Overview
This project develops a comprehensive theoretical framework analyzing how banks optimally allocate capital between environmentally sustainable (green) and conventional (brown) projects while managing financial risks and responding to heterogeneous policy instruments. The framework addresses fundamental questions about nonlinear dynamics in green finance, policy interactions, threshold effects, and the dynamic adjustment paths toward sustainable equilibria. Through rigorous mathematical modeling, the study demonstrates how policy heterogeneity across jurisdictions shapes the financial sector's role in climate transition, with implications for both regulatory design and bank strategy.
A. Key Theoretical Contributions
1. Nonlinear Portfolio Dynamics
- Establishes rigorous conditions under which nonlinear risk-return dynamics fundamentally alter optimal allocation decisions compared to traditional linear portfolio theory
- Proves that nonlinear specifications generate qualitatively different outcomes including multiple equilibria and discontinuous policy responses
- Demonstrates inverted U-shaped relationships between green lending and portfolio quality, where optimal allocation exhibits state-dependent behavior
2. Policy Interaction and Threshold Effects
- Derives analytical results showing how different policy instruments (carbon taxes, green subsidies, preferential capital requirements) interact nonlinearly to create threshold effects in bank lending behavior
- Provides closed-form conditions under which banks switch from zero to positive green lending
- Shows how policy combinations create both complementarities and substitutabilities, with small policy changes producing negligible effects while strong policies induce discrete portfolio shifts
3. Dynamic Adjustment and Convergence
- Characterizes the dynamic adjustment path of green lending portfolios with explicit convergence conditions to sustainable equilibria
- Proves stability properties showing decade-long transitions even under optimal policies
- Demonstrates path dependence where historical portfolio choices influence future responses, creating non-reversible adjustment paths
B. Core Research Questions Addressed
Q1: When do nonlinearities matter? Under what conditions do nonlinear risk-return dynamics alter optimal green lending allocations compared to linear portfolio models?
Q2: How do policies interact? How do heterogeneous policy instruments interact to generate threshold effects and discontinuous shifts in bank lending behavior?
Q3: What are the dynamics of transition? What are the dynamic adjustment properties of green lending, and when does the system converge to sustainable equilibria?
Q4: How does cross-jurisdictional variation affect strategy? How does policy heterogeneity across jurisdictions influence optimal allocation strategies for internationally active banks?
Q2: How do policies interact? How do heterogeneous policy instruments interact to generate threshold effects and discontinuous shifts in bank lending behavior?
Q3: What are the dynamics of transition? What are the dynamic adjustment properties of green lending, and when does the system converge to sustainable equilibria?
Q4: How does cross-jurisdictional variation affect strategy? How does policy heterogeneity across jurisdictions influence optimal allocation strategies for internationally active banks?
C. Expected Outcomes
This research provides:
- Theoretical Foundations: First rigorous framework integrating nonlinear dynamics with policy heterogeneity in green banking
- Policy Guidance: Actionable insights for designing effective green finance regulations that overcome coordination failures
- Strategic Tools: Analytical framework for banks to optimize green lending under complex policy environments
- Academic Contribution: Bridging portfolio theory, climate economics, and threshold econometrics in unified framework
- Practical Relevance: Addresses why green transitions are sluggish despite supportive policies and identifies conditions for tipping points