How Do Global Banks Respond to Changes in Climate Policy?

A central objective of climate policy is the reduction of carbon emissions, either by promoting renewable energies and increasing energy efficiency across sectors, or by imposing restrictions on activities contributing to greenhouse gas (GHG) emissions. The financial sector is expected to play a major role in the effectiveness of climate mitigation strategies. By adjusting their lending in response to climate policy, banks—the largest source of external finance for most firms—might direct capital away from high-carbon and into low-carbon activities, fostering the transition by supporting green investments. However, whether banks will act as catalysts of climate policy is not obvious. Consider global banks; to the extent that strategies addressing climate change are mostly designed and executed at the national level, some banks might reallocate their portfolio away from countries implementing more stringent climate rules and into less stringent jurisdictions, engaging in regulatory arbitrage. Alternatively, public sector initiatives that support technological innovation and GHG reduction might create profitable business opportunities, therefore attracting capital toward green projects.

So, do banks help or hinder the implementation of climate policies? In a new CGD working paper published today, we address this question by examining how foreign subsidiaries of global banks adjust their credit following changes in host-country climate policies. We use a sample of 120 global banks that operate in 58 countries, where we can assess the strength of climate policies.  This information is based on a Climate Policy Measure (CPM), which is an annual survey among energy policy experts within the countries that are evaluated rating the climate-related measures of their governments. Rather than actual outcomes which may take time to materialize, using CPM allows us to capture experts’ perception of new policies which shows considerable variation even within countries and over time.  We also take into account differences across global banks in terms of their commitment to climate policies based on emission, innovation, and resource use according to their own corporate records.

We find that global banks with high environmental performance significantly increase their lending in countries after local authorities strengthen their climate-related actions. Through their foreign subsidiaries, these banks expand their credit by 4.6 percentage points following an increase in one-standard deviation of the host country climate policy measure.  The bank’s own commitment to climate policies matters:  The lending portfolio of the average bank still increases after authorities in the host country strengthen their climate-related actions, but this increase is marginal. This is because the average effect masks important differences among banks.  Banks with high environmental performance react much more strongly to climate action by authorities.

Hence, the response to policy measures is largely driven by the “green profile” of banks.  It is the subsidiaries of foreign banks with high environmental standards that increase their credit following the implementation of climate-related actions in host countries.  In addition to lending, and consistent with this finding, these banks also increase their overall presence in the country so that total bank employment at that location increases. Importantly, we do not find any evidence that global banks with low environmental scores exit countries implementing climate policies. That is, there is no evidence that their total credit shrinks in their host countries nor that the banks reduce their labor force in those locations. Similarly, domestic banks, regardless of their environmental score are mostly irresponsive to climate actions by local authorities. In summary, our findings suggest that after the implementation of climate policy, foreign banks with preferences towards green assets tend to increase their lending in that country, leading to a net increase in foreign capital whereas ‘brown’ banks, those with low environmental scores, are mostly irresponsive to the host country climate policy.

Our research has important policy implications. Our results highlight a selection mechanism whereby government commitments to address climate change also attract foreign banks with strong preferences for green assets, rather than spur capital flight. Therefore, climate policies appear to be a win-win strategy for policymakers, improving the environment by directly addressing carbon emission reduction and also by attracting foreign finance to support green policies.