We investigate the hurdles to the effective implementation of sustainable banking regulation. We argue that existing approaches rest on an implicit assumption of verifiable asset quality, which is inconsistent with the informational structure of banking. Accordingly, we develop an analytical framework centred on structural asset opacity and information asymmetry: banks operate through opaque balance sheets and possess superior information about asset quality relative to both markets and supervisors. This opacity generates moral hazard in the asset classification when regulatory incentives tied to ‘green’ or ‘brown’ labels induce strategic misrepresentation and adverse selection.

We recast the main regulatory tools proposed in the literature. The analysis shows that incorporating sustainability objectives into prudential requirements, particularly capital regulation, is prone to distortion under conditions of unverifiable information, while supervisory tools remain constrained by their reliance on bank-generated data. We advance an alternative approach based on mandatory contractual mechanisms embedded in lending relationships. Properly designed and supervised, these private law tools operate as sorting devices that differentiate between green and brown activities without requiring full information about asset quality.

Read the entire article here: https://ssrn.com/abstract=6814302.