N°26-46: Do Banks Price Pollution Risk?

This paper examines when and how pollution risk is priced in bank loan markets. Using toxic emission intensity as a proxy, we find that pollution risk has little effect on loan spreads in non–stress-testing periods, while conventional credit risk is strongly priced. When firms’ relationship banks are subject to regulatory stress testing, pollution risk becomes significantly priced, with spread effects comparable to a one- to two-notch credit-rating downgrade. The repricing is strongest for banks with tighter post-stress capital positions and stronger environmental orientation, yet higher spreads do not translate into subsequent reductions in emissions. These findings align with our state-dependent lending model, which adapts the intermediary asset pricing perspective to credit by linking loan risk premia to intermediary capital scarcity.