Green Banking Resilience: Trade-offs under Shocks

This work presents a dynamic three-period model integrating the European Union’s (EU) Green Asset Ratio (GAR) with the Basel III Leverage Ratio (LR) and Liquidity Coverage Ratio (LCR) in a context of stochastic economic and deposit shocks. Banks optimize portfolios across green and non-green assets, highlighting critical inefficiencies. Unregulated equilibria favor overinvestment in volatile assets and elevated systemic risk; binding GAR constraints distort allocations toward volatile green assets; and LCR requirements exacerbate fragility through deposit volatility. We highlight the dynamic interplay between these regulations, demonstrating the conditional effects under shocks of varying magnitudes. We propose an adaptive regulatory supplement that realigns incentives with first-best efficiency. We demonstrate the greater effectiveness of flexible, dynamic regulations over static ones in terms of risk mitigation. Numerical simulations and simple examples validate these results, offering insights for the design of sustainable banking policies.