Do banks practice what they preach? Brown lending and environmental disclosure in the euro area

Summary

Focus

The reduction of information asymmetries between banks and their stakeholders is essential to guarantee the functioning of the market discipline mechanisms that allow investors, depositors and other actors to monitor bank risk-taking practices. Despite regulatory requirements, there is still a risk that banks may engage in "environmental window dressing", which involves increasing the environmental disclosure in their financial reports without actually acting as environmentally responsible lenders (ie not practising what they preach).

Contribution

We detect bank environmental window dressing practices by matching an expert-validated tailored disclosure index with loan-level data collected from the credit register of the European System of Central Banks (AnaCredit), bank- and firm-specific characteristics and firms' GHG emission data collected from the Urgentem database. We address potential endogeneity between bank environmental disclosure and their lending practices by relying on two competing theoretical frameworks: (i) the "signalling theory", according to which banks may use environmental disclosure to signal their actual commitment to combat climate change, manage environmental risks effectively and limit their negative financial consequences; and (ii) the "impression management theory", which suggests that banks can use environmental disclosure to manipulate stakeholders' and investors' perceptions of their commitment to manage environmental risks impact, regardless of their actual behaviour.

Findings

We reject the environmental window dressing hypothesis. Specifically, an increase of one standard deviation from the mean in the environmental disclosure index is associated with a 0.7% reduction in lending volume to more polluting firms. This result is in line with the "signalling theory" and in contrast with the "impression management theory". However, this depends on the overall tone of the disclosures. Banks that use a more negative tone in their annual reports, indicating a genuine concern about environmental issues, typically provide less credit to firms that pollute more. In contrast, banks that use a positive tone, which reassures investors and stakeholders about environmental risks, lend more to polluting firms. Hence, we observe a window dressing behaviour in those banks that use a positive tone in their reports.

Abstract

This study examines whether the level of environmental disclosure in banks' financial reports matches less brown lending portfolios. Using granular credit register data and detailed information on firm-level greenhouse gas emission intensities, we find a negative relationship between environmental disclosure and brown lending. However, this effect is contingent on the tone of the financial report. Banks that express a negative tone, reflecting genuine concern and awareness of environmental risks, tend to lend less to more polluting firms. Conversely, banks that express a positive tone, indicating lower concern and awareness of environmental risks, tend to lend more to polluting firms. These findings highlight the importance of increasing awareness of environmental risks, so that banks perceive them as a critical and urgent pressing threat, leading to a genuine commitment to act as environmentally responsible lenders.

JEL classification: G20, G21, M41, Q56

Keywords : green banking, brown lending, banking, environmental disclosure, environmental risks, climate change