Green banking as a tool to reduce risk, boost returns and align engagement
July 2025 | SPECIAL REPORT: FINANCIAL SERVICES
Financier Worldwide Magazine
July 2025 Issue
Green banking faces a fork in the road between influence and irrelevance at a time when environmental and geopolitical risks are rising and economic and policy uncertainty is spreading.
To some, green banking may appear either ineffective or inappropriate. To others, it is smart business, morally imperative, or both.
An analytical focus is often placed on the impacts (positive or negative) of financing certain types of technologies or sectors, whether banks can (or should) be agents of environmental and social responsibility, and the linkage (if any) between credit risk and global risk.
Banks may be ill-equipped to compensate for what is essentially a market and regulatory failure of governments to address climate change. The impetus for systemic change – whether in the financial system exposed to climate risks, in the economic system that rewards environmentally-detrimental behaviour, or in the way that natural systems and planetary boundaries are challenged by the physical impacts of human activity – relies on rules and incentives on a national and even global scale, not on the terms of individual banking transactions or private capital markets.
A better approach would be to ask precisely what problem green banking is expected to solve, and what types of risks it is capable of ameliorating. By taking a risk-based approach, bank policies and behaviours can be targeted to achieve beneficial impact in ways that result in a more efficient allocation of capital.
In the process, as a bonus, banks may create more aligned engagement with commercial borrowers and other customers of financial services, gaining deeper insight and potential influence on the longer-term direction of their customers’ businesses and markets.
Importantly, banks serve as trusted financial intermediaries in a system that is premised on the drive to optimise risk-adjusted returns on capital. One way to achieve that end is to boost profits. The other way is to reduce risk, specifically credit risk: default risk in individual transactions and performance of wider portfolios and pools of loans and other assets.
Assuming consistent margins and prudent risk management, scale boosts total returns and creates opportunities to spread risk and to more creatively manage it. On the downside, scale can also create administrative bloat, hinder nimbleness, and mask risk and potential liabilities.
Most green banking policies, at least initially, are not designed primarily to reduce credit risk. It is worth exploring whether that might be a realistic goal and the actual effect of bank policies that deemphasise lending to legacy, highly polluting industries (like coal, oil and gas) in favour of more lending to rapidly growing, cleaner industries (like renewable energy).
In a 2024 Working Paper on ‘The Economics of Net Zero Banking’ for the National Bureau of Economic Research, Adair Morse, a professor at the University of California, Berkeley, and Parinitha Sastry, an assistant professor at Columbia University, highlighted three possible outcomes, outlined below, that explain why banks may find it more profitable to engage in net zero lending policies.
First, long-term default risks improve by avoiding loans to carbon-intensive industries that face regulatory and market headwinds as decarbonisation and the energy transition accelerate over time.
Second, the huge appetite for debt financing for investments in innovative, less carbon-intensive or clean energy technologies creates significant growth opportunities for lenders and the chance to boost profits accordingly.
And third, adjusting loan portfolios in anticipation of regulatory changes intended to mitigate climate risks reduces future compliance costs and perceived reputational risks.
Public policies that, through bank regulation, encourage green banking are typically intended to achieve systemic change by decreasing the availability or increasing the cost of debt financing to industries that are associated with high greenhouse gas emissions or other adverse environmental impacts.
In Europe, the European Union Taxonomy (Regulation (EU) 2020/852) that classifies environmentally sustainable economic activities and related directives – together with green bond rules, investor appetite for sustainability-linked instruments, and the European Central Bank’s double-materiality mandate – encourage banks to lend more to borrowers and industries that are aligned with the EU’s climate and environmental goals. The taxonomy and rules are meant to result in reductions in emissions in line with the targeted nationally determined contributions set by the EU and its member states in line with the Paris Agreement.
In contrast, there is little political consensus and a high degree of regulatory uncertainty in the US. That heterogeneity in global regulation and public policy highlights related challenges to green banking today. Although large banks and multinational corporations compete for capital and investment opportunities in global capital markets and as part of the international banking system, rules remain highly variable. Hence, bank policies for green lending – and the regulations that impact their borrowers’ businesses – cannot rely on compliance as a justification for changes in lending policies.
The collective failure to mitigate climate impacts increases the physical risk to assets, collateral and balance sheets of borrowers and lenders alike. It affects the cost and availability of insurance. And it adversely impacts cash flows and asset values, thus creating credit risks.
Increased disclosure of climate risks is increasingly a key aspect both of bank regulation and of the covenants and other loan terms that banks negotiate in credit documentation. More critical, however, is the opportunity for banks to establish long-term relationships with borrowers and other customers by inviting discussion of climate risks and investment priorities in the context of business development, loan underwriting, negotiation of credit terms and documents, covenant compliance, and loan administration, not merely as a one-off screening device or blanket exclusionary preference.
To the extent that there is a mismatch between what is material to banks (or their customers) and what is material to the broader global environment, green banking rules will be less effective and less important in banking relationships and transaction terms. To the extent that green banking policies and practices reduce risk to banks directly or indirectly, they serve to preserve capital, enhance valuations and increase profits.
Allan T. Marks is a senior advisor at SidePorch. He can be contacted by email: allan@sideporch.co.
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