Banks, Markets, and the Color of Finance

We develop a model in which brown (high-emission) and green (clean-energy) firms compete and seek financing from banks and the capital market. We use this model to examine the effects of higher minimum capital requirements on banks making brown loans so as to discourage such lending. Facing costlier bank financing, some brown firms leave banks for the market and invest more, increasing brown investments at the intensive margin. This increases competition for green firms, causing banks financing these green firms to keep less capital and reduce screening. Ironically, higher capital requirements on brown loans hurt financial stability and increase pollution.