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.
