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Sustainable Banking and Credit Market Segmentation

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  • David L. Kelly
  • Christopher Paik

Abstract

We assess the feasibility, optimality, and policy implications of Environmental, Social, and Corporate Governance (ESG)-linked or “green” lending in a credit market where banks incorporate such non-financial data in credit allocation decisions. We identify an asymmetric information problem: borrowers signal low financial risk to banks who are uncertain about borrower risk levels by engaging in green investments. We derive conditions under which banks segment the market into green and brown loan products and evaluate market efficiency. We find borrowers prioritize signaling over the environmental impact of green investments, and the market sustains only limited green lending, since if all borrowers make green investments, no signaling value exists. The optimal carbon tax policy replaces the signaling value of green investments with the marginal damage and outperforms a brown reserve requirement aimed at discouraging brown lending. However, both policies also can sustain only a limited amount of green investments. We conclude that while green lending by banks can enhance welfare relative to an unregulated market, the resulting market segmentation can make the social optimum infeasible, even with carbon tax regulation.

Suggested Citation

  • David L. Kelly & Christopher Paik, 2024. "Sustainable Banking and Credit Market Segmentation," CESifo Working Paper Series 11522, CESifo.
  • Handle: RePEc:ces:ceswps:_11522
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    File URL: https://www.cesifo.org/DocDL/cesifo1_wp11522.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    competitive screening; ESG; environmental risk; climate risk; sustainable banking; sustainable finance; stranded assets;
    All these keywords.

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming
    • Q56 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environment and Development; Environment and Trade; Sustainability; Environmental Accounts and Accounting; Environmental Equity; Population Growth
    • Q58 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environmental Economics: Government Policy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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