Many commercial banks worldwide have recently expressed their commitment to curbing "financed emissions." This trend is evident in the substantial growth of the Net-Zero Banking Alliance (NZBA) membership, which surged from 43 to 122 banks in 2022, according to a recent
McKinsey report. As part of their dedication to the NZBA's objectives, several banks have taken significant steps to provide sustainability-linked loans (SLL) with reduced interest rates to businesses that align their activities with emission reduction efforts. SLL has been growing tremendously in recent years (see figure below).
SLL in Singapore
Singapore has positioned itself as a regional hub for green finance. This has resulted in sustainable loans gaining prominence, with the share of Sustainability-Linked Loans (SLL) rising more the more conventional Green Loans.
In contrast to Green Loans which fund environmental or climate-related initiatives, SLLs open the door for borrowers outside the conventional green sectors to secure funding. A notable aspect of SLLs in Singapore is that a segment of the interest rate is contingent upon the borrower's ability to attain sustainability performance targets (SPTs). These targets typically encompass a range of environmental, social, and governance (ESG) metrics, such as reductions in greenhouse gas emissions or the adoption of renewable energy.
The emission reduction goal
Using simulation exercises, our study finds that the cheaper financing option through SLL nudges corporates to purchase more clean capital. With cheaper clean capital inputs, firms substitute towards clean modes of production. This aids in emission reduction.
We also find that SLL can dampen transition risk when the economy faces a permanent increase in carbon tax with smoother capital reallocation between clean and dirty sectors.
Why are banks interested in SLL?
In the context of rising SLL, the question arises on the precise motive behind banks positioning themselves as champions of environmental sustainability. As financial intermediaries, banks rely on interest earnings generated from lending. While adopting sustainability mandates on loans may offer reputational advantages, providing preferential interest rates for SLL may seem incompatible with their core objective of maximising profits.
Bank profit margin rises with SLL
According to our research, offering favourable lending rates through SLL stimulates corporate demand for acquiring clean capital inputs. This results in an overall increase in aggregate loans which would more than compensate for the lower interest rates. This subsequently boosts the bank's profit margin, aligning with its primary goal of profit maximisation. However, this expansion in lending also introduces uncertainties in the financial sector, raising concerns that can negatively impact households' welfare. Such an outcome may not be desirable for central banks, especially in times of financial instability or high inflation.
Financial sector uncertainty and social welfare with SLL
SLL issuance is a double-edged sword. On the one hand, these preferential lending terms contribute to emission reduction and bolster banks' profit margins. However, it is essential to note that social welfare improvement with SLL is very small.
Our study finds the expansion in lending triggered by the introduction of SLL generates concerns among households regarding the financial sector's stability. The heightened volatility in bank lending leads to instability in aggregate deposits as banks create deposits to fund loans. Households prefer stable deposit patterns since their welfare is closely linked to deposit money balances. As a result, SLL issuance only yields a marginal improvement in social welfare, largely due to the positive externality from emission drop associated with SLL.
SLLs serve as intuitive instruments to steer businesses towards more environmentally friendly production practices, given that banks typically serve as the primary source of funding. However, as societal consciousness regarding the significance of transitioning to sustainable practices grows, banks and regulators would need to assess the costs and benefits of preferential lending rates through SLL.
Read the full study here.