Key questions on subordinated bonds could remain unanswered – Fitch
Key questions on how green subordinated bonds issued by banks will be treated in a stress scenario could remain unanswered until there are real-life case studies, Fitch Ratings says.
Banks use the proceeds of green bonds to invest in sustainable assets but regulators could, in a stress scenario, force the bonds to absorb losses and write-downs on all assets, including non-green assets. This raises questions about the feasibility of ring-fencing sustainable asset and liabilities, and the potential clash between sustainability objectives and prudential regulation of banks.
On 7 July 2020, Spain’s BBVA (BBB+/Stable) issued a EUR1 billion green hybrid bond which qualifies as additional Tier 1 (AT1) for prudential regulatory capital purposes. On 15 July, Dutch bank De Volksbank (A-/Negative) issued a EUR500 million subordinated Tier 2 green Bond. Both instruments can be used to absorb losses through write-down or conversion to equity if regulators consider that the bank is failing or likely to fail. Proceeds from the bonds will be used to fund eligible green assets to support the banks’ sustainability goals, although the bond covenants do not give precise details.
BBVA’s sustainable development bond framework supports its commitments to meet Paris Agreement targets and the United Nations Sustainable Development Goals, through projects encompassing well-being, education, affordable energy and industry innovation. De Volksbank’s target is a 45% climate-neutral balance sheet by end-2020, increasing to 100% by 2030. It aims to achieve this by supporting the financing and refinancing of assets such as energy-efficient residential buildings, as defined in its green bond framework.
Tracking the usage of green bond proceeds is already difficult given the fungible nature of cash and the loose labelling that many banks use to reference sustainable and green projects. The structure of green AT1 adds complexity as there is no regulation or market precedent (beyond creditor hierarchy) for how the use of proceeds would be tracked if the instrument is required to absorb losses. Progress with the EU Green Bond Standard, including the EU taxonomy for sustainable activities passed in June 2020, is helping to define which projects and assets can be financed by sustainable instruments. But the standard is less clear on technical considerations for complex green instruments beyond senior unsecured bonds.
The evolving policy landscape could lead to new classes of sustainable finance instruments, beyond those entirely defined by the use of proceeds. Policymakers are considering whether a preferential capital regime can be justified for green financing to reflect the physical and transition risks from moving to a lower-carbon economy. The focus has been on the risk-weighting of assets. Regulatory capital eligibility criteria remain indifferent to green considerations and it is unclear whether policymakers will consider creating a new class of green regulatory capital’to support the financing of sustainable assets. Factoring green elements into regulatory capital eligibility would only make sense if taxonomy and classification were clear and consistent globally, which is not currently the case. This highlights the potential clash between banks’ sustainability objectives and the prudential capital regulations they operate under.
There are no mechanisms in bank liquidation or resolution procedures allowing the ring-fencing of assets, green or otherwise, to be carved out and protected, other than those specifically segregated and pledged as collateral. Ring-fencing green assets and liabilities from their non-green counterparts would firm up the green credentials of subordinated instruments and could significantly increase green asset expansion due to the inherent leverage of green regulatory capital instruments. However, it would also weaken banks’ capital resilience because ring-fencing limits the ability of stronger parts of a banking group to support weaker parts.