The biggest reform of the banking system in the last decade is underway and will last at least until the end of 2024. Unlike the hectic restructuring caused by the subprime crisis of 2008, this one will be quiet. But equally impactful.

Starting this year, banks will undergo the biggest internal transformation since the financial crisis of 2007-2008. European regulations require them to become one of the main drivers of the decarbonization of the European economy. Banking institutions will be at the center of a large-scale system of financial incentives that will affect consumers' pockets and companies' cost of capital if they do not adopt sustainability practices.

We have tried everything to make people and companies more sustainable. Alarmist warnings. Quantitative science. An unlimited number of summits. But most continue to look at sustainability with lyricism, mistrust, or no sense of urgency. Incentives are lacking, above all. Statistical studies indicate that the most effective type of incentive is not social (reputation, recognition), informational (access to new data, knowledge or experiences), emotional (generous acts that generate a positive impact for others) or related to physical pleasure - but material. If given a financial incentive, a human being is a wannabe genius. In the USA, 77% of companies employ some kind of material incentive. We need incentives to study more, work better, consume more renewable energy, eat healthier. Without incentives, we are manifestations of the commonplace turned to dullness and egolatry.

And the material incentives for sustainability are finally coming. From the top down. European regulations, introduced in 2020, require banking institutions to integrate ESG and climate risk indicators into their strategies, balance sheets and practices by the end of 2024. Quantitative instruments (such as the Green Asset Ratio and the Banking book Taxonomy Alignment Ratio) will allow the volume of green lending to be accounted for. Banks will profile and quantify the sustainability of all the projects, companies and individuals they support financially. Each of these will receive an ESG score. Commercial banking, private banking, investment banking, and asset management are now accelerating the pace for their risk identification and value pricing methodologies to integrate the new sustainability dimension. All of a bank's activities will pass through sustainability filters.

But how will this financial incentive system work? First, it will be the banks that will be materially stimulated to embrace sustainability. Their capital requirements could vary according to the carbon intensity of their funding portfolio. ECB lending conditions could be shaped by banks' sustainability performance. Being green will pay off financially.

To benefit, banks will have to encourage their entire customer network to adopt sustainability practices. They will reward the most environmentally sound and penalize clients with polluting businesses or poor social and governance practices. There will be variations in the pricing of credit (spread). Companies that do not adopt sustainability practices will be financially penalized. There is a whole new green market that will germinate under pressure from the banks.

The ECB has already made it clear that there will be no exceptions and that the rules must be applied by all. In 2022 it conducted its first bank stress test to assess the financial sector's exposure to environmental risks. The results were not encouraging. A few months ago it also published the results of another assessment of European banks in which it concluded that 96 percent of them are still not able to meet all legal obligations in this area.

Portuguese banks have started to correct internal processes. Those owned by foreign parent companies are more advanced, but there is a astonishing lack of technical training in the field of sustainability. Tis is a warning by the CMVM: "Whether consumers of financial products and services or financial entities that provide sustainable financial products and services, there is evidence of gaps in the knowledge and operationalization of ESG elements in financial decisions."

Above all, Portuguese banking institutions need to realize the material advantages of this transition. The stimulus doesn't just have to be moralistic or legalistic.

More sustainable companies are generally more profitable and less likely to default on debt payments. By supporting the green transformation of the economy through the allocation of dedicated resources to companies, banks not only contribute to climate change mitigation. They also take a step toward improving their own financial performance. This is a good incentive.


This opinion article was originally published in Expresso. Read the original text here.

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