The article develops a capped barrier option model to evaluate a bank’s equity. We explore
the effects of borrowing-firm carbon emission trading on bank carbon-linked lending, explicitly
considering borrowing-firm credit risks under capital regulation. We also integrate the regulatory
compensation for bank low-carbon lending with borrowing-firm carbon allowance transactions in
the emission trade scheme. Results show that an increase in the regulatory low-emitter lending
compensation decreases loans at an increased interest margin, contributing to bank profitability and
stability. The stringent regulatory cap for carbon emission allowances hurts profitability and stability.
Strict capital regulation would jeopardize bank performance.
