Banking regulation: capital adequacy rules blocking billions needed for transition

Private enterprises will have to invest many billions in the climate-neutral transition of the economy by 2045. And yet, a study by researchers at the German Economic Institute (IW) warns: The capital adequacy limits imposed on banks put the financing at risk.

Based on the rules in place at present, to secure the additional credit needed for the climate-neutral transition of the economy, European banks would have to build up additional capital totalling EUR 867 billion by 2045. This is equivalent to an increase of around 44%, according to an IW study commissioned by the Association of German Pfandbrief Banks (vdp). The study points out that if equity capital were to remain at the present level, the capital ratio of 19.3% in 2024 would drop to 13.5% in 2045.

Enormous investments needed in the building sector

The context here are the enormous investment amounts that will be required in the coming years. The IW estimates amounts of around EUR 819 billion per year for industry, transport and energy. In the building sector alone, additional investments will be needed of EUR 435 billion per year until 2045, for instance for energy-efficient renovations and new housing construction. The greater part of this will be financed through loans. The banks would then have to increase their risk-weighted assets in this area alone by EUR 214 billion per year.

Banking regulation is exacerbating the situation further. The implementation of the European banking package will make additional capital necessary of between EUR 129 billion and EUR 135 billion. These additional requirements are supposed to strengthen the resilience of the financial system. However, policymakers and supervisors themselves acknowledge that the European banks are today already stable.

EU must find the right balance

“The EU faces a balancing act,” Markus Demary, a financial market expert at the IW, commented with regard to the findings. He went on to say that, basically, the stringent capital adequacy rules proved their worth during the crises of past years, and that the banks are well capitalised. “If the decarbonization of the economy is not to fail, reforms are nevertheless necessary,” Demary remarked. Borrowers are already turning increasingly to alternative finance providers in the non-banking sector. These providers are less well regulated, which heightens the risk to financial stability. Possible measures might be, for example, to review individual capital buffers, to dispense with stricter elements of the Basel III implementation or to cut red tape in sustainability regulation.