At their current levels, sustainable investments are considerably below the levels needed to achieve decarbonization and the targets of the Paris Agreement. The World Economic Forum suggests that, to meet these goals, investments in nature-based solutions must quadruple by 2050, resulting in an annual investment exceeding $536 billion. Several strategies have been proposed, emphasizing the pivotal role of banks. Banks are uniquely positioned as the main financiers for many businesses, especially private ones with limited market access. Their expertise in screening and monitoring makes them ideal for financing the green transition’s inherently risky and innovative projects. Under the Paris Agreement’s push, banks have begun to adopt more environmentally-friendly lending standards, as evidenced by studies like Degryse et al. (2023) and Delis et al. (2019). They have also engaged in initiatives such as the Net Zero Banking Alliance and the Science-Based Targets initiative (SBTi), underscoring their commitment to transitioning to a low-carbon economy as shown in Kacperczyk and Peydro (2021).
Despite this, the role of banks in financing the transition to a low-carbon economy has been limited by two key barriers. First, banks lack the balance sheet capacity to close the investment gap on their own. Second, they are heavily invested in the brown economy, negatively impacting their incentives and ability to speed the transition. In contrast, nonbank financial intermediaries (NBFI or nonbank), which include insurance companies, pension funds, mutual funds, and private equity, have fewer at-risk legacy positions in the brown economy and may thus be less exposed to the asset-overhang problems described in Degryse et al. (2021). As a result, they can more flexibly adjust their investment portfolios than banks and accommodate the increasing pressure from investors to adopt more sustainable standards, as already reflected in the pricing of bonds and stocks (Seltzer et al. (2022), Bolton and Kacperczyk (2021)). A diverse range of factors motivates this demand of nonbank investors for more climate-friendly portfolios, and the literature suggests these are both pecuniary (physical, technological, and regulatory transition risk) and non-pecuniary (Krueger et al. (2020)).
The potential role of nonbanks in green lending is a topic of ongoing discussion in climate finance. This debate emerges from the substantial growth of the NBFI sector in recent decades. Since the 2008 financial crisis, the rise in financial assets can largely be attributed to these entities, which recently made up 48.3% of total global financial assets. However, as illustrated by Boot and Thakor (2010), nonbanks are better trained in the arm’s-length arrangements of market transactions and lack experience in resolving informational problems for effective lending, an area where banks have better expertise. In light of these respective strengths and weaknesses, our recent paper explores the potential complementarity of banks and nonbanks in relation to their common goal of financing a green transition. The exploration centers on whether banks’ expertise in borrower screening and monitoring, combined with nonbanks’ substantial financing capacity, can collaboratively reduce the considerable gap in green investment needed to achieve the goals of the Paris Agreement.
To this end, we provide empirical evidence on the role of nonbanks in green financing in the syndicated corporate loan market. This market offers an ideal setting since the participation of nonbanks in it is well-established, and their investment is considered integral to the market’s functioning. Our main finding is that after the Paris Agreement caused a dramatic shift in the demand for green investment, the heightened demand by nonbanks to invest in green assets result in a significant increase of banks’ origination of green loans and this increase is concentrated on the type of loans that are structured to receive nonbanks’ investments (institutional tranche loans). It suggests that a partnership between banks and nonbanks is created towards green financing in such a way that the two types of institutions combine banks’ role of screening and monitoring loans and nonbanks’ superior financing ability.
One of the key challenges when discussing green finance is the definition of what type of investments can be considered green. It is often common for academic researchers and market participants to rely on firm-level ESG scores. However, as Berg et al. (2022) have criticized, their use because of potential manipulations and overall unreliability. Moreover, the use of ESG scores emphasizes businesses that are already green rather than businesses which need to finance their transition towards a low-carbon economy, which are the vast majority. We address the challenge of defining green financing by adopting a novel loan-level approach in which we use textual analysis of loan-purpose information to capture green-transition financing. This measure captures lending to firms “in green transition,” exemplified by their investment in areas like wind farm or renewables. Importantly, our measure of greenness is extracted from loan descriptions that are not part of the environmental disclosure of banks, often criticized for “greenwashing” banks’ activities.
In additional tests, we find that among nonbanks, the demand for green financing is mostly directed toward private firms that have limited market access. Nonbank participation also has implications for the pricing of the loans: investors’ high demand for green loans reduces the spreads on institutional tranches and the covenants on the syndicated loans that contain these. Examining the factors driving nonbanks’ demand for green loan tranches, we discover that the dominant concerns are regulatory changes rather than climate risk. Nonbanks were hesitant to invest in green loans after US policy signalled opposition to the Paris Agreement in 2016; demand resumed following the country’s 2020 presidential elections, which marked a change in government and increased expectations of the country re-adopting pro-climate policy. This underscores how any uncertainty in the policy attitude towards climate change has a strong effect on the decision of nonbanks to finance the green transition.
Our paper extends the literature on sustainable investing, which thus far has largely focused on institutional investors’ investment in green securities, by exploring the participation of institutional investors in corporate lending markets and, further, by considering the partnerships that institutional investors establish with banks. We demonstrate how nonbank lenders have turned their attention to green investments within the syndicated loan market, which is manifested through the increased involvement of nonbanks in both the primary and secondary markets for institutional tranches. Given that nonbanks prioritize investing in private firms, we show that they have a pivotal role in supporting the transition of businesses that might have more limited access to resources.
Additionally, we contribute to the literature on green bank lending by adopting a novel loan-level approach to identifying green loans. Our approach in this paper is ESG-score-free and is less likely to be driven by greenwashing–these have been the two main concerns expressed in the literature to date. The proposed approach also has the advantage of identifying green loans granted for green purposes to non-green firms, which accounts for most loans. As a result, it provides an estimation of green transition financing with numerous advantages compared to the prevailing company-level approach, which frequently neglects the purposes for which financing is sought and instead focuses solely on whether green firms manage to secure funding.
Lastly, we document the extent to which banks rely on nonbanks to originate green loans, adding to the literature on the role played by nonbanks in credit markets (for an overview of this role, see Aldasoro et al. (2022)). The increasing relevance of nonbanks in private lending to non-financial firms, and in credit supply activities in general, is documented in several markets (see Irani et al. (2021) for corporate loans, Gopal and Schnabl (2022) and Chernenko et al. (2022) for small business lending, and Buchak et al. (2018) for mortgage lending). We demonstrate how nonbanks can contribute to closing the financing gap in the economy, particularly in the face of climate change. This is crucial because banks may have insufficient capacity to cope with such demands alone.
Angela Gallo is a Senior Lecturer in Finance at the Bayes Business School of the City, University of London.
Min Park is a Senior Lecturer in Finance at the School of Accounting and Finance of the University of Bristol.
This post was adapted from their paper, “Financing Green Transition: Bank-Nonbank Partnership,” available on SSRN.
