To create a green and sustainable economy, we need banks’ lending practices to align with sustainable finance goals. To achieve this, the EU parliament and the Committee for Economic and Monetary Affairs are considering the introduction of a ‘Green Supporting Factor’, which would reduce the capital requirements for low-carbon projects.

Capital requirements mean that banks have to back a proportion of their lending with shareholders’ equity. This means that shareholders will have more ‘skin in the game’ when banks grant loans – this encourages banks’ to make less risky lending decisions. Also, if loans are defaulted on, banks have a financial cushion to absorb losses, so taxpayers don’t have to bail them out.

On the surface of it, reducing the capital requirements for green businesses seems like a promising idea. Supporters of this move argue that it would boost green lending and encourage sustainable investments.

But capital requirements are there to mitigate the risks posed by the banking sector. They are the legislative result of a long, hard-fought battle aimed at fostering banking stability; protecting taxpayers from future bailouts; and preventing a repeat of the 2008 GFC and the recession that followed.

A Green Supporting Factor would make our financial system less stable. Not only would it erode the hard work and progress that has been made towards stabilising our financial system, but it could also weaken an already fragile banking system, and cause reputational damage to the field of sustainable finance which is still developing.

It is highly unlikely that introducing a Green Supporting Factor would lead to an increase in sustainable investments. However there are a number of alternative instruments worth considering, that could both boost green investments and put the Eurozone on a more environmentally sustainable footing.

Frank van Lerven and Dr Josh Ryan-Collins outline the problems with the Green Supporting Factor, and what we should do instead, below.