Green Capital Requirements, ESG Rating Uncertainty, and Greenwashing

Abstract

We propose a model where a bank regulator sets green capital requirements based on their belief regarding the proportion of investments in clean and dirty firms. We analyze the effects of green- and brownwashing on banks' lending to firms, the regulator's deposit insurance subsidy, and carbon emissions under different capital requirement functions. Furthermore, we consider the implications of large jumps in ESG ratings and show that, in this situation, green capital requirements may compromise financial stability. Greenwashing can disproportionately reinforce this effect.

Keywords: Bank Capital Regulation, Capital Requirements, Climate Change, Climate Risk, ESG Ratings, Greenwashing

JEL Classification: G21,G28