency risk of banks and promoting a level playing field for banks. This regulatory package is based on the three pillars of minimum capital requirements (Pillar 1), the supervisory review process (Pillar 2) and enhanced disclosure and market discipline (Pillar 3). For corporate financing, the innovation was that banks had to assess the creditworthiness of their borrowers on the basis of a rating. A loan granted represents a risk position from the bank's perspective due to its default risk. Depending on the risk assessment, risk weights of 0 per cent to 150 per cent are assigned to the risk position. Depending on the default risk, a loan of EUR 1 million can therefore correspond to a risk position of EUR 0 or EUR 1.5 million. As the regulatory capital ratio is the ratio of liable capital to the sum of the risk positions, it plays a major role in the bank's capital management whether the granting of a loan results in EUR 0 or EUR 1.5 million in additional risk assets.
Following the insolvency of the US investment bank Lehman Brothers in September 2008, financial market regulation took the approach of making banks more crisis-proof. The CRD was revised again (CRD IV) and a Capital Requirements Regulation (CRR) was adopted. As the implementation of CRD IV took place during a phase in which banks had to recover from the global financial market crisis and the banking and sovereign debt crisis in the eurozone, there were initially fears of financing bottlenecks. However, due to the long period of low interest rates, banks were able to build up equity without the expected financing bottlenecks. During the pandemic and the subsequent energy crisis as a result of Russia's war of aggression against Ukraine, banks in Germany and the European Union proved to be extremely robust.
The implementation of this banking regulation has not yet been fully completed. The changes to the Capital Requirements Regulation (CRR III) will apply from 1 January 2025 and the changes to the Capital Requirements Directive (CRD VI) as part of the EU banking package will apply from 30 June 2026. The implementation falls into the first phase of transformation financing and can therefore lead to restrictive lending in this phase in particular. Sustainable finance, the Supply Chain Act and the taxonomy add additional dimensions to the credit assessment, which can make financing the transformation more difficult. An important question is therefore whether the banks' equity for financing the transformation could represent a bottleneck factor in the event of very strong demand for credit.
The EU banking package 2021
Institutions must currently fulfil capital requirements relating to a Common Equity Tier 1 capital ratio of 4.5 per cent of their risk-weighted assets (RWA), a Tier 1 capital ratio of 6.0 per cent of their risk-weighted assets and a total capital ratio of 8.0 per cent of their risk-weighted assets. In addition, there is a capital conservation buffer of 2.5 per cent of risk-weighted assets. In addition to these minimum capital requirements, there are also capital buffer requirements that the institutions must fulfil. These can include a domestic countercyclical capital buffer, which is set by the German Federal Financial Supervisory Authority (BaFin) and can amount to between 0 and 2.5 per cent of risk-weighted assets. This currently stands at 0.75 per cent of risk-weighted assets. Other capital buffers include the systemic risk buffer, a capital buffer for global systemically important institutions and a buffer for nationally systemically important institutions (Deutsche Bundesbank 2024; BaFin, 2024).
While the CRD and CRR reforms following the financial market crisis focussed on calculating the numerator of banks‘ risk-weighted capital ratios, i.e. the quality and quantity of banks’ capital instruments, the reforms currently being implemented focus on calculating the denominator, i.e. risk-weighted assets (RWA) (Deutsche Bundesbank, 2021). These are not identical to the bank's total assets, as not all bank assets are considered to be at risk and, unlike the calculation of total assets, these assets are not added up in an equally weighted manner, but are multiplied by different risk weights that reflect the respective default risk of the respective asset class. Two main methods have been introduced for calculating RWAs (Deutsche Bundesbank, 2024a,b):
- Under the standardised approach, regulatory risk weightings that depend on the asset class and are linked to external ratings are used to calculate the RWAs. The weighting factors for corporate loans can assume the values 20 per cent, 50 per cent, 100 per cent and 150 per cent. For companies without an external rating, the risk weighting is 100 per cent. Around 85 per cent of SMEs do not have an external rating (Deloitte, 2018). This means that the costs for an external rating could only pay off from a rating of BBB- due to lower risk premiums. The standardised approach is primarily used by smaller and medium-sized banks. For loans used to finance the transformation of companies, these institutions may have to apply risk weightings of up to 150 per cent if they expect high credit risks from the uncertain success of the transformation. In other words, banks may have to invest quite a lot of equity to finance these loans.
- Under the internal ratings-based (IRB) approach, banks are allowed to develop their own rating systems for calculating credit risk, which must be approved by their respective supervisory authorities. Banks may use either the advanced IRB approach or the foundation IRB approach. Under the advanced IRB approach, banks can use internal models to calculate the probability of default (PD), the expected loss (EL, i.e. risk position multiplied by PD), the exposure at default (EaD, i.e. the amount of the loss at the time of default) and the loss given default (LGD = EL divided by the product of PD and EaD). In the basic IRB approach, banks only use their internal models to estimate the probability of default. The IRB approaches are generally used by larger banks to determine their risk-weighted assets.
Although the standardised approach promises greater transparency and comparability, the risk allocation to classes is relatively rough. Two companies may have the same rating but at least a slightly different default risk. An internal model may be able to predict more precise probabilities of default here. Banks can then calculate the volume of their risk assets more accurately. However, banks may only use their internal models to a limited extent. Limits apply so that banks do not use their internal models to minimise their capital ratios too much.
The standardised approach is also intended for standardised risks. However, it is doubtful whether the transformation risks of companies, which result from the fact that the cost structure of companies is still uncertain once their transformation is complete, can be standardised. Banks that use internal models may well be able to determine transformation risks more precisely than banks that use the standardised approach.
The 2021 banking package sets limits on the use of internal models in the form of input floors and the output floor (Deutsche Bundesbank, 2018):
- The input floors define a lower limit for the default probability of a loan and a lower limit for the expected loss of a bank in the event of actual loan defaults. If these two parameters are calculated using historical data, both the probability of default and the loss given default are zero for a company that has not yet defaulted on a loan during this period. However, this does not necessarily mean that the two parameters will also have a value of zero in the future. The input floors prevent this corner solution.
- The output floor limits the use of internal models to calculate the RWAs. The benchmark for the output floor is the calculation of RWAs using the standardised approach. For banks that use internal models to calculate risk-weighted assets instead of the standardised approach, the sum of risk-weighted assets is lower when using internal models than when using the standardised approach, provided they grant loans to borrowers with a low default risk. The output floor restricts their ability to reduce their risk-weighted assets too much using internal models by setting a lower limit of 72.5 per cent of the value under the standardised approach.
The implementation of the output floor increases the capital requirements for banks that predominantly grant loans to borrowers with a lower credit risk. This will primarily affect loans to companies without an external rating that have more than 250 employees and for which the SME support factor is therefore not applicable. In Germany, these are a large proportion of mid-cap companies. For companies without an external credit rating that are classified by banks as low-risk using internal models, the risk weights calculated under the IRB approach are significantly lower than the 100 per cent required under the standardised approach. Consequently, the need to adjust the risk weights upwards will be greater for loans to these companies. This means that the output floor will be relevant for a significant proportion of the IRBA banks' corporate loan portfolios (Demary/Taft, 2024).
At the beginning of 2025, the output floor will be 50 per cent and will continue to rise in the following years. From 2030, it will then reach 72.5 per cent. This means that the first phase of the transformation and its financing will fall into a phase of increasing capital regulation by banks. Lending can then become very restrictive for SMEs and mid-cap companies because the majority of them do not have an external rating. A risk calculation without an external rating would use a risk weighting of 100 per cent, which would lead to very high capital requirements for SME loans. In contrast to the increase in equity capital through the implementation of CRD IV and CRR, the current increase in equity capital is not taking place in an environment of low interest rates and a long economic upswing.
Equity requirements due to transformation financing
The following calculations are intended to show how the transformation path assumed for NRW in Fin.Connect.Kompakt No. 1 (Demary, 2024) affects the banks' regulatory capital ratios and what capital gap would arise if the banks wanted to keep the capital ratio constant along the transformation path. In Fin.Connect.Kompakt No. 1, an investment requirement of around EUR 80 billion per year was calculated for NRW for the years 2024 to 2045 just to achieve climate neutrality. Based on emission shares from the European Commission's EDGAR database, the investments could be broken down into €19 billion per year for industrial plants, €17 billion for the transport sector, €15 billion for buildings and €29 billion for the energy sector.
Sources such as the extrapolated annual financial statements from the statistics of the Deutsche Bundesbank can be used to determine the debt financing shares of the required financing for investments in climate neutrality. These can then be broken down into the individual years and allocated to the banks' risk assets. Assuming an average term of seven years for the transformation loans, the banks' core capital ratio would fall from 16.2 per cent of risk-weighted assets to 12.1 per cent in 2031 along the assumed transformation path of the study. Alternatively, a constant core capital ratio of 16.2 per cent along the transformation path would result in an equity gap of EUR 33.1 billion, which the banks would have to build up, e.g. by retaining profits, in order to be able to finance the transformation along this path. By 2045, the assumed repayment would result in an equity gap of €82.2 billion. The equity gap varies depending on the assumed transformation path and risk weighting, which depends on the creditworthiness of the companies and the risk content of their transformation. Loans to companies without external credit ratings would be included in the calculation of risk-weighted assets with a risk weighting of 100 per cent. In the EU, this is 80 per cent of companies (BDI, 2022). A maximum risk weight of 150 per cent could be used (Table 1).
The forecast capital shortfalls will arise during a phase in which the banks have to implement the output floor. The implementation of the banking package is expected to increase the banks' equity by 5 to 10 per cent (Institutional Money, 2021). The expected capital shortfall for NRW banks would then be between EUR 4.8 and 9.6 billion. It is true that not all companies from NRW also finance themselves with banks from NRW. However, banks with a regional focus, such as the savings banks and credit cooperatives, cover 60 per cent of corporate lending (Demary/Taft, 2023). This hypothetical equity gap can therefore serve as a benchmark. This capital gap would be added to the capital requirement calculated above as a result of the banking package. According to the Deutsche Bundesbank, four banks from NRW are among those using the IRB approach (Deutsche Bundesbank, 2024c). This means that companies in NRW could also be affected by restrictive lending in the first phase of the transformation.
What options do banks have?
One way in which banks can finance the transformation and relieve the pressure on their equity is by securitising small-volume corporate loans, particularly loans to small and medium-sized enterprises. Around 60 per cent of the volume of corporate loans were granted by many small banks (Demary/Taft, 2023). These are banks with an average loan volume of less than one billion euros. These many small loans are suitable for securitisation transactions due to their granularity and could be outsourced by the banks through securitisation. The loans can then be bundled on a securitisation platform that issues bonds and sells them to capital market investors (TSI, 2023). With PROMISE and PROVIDE, such platforms existed in the past and could be used as a model for the establishment of one or more platforms in NRW. The use of platforms for securitisation offers smaller banks the opportunity to reduce transaction costs by standardising processes.
The loans used for the securitisation transactions should not consist of loans that the banks would not have granted without the securitisation. This would expose the capital market to risks that would not have arisen without the securitisation. One lesson learnt from the global financial market crisis of 2008 and 2009 is that this can only be achieved if banks keep a deductible on their books. The European Union's framework for simple, transparent and standardised (STS) securitisation can help to ensure that securitisation promotes transformation financing without outsourcing too much risk to the capital market (Council of the European Union, 2020). The underlying loans for an STS securitisation should be homogeneous. This can be challenging, particularly in view of the different transformation requirements for the various sectors. It becomes more difficult if the borrower's transformation consists of disruptive innovations that lead to a completely new business model. In the case of a transformation strategy with incremental innovations through innovations that have already been tested on the market (e.g. electric drive or heat pump), however, the credit default risk from the banks' perspective is in the assessable range. To prevent excessive and non-transparent risks from entering the capital market, the loans that are considered for securitisation should only finance incremental and not disruptive innovations.
In addition to securitisation, guarantee instruments, such as indemnities, offer an opportunity to reduce default risks for banks. Guarantee instruments are useful if the borrower is unable to offer any or sufficient loan collateral. This may be the case if decarbonisation or climate change causes loan collateral to depreciate because it is too CO2-intensive or is exposed to particular climate risks (stranded assets).
What should borrowers be aware of?
Borrowers must develop a transformation strategy for their company in good time. This must be suitable in order to be able to produce in line with the new regulatory requirements, i.e. taxonomy-compliant. At the same time, sales from taxonomy-compliant products must be stable and production costs must not be too high, as customers' willingness to pay for taxonomy-compliant products may only allow for limited price increases. In addition to achieving climate neutrality, the transformation strategy should also include measures to increase productivity so that the credit rating does not deteriorate during the transformation process and follow-up financing is jeopardised.
Even if it involves a great deal of bureaucracy for companies to collect all the data on their own sustainability and disclose it to banks and customers, such signalling can be worthwhile for borrowers. Companies in the transformation process should therefore also establish a data management system, as this can serve to signal their own sustainability.
Companies must also bear in mind that, as described above, banks only have a limited amount of equity available and must first release equity in order to grant new loans. It can therefore be beneficial to start the transformation as soon as possible, before the majority of companies submit loan applications and the high demand for credit is met with a limited supply of credit.
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