ESG Performance, Green Finance Activities, and Bank Financial Stability: The Role of Institutional Quality

ABSTRACT This study investigates the relationship between Environmental, Social, and Governance (ESG) performance and bank financial stability within the context of the green finance transition. Utilizing an unbalanced panel dataset of 251 banks across 56 countries, observed over the period 2009–2024, we analyze how this relationship is moderated by the share of green financial products in the bank's total product portfolio and by the quality of the institutional environment, as captured by the Rule of Law (RoL) index. Our estimations reveal that while ESG is generally positively associated with bank stability, measured by the Z ‐Score, this stabilizing effect weakens as the share of green products increases, confirming a substitution effect. This mechanism is moderated by the institutional environment. In developed economies, the RoL acts as a substitute for sustainability strategies, reducing their marginal stabilizing impact. In contrast, in emerging economies it functions as a complement, strengthening the joint stabilizing impact of ESG performance and green financial products. These findings have important implications for global banking regulators and managers, emphasizing the need to make strategic trade‐offs between sustainability ambitions and financial resilience while accounting for cross‐country differences in institutional quality.