The current dominant policy narrative relies on the private sector to lead the pace and direction of decarbonizing financial flows to support the green transition. Policy interventions by financial authorities are limited to mandate-relevant actions that support these efforts without endangering price- and financial stability. However, historically, central banks and other financial policymakers have played far larger roles in supporting structural economic transformations through the use of credit policies. In this Digest, we reflect upon the potential relevance of credit policies to support the green transition.
In his book, Monnet (2018) provides detailed evidence of the Banque de France’s active role in using credit policies to support broader economic policy objectives in the period following the Second World War. The author explains that French policymakers, fearing that the market alone was incapable of financing the postwar reconstruction, prioritized medium- and long-term lending to certain sectors through an institutional body within the Banque de France called the National Credit Council. Under Bretton Woods, French interest rates set in line with US rates and other credit tools used instead to pursue domestic monetary policy goals. The Banque de France rationed credit by quantity, rather than by price, and changed banks’ rediscounting ceilings to directly reduce aggregate credit supply, targeting credit allocation towards medium to long term investment in productive sectors, while repressing credit to less desirable sectors.
Bezemer, van Lerven and Zhang (2023) highlight how the market alone and in the absence of any credit policies can lead to credit allocations with negative macroeconomic implications. From the 1980s onwards, credit policies implemented by advanced and emerging economies were abandoned. The authors argue that this has resulted in a “debt shift,” i.e., the decrease in the share of credit to non-financial firms and the parallel significant increase in mortgage lending. This debt shift has characterized the advanced economies for the last thirty years with important negative implications such as financial instability, debt distress, and less provision of credit for productive investment. The authors provide empirical evidence of the association between the end of credit policies and the decline of lending to non-financial firms. Finally, they suggest a revisit of credit policies to support adequate financing for goals such as innovation, industrial development, and the
transition to a low-carbon economy.
Kedward, Gabor, and Ryan-Collins (2023) demonstrate several blind spots in the dominant ‘risk-based’ approach to greening finance, including its neglect of market-based finance and vulnerability to regulatory arbitrage and capture. The authors outline how green credit policies could more effectively decarbonize financial flows with the ecosystem of broader institutional capital markets. Proposing that green credit policy should be organized around green industrial policy objectives, the authors also reflect upon the implications for central bank independence and inflation targeting.
“The focus is on sector-specific targets on quantities and prices to ensure the orderly reallocation of capital under conditions of uncertainty. Credit creation would be directed to priority sectors dictated by green industrial strategy, and obstructed for dirty sectors, defined by a public taxonomy. A typology of allocative credit policies is shown in Table [1] to map out how different measures could be combined to align the 21st century, market-based financial system with the needs of the green transition.”
To operationalize the allocative credit policy framework, several enabling policy reforms will be required:
- First, a public taxonomy that determines harmful activities that are incompatible with government transition objectives, where capital allocation must be urgently restricted. National governments should also identify priority activities and sectors where finance urgently needs to be scaled up, to support broader green industrial policy goals.
- Second, mandatory disclosures – for both regulated lending institutions and broader institutional capital – of portfolio composition to priority and dirty activities, together with mandatory phase-out plans for the latter, where relevant, are required.
- Third, the creation of new national public agencies comprised of representatives from central banks and relevant financial supervisory bodies and ministries of finance, industry, and environment/climate that could coordinate the design and deployment of green credit policy, and monitor its ongoing effectiveness in supporting green industrial strategy.
One successful example of this “allocative” approach to green credit policy is described by Krebel and van Lerven (2022), who outline how the Term Funding Scheme (TFS) by the Bank of England, a tool that is designed to support credit flows to specific sectors in the economy, could be steered towards green investments. The authors propose low-cost funding for activities included in a green taxonomy, low-cost reporting standards for small and medium enterprises, as well as the decarbonization of the central bank’s collateral framework. They also argue that the collaboration between the Bank of England and the Treasury could facilitate the extensions of this green credit policy to firms that do not have access to high street bank lending, and instead rely on credit unions and other public finance
institutions.
