From financial instability to green finance: the role of banking and credit market regulation in the Eurace model

Abstract

We investigate appropriate banking and regulatory policies aimed at pushing the banking sector to shift from speculative lending, the cause of asset bubbles and economic crises, to green investments lending, so as to foster the transition to a more energy efficient production technology. For this purpose, we consider an enriched version of the Eurace model, which includes heterogenous capital goods, allowing for different degrees of energy efficiency in the production technology. Credit money in Eurace is endogenous and limited by Basel capital adequacy regulation on the supply side, while on the demand side it is determined by firms’ investments and households’ house purchasing. We introduce a differentiation of capital requirements according to the destination of lending, demanding higher bank capital in the case of speculative lending, thus encouraging banks to finance firm investment. As up-to-date capital goods have better energy efficiency in the model design, a higher pace of investment implies also a positive environmental effect. Results suggest that the proposed regulation is able to foster investments and capital accumulation in the short term, improving the energy efficiency of firms. However, reducing mortgages with a restrictive regulation has a negative impact on total private credit, and thus on endogenous money supply, weakening consumption and aggregate demand. In the long term, the contraction of total credit becomes stronger, and the negative outcomes on aggregate demand also affect investment. Therefore, in the long run, the positive effects on capital and energy efficiency become negligible, while the main economic indicators deteriorate.