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The imminent arrival of the Green Asset Ratio
Executive Education / 20 May 2022
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Professor für Finance & Accounting und Unternehmensberater
Dr. Johannes Hofinger is a Professor of Finance & Accounting at Munich Business School in the fields of Financial Management, Managerial Accounting and Bank Management. He also advises banks on risk management, sustainability and ESG, disclosure and non-financial reporting, Basel III, CRD/CRR. In his family's forestry business in the Alpine region, he deals not only theoretically but also practically with the effects of climate change and the challenges of sustainable management for future generations.

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Things are getting serious. The time for simply discussing sustainability is nearly over. As from the start of 2024, EU banks will have to produce concrete figures demonstrating the extent to which their business activities already meet sustainability criteria by applying the Green Asset Ratio (GAR). This means that, for the first time, progress towards climate neutrality will become transparent and measurable. By clearly indicating their current status, some banks will earn public praise, others public censure.

“Inventory” of sustainable business models boosts actual demand

Large, publicly traded undertakings in the EU – including banks – have been producing qualitative reports on the sustainability of their economic activities for years, as part of their non-financial reporting obligations under the NFRD[1]. Sceptical analysts have suggested that these (often very comprehensive) reports are useful purely for marketing purposes, being utterly toothless in terms of actual accountability. More generous natures have pointed out, however, that in recent years, these reports have resulted in a kind of “inventory” of sustainable business models, giving corporate sustainability a major boost.

The question of which economic activities may justifiably be regarded as sustainable, and what goals they are intended to achieve, has long hampered the intensity and quality of corporate sustainability efforts. In 2020, a legal framework was adopted in the form of the EU Taxonomy Regulation[2] which, while very technical in nature, does provide in-depth answers to this question. Or at least, to a large part of this question, in that it deals primarily with issues relating to climate change mitigation and climate change adaptation – the retrospective addition of further provisions covering other environmental objectives is expected in the course of 2022. It is also important to note that the jury is still out on the use of nuclear energy and natural gas as bridging technologies – a proposition that has proved politically controversial.

Green Asset Ratio – the definitive sustainability metric for banks

Article 8 of the EU Taxonomy Regulation requires large, publicly traded undertakings in the EU to disclose quantitative information (in the form of KPIs – Key Performance Indicators) that make it possible to assess the sustainability of their business activities. Non-financial companies measure this ratio by reference to their sustainably generated revenues and sustainable capital expenditure (CapEx), plus – where applicable – their operating expenditure (OpEx). For financial institutions, the Green Asset Ratio (GAR) was set up as a more meaningful metric[3]. This indicator defines the proportion of sustainably financed (= taxonomy-aligned) economic activities and sustainable investments as a share of total assets (“covered assets”). The Implementing Technical Standards (ITS) for disclosing ESG risks pursuant to Article 449a CRR published on 24 February 2022[4] specify additional, more extensive disclosure requirements that are intended to make the transactions and assumptions underlying the GAR – such as classification by physical/transitional risk or breakdown by sector, timeframe and Scope 3 emissions – fully transparent.

The challenge for banks: taxonomy eligibility, taxonomy alignment and GAR

But why are things now getting “serious”? It is clear that analysing the taxonomy-eligible and consequently taxonomy-aligned compliance of their business activities is already a challenge for banks. But this should not distract us from appreciating the importance of the “after the fact” consequences of publishing a GAR in terms of its impact on the financial markets. Not all GARs will please all stakeholders (including social or socio-political interest groups). We can expect to see critical scrutiny both within and outside the organisation, the consequences of which could be far-reaching. Not only will they be affected by the currently widespread “culture of outrage”; they could also result in reputational damage, potentially impacting share prices and business relationships, as well as liability issues associated with “environmentally harmful” business conduct at corporate and management level.

So how best to respond to the various challenges posed by the GAR? Although there is no obligation to publish GARs until early 2024 (for the 2023 financial year), it is important for financial institutions to deal with the anticipated features of this metric and its impacts as early as possible – starting right now.

Banks with taxonomy-relevant information have an advantage when calculating GARs

As things stand, banks are still concentrating on the collection and processing of the data required to calculate their GAR indicators. There are several IT tools on the market for applying the EU taxonomy to “economic activities”. But in practice, banks have only been able to classify a fraction of their balance-sheet assets under the taxonomy. What are known as “taxonomy-eligible” economic activities should fall within the scope of the taxonomy as a matter of course; at the same time, the institutions should also have obtained the data they need to assess their customers’ economic activities. In principle, the EU taxonomy targets large, publicly traded undertakings that are already capable of providing taxonomy-relevant information. This means that banks with a corresponding focus on such enterprise customers should have certain advantages when calculating their GARs, compared to institutions that specialise primarily in SME and/or retail finance.

After preparing the data, banks should immediately carry out GAR projections, to gain a first impression of the probable level of the ratio. This preliminary metric is essential for ongoing calibration, in that it indicates the appropriate direction for future management decisions. Bank associations also have a role to play here, by enabling intra-sectoral comparisons so that individual banks can identify and respond to their positions in bank rankings prior to the GAR publication deadlines. Not for nothing does the EBA report[5] published in June 2021 repeatedly emphasize the urgent recommendation by Germany’s financial supervisory authority that all bank employees should be given comprehensive training in ESG-related matters!

We can expect the publication of GARs to have a broader impact than solvency and liquidity ratios combined. It is more than advisable – it is vital! – for banks to devise a suitable strategy in good time, i.e. before the end of 2022. This strategy should cover both the bank’s efforts to transition to sustainable business activities, and its response to potential reputational or liability issues.

Dr Patrik Buchmüller is co-author of this blog post and lectures on the Risk Manager – Non-Financial Risks certification course at Frankfurt School. While working for Germany’s Federal Financial Supervisory Authority (BaFin), Dr Buchmüller was responsible for implementing Basel II operational risk (OpRisk) provisions in national supervisory legislation, and was a member of the Basel Committee’s OpRisk Group. He has many years of experience as a risk manager working in the public and private banking sectors. As an independent consultant, he currently works on implementation issues associated with the Minimum Requirements for Bank Risk Management (MaRisk) and the Banking Supervisory Requirements for IT (BAIT). Dr Buchmüller, who also lectures at the Worms University of Applied Sciences and Leipzig University, is the author of numerous publications on banking supervisory law, including commentaries on the relevant provisions in the German Banking Act (KWG), Act on the Recovery and Resolution of Financial Institutions (SAG) and the EU’s Capital Requirements Regulation (CRR).

References:

[1] NFRD Non-Financial Reporting Directive (Directive 2014/95/EU)

[2] EU-Taxonomy Regulation (Regulation (EU) 2020/852)

[3] Delegated Act of 6.7.2021 supplementing Art. 8 Regulation (EU) 2020/852 (EU-Taxonomy) („Disclosures Delegated Act“)

[4] EBA/ITS/2022/01.

[5] EBA Report on the Management and Supervision of ESG Risks for Credit Institutions and Investment Firms of 23. June 2021. EBA/REP/2021/18. See for instance side points 202, 214, 216 or 226.

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