Greening collateral frameworks

Greening collateral frameworks

Central bank collateral frameworks play a powerful role in contemporary market-based financial systems. Collateral rules and practices affect the demand for financial assets by financial institutions, with significant implications for governments’ and non-financial corporations’ access to finance. However, existing collateral frameworks lack environmental considerations and suffer from a carbon bias: i.e. they create disproportionately better financing conditions for carbon-intensive activities.

Environmental issues can be incorporated into collateral frameworks in a number of ways, notwithstanding various methodological and data challenges. We distinguish between (i) the environmental risk exposure approach, whereby credit assessments in collateral frameworks are modified to capture the exposure of financial institutions and central banks to climate-related financial risks, and (ii) the environmental footprint approach, in which haircuts and eligibility are adjusted based on the environmental impacts of financial assets. The two approaches have differing implications and design requirements.
We argue that the environmental footprint approach should be at the core of central banks’ green transformation of collateral frameworks. This approach contributes directly to the decarbonisation of the financial system, faces fewer practical challenges than the environmental risk exposure approach and does not penalise companies that are exposed to physical risks. It is also conducive to the reduction of systemic physical financial risks.

Central banks have a crucial role to play in developing a framework that will accelerate the collection and harmonisation of environmental data associated with financial assets. This will not only help to successfully decarbonise the assets of non-financial corporations included in the collateral framework but will also allow the expansion of greening to other asset classes, such as covered bonds, mortgages, corporate loans and asset-backed secu

Authors
Publisher

SOAS Centre of Sustainable Finance, LSE Grantham Research Institute on Climate Change and the Environment

Published August 8, 2022