Substantial sums of banking assets will not be included in the scope of the upcoming green asset ratio, revealing the metric's shortcomings in accurately comparing European lenders' environmental efforts.

The European Banking Authority will require around 150 lenders to publish a so-called green asset ratio, or GAR, from 2024. The ratio is slated as a comparable and harmonized metric showing environmentally sustainable assets as a percentage of lenders' banking books. Banks will follow a common classification system, the EU's taxonomy, to define a "green" asset.

But the ratio may be of limited use to compare the greenness of banks' balance sheets across the board as large parts of assets are out of its scope, according to European banks' latest sustainability reports. For example, assets held for trading and exposures to governments and central banks are excluded from the GAR calculation altogether, while financing to small and medium-sized enterprises or non-EU corporate counterparties can never qualify as green.

These structural features are likely to drive divergence in the coverage and value of the green asset ratio depending on a bank's business model and geographical footprint.

"You can't just compare the ratio across two banks and go, 'That bank has a higher ratio, therefore, the balance sheet is greener,'" said Simon Brennan, director at Deloitte who specializes in prudential regulation for banks. "You have to think, are those balance sheets comparable?"

Diverging scope and value

While European lenders are not required to publish their GARs just yet, they have already disclosed how large a share of their total assets as of the end of 2021 would fall within the scope of the ratio calculation. The figures deviate significantly among banks.

BNP Paribas SA estimated that only about half of its assets will be covered by the ratio, primarily due to its large trading book and exposures to central banks and governments. For Banco Santander SA, a retail-focused lender, 90% of its total assets would be included.

European banks have also disclosed the share of assets in the scope of the green asset ratio that are "taxonomy-eligible" and, as such, can qualify to be included in the numerator of the GAR. An activity is considered taxonomy-eligible if it is described in the taxonomy regulation, such as renewable energy or real estate, and therefore has the potential to contribute to one of the EU's environmental objectives. Only in 2024 will EU banks have to assess whether these assets actually meet the performance criteria and can be labeled green and be used to calculate the GAR.

The EU's green classification system currently covers the economic activities of roughly 40% of listed companies in the EU and is focused on objectives related to climate change mitigation and adaptation activities.

Of Europe's largest five lenders by assets, Groupe BPCE posted the highest eligibility ratio, at 54%. Those of Société Générale SA and BNP Paribas were the lowest, at 18.4% and 25.8%, respectively. Société Générale has at this stage published only mandatory disclosures, which must be based on data provided by the relevant counterparty.

Other banks in the sample have supplemented their mandatory reporting with voluntary disclosures, which may use estimates and proxies, driving up their eligibility ratio.

At present, taxonomy-eligible assets are largely limited to banks' financing of residential real estate as well as to EU corporates subject to disclosure obligations under the Non-Financial Reporting Directive, or NFRD, a piece of EU disclosure regulation that applies to certain large companies.

Meanwhile, financing to SMEs, non-EU counterparties and sectors not covered by the EU taxonomy will be excluded from the numerator but not the denominator of the GAR. In essence, this means such assets will be assumed to be 0% sustainable in the GAR calculation. This puts banks with large exposures to those segments at a structural disadvantage when seeking to boost their GAR. Even if every single asset in a bank's banking book is environmentally sustainable, its green asset ratio could never exceed the eligibility ratio.

A spokesperson for Groupe BPCE said the eligibility ratio currently represents "more the nature of the business lines of a bank" rather than its greenness, with its own eligibility ratio made up mostly by its mortgage loan book. The bank expects the ratio of taxonomy-aligned assets — the green asset ratio — to be much lower than that of taxonomy-eligible assets, the spokesperson said, acknowledging that comparing the GAR of banks will not always be easy or relevant.

The green asset ratio comes with other limitations, too. For example, it only measures activities that are green and therefore does not necessarily capture banks' transition efforts within the banking book as a whole, said Maureen Schuller, head of financials sector strategy at ING. A bank can be making significant progress in helping polluting clients reduce their environmental impact without it conforming to the taxonomy.

An EU-wide pilot exercise on climate risk, published by the EBA in May last year, estimated an average GAR of just 7.9% for a sample of 29 EU banks, although it emphasized limitations such as data gaps and variation in approaches used.

Improved data

Pilar Gutierrez, head of unit reporting and transparency at the EBA, recognized that it will be more relevant to compare the green asset ratio of banks with similar business models, in particular those that have a predominantly traditional lending business. But, she added, to understand institutions' ESG exposures and risks, the GAR should be assessed together with the range of other disclosure requirements the EBA has introduced into the Pillar 3 framework, and not in isolation.

Pillar 3 is part of the global Basel standard for bank prudential regulation that seeks to promote market discipline through regulatory disclosure requirements.

In its proposed framework, the EBA asks banks to release information on everything from exposure to carbon-intensive companies to climate change physical risk. It also proposes a Banking Book Taxonomy Alignment Ratio, or BTAR, which attempts to make up for one of the GAR's shortcomings by extending the numerator to include counterparties not covered by the NFRD. This complementary metric is intended to help give a more complete picture of banks' taxonomy alignment and incentivize lenders to provide green finance to SMEs, even if institutions still face significant data availability challenges and may have to rely on estimates and proxies when calculating the BTAR.

The EBA furthermore intends to introduce a measure that can capture ESG risks in banks' trading book at a later stage, said Gutierrez. She said the regulator left the trading book out of the scope of the Pillar 3 standard for now because this business is more volatile in nature, with assets often staying on banks' balance sheets for short periods. This makes it more complex to measure a green asset ratio and raises the risk that banks "window dress" their holdings the day the ratio is calculated.

Over time, the scope of the green asset ratio and availability of data will improve to some extent. European corporates are now required by the taxonomy regulation to disclose information on their own eligible activities, which a BNP Paribas spokesperson said will enhance the bank's disclosures from 2023. This year BNP Paribas used NACE codes, the European standard for classifying economic activity, to qualify taxonomy eligibility for corporate clients, which represents an estimate only.

From 2023, the Corporate Sustainability Reporting Directive will furthermore amend the existing reporting requirements of the NFRD, expanding coverage to all large companies and all companies listed on regulated markets, although non-listed SMEs will still be excluded.

The span of taxonomy-eligible activities will also grow as the EU plans to release performance criteria that cover more sectors and another four environmental goals, including pollution prevention and the protection of biodiversity.

Even if the green asset ratio comes with limitations, it will still be an important improvement in European banks' ESG disclosures as it provides a binding, quantitative and consistent ESG measure, which has so far been missing, said Vitaline Yeterian, senior vice president for DBRS Morningstar's global financial institutions group.

The GAR may not be fully comparable, Schuller said, but she nevertheless expects it to feed into investor decisions, which could in turn translate into lower funding costs for banks with a higher ratio.

"The comparison will obviously be made," Schuller said. "Investors will ultimately differentiate between banks because it's also important for their own green investment ratio disclosures."