Combining financial and ecological sustainability in bank capital regulations

Purpose: With the macroprudential approach, systemic risk is explained by a general equilibrium (GE) model. However, since on-balance-sheet and off-balance-sheet (OBS) risks are structurally segmented, for example annually or periodically on financial statements, the GE model might need further integration with OBS risks including ecological shocks.
Design/methodology/approach: This study develops a theoretical two-period model with consumption, investment and loans, which further includes carbon emissions to distinguish between loans for “green” or “brown” firms to enhance the perspective of ecological sustainability.
Findings: The paper shows how the environmental, social and governance (ESG) factors might be of relevance in the standard bank capital regulatory structure. In dealing with ecological sustainability, a new methodological framework with the green K-index introduces penalties to be paid in the capital structure related to ESG factors. The model is enhanced for screening green or brown firms related to impact investing. The integrated view of financial stability and ecological sustainability further illuminates how a wide cross-sectoral resilience of a green K-index measure for the economy might be achievable.
Research limitations/implications: A stock-flow consistent model with balance-sheet methods raises the question whether all necessary variables and parameters can be computed in practice. Compared to the agent-based model (ABM), this model additionally lacks inputs from agents' behaviour, thus non-rational decisions, which may be relevant in practice. More generally, by adopting a balance-sheet structure, the model shows a coherent framework with relevant variables. The methodology of the GE model with OBS has not been scholarly explored and thus is presented for discussion rather than generalisation. The GE model with OBS provides a new interpretation of systemic risk and interbank relations with a consideration of ecological aspects. Its economic implication contributes to contemporary banking theory as well as to the sustainability discussions in the larger financial sector.
Practical implications: Banks and investors can more carefully measure the ecological risks in their loan portfolios and make better informed decisions leading to a better sustainability of the financial markets.
Originality/value: This study develops a theoretical GE model with off-balance-sheet risks. The model adds green regulation enhancing the capital regulation framework relevant to sustainability. This, in turn, enhances the role of banks in a coherent economic framework for loan decisions towards a much greener finance.