Key questions remain around how subordinated green bonds sold by banks would work in a crisis, as regulators could force the bonds to absorb losses and take writedowns on some non-green assets, according to Fitch.
The issue raises difficult questions around green bank capital, specifically on banks’ inability to ring-fence green assets and liabilities and highlights the time-lag between rapidly-developing sustainable finance and the slower pace of regulation, the ratings agency said.
"The issue here is that the regulatory framework hasn't yet quite caught up with innovations in the market," said Monsur Hussain, a senior director in financial institutions at Fitch.
Spain’s BBVA sold a €1bn green hybrid bond offering in early July that qualifies as Additional Tier 1 regulatory capital and Dutch bank de Volksbank issued €500m of subordinated Tier 2 green bonds a week later.
Both deals can be used to absorb losses through writedowns or debt-for-equity swaps if regulators think that a bank is failing or likely to fail. Proceeds will be used to fund eligible green assets to support the banks' sustainability goals, but bond covenants do not give precise details.
"There are no covenants linked to how proceeds are used, and investors have limited legal room to force the banks to ensure that those proceeds are used in the manner described," Hussain said.
"Given that this is a capital instrument, if it were to have a trigger or call linked to ESG or sustainability, that would most likely prejudice the ability of the instrument as regulatory Tier 1 capital."
BBVA's sustainable development bond framework supports its alignment with Paris Agreement climate targets and the UN's Sustainable Development Goals, and de Volksbank is aiming for a 45% climate-neutral balance sheet by the end of 2020, increasing to 100% by 2030 via its green bond framework.
“We were a bit sceptical about BBVA. The whole point of AT1 is capital for a bank, not a specific use of proceeds. ‘Is it actually going to have an impact?’ was our question,” an ESG investor said.
It could take a real-life case study to resolve the question, however, as there is no regulatory or market precedent beyond standard creditor hierarchies for how use of proceeds would be tracked if green bonds had to absorb losses.
“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 Fitch report said.
Progress with the EU Green Bond Standard and the EU taxonomy, which defines sustainable activities, is helping but standards are still unclear on technical considerations for more complex green instruments other than senior unsecured bonds.
Policymakers are considering a preferential capital regime for green financing, but it is currently unclear whether a new class of "green regulatory capital" will be created.
The confusion highlights the current clash between banks' sustainability objectives and prudential capital regulation, and the need for a consistent global taxonomy and classification, the report said.
No mechanisms currently exist in bank liquidation or resolution procedures to ring-fence assets that could allow green assets to be carved out and protected, other than those pledged as collateral, the report said.
"Investors looking at opportunities to invest in green capital instruments may start to require a more carved-out approach, whereby green loans and investments funded by green capital instruments can be clearly segregated when it comes to assessing loss-absorption,” said Janine Dow, a senior director in sustainable finance at Fitch.
“Otherwise, it makes it a bit confusing to be green on the way in and potentially non-green on the way out."
Ring-fencing green assets and liabilities would firm up the green credentials of subordinated instruments and could significantly increase green asset expansion as banks increasingly use them as a leverage instrument to maximise green lending, rather than a straightforward funding tool.
"On a use-of-proceeds or going-concern basis if there's clear green funding for the assets on a loss-attribution basis, those green losses would then be absorbed by the green capital issuance. We're not there yet,” Hussain said.
However, ring-fencing would also weaken banks' capital resilience because it limits the ability of stronger parts of a banking group to support weaker parts.