The Paris Agreement’s commitment to aligning finance with efforts toward net-zero emissions has catalyzed an unprecedented shift in financial markets. Sustainable finance has evolved from niche to mainstream, with financial institutions increasingly incorporating environmental considerations into their decisions. By withdrawing funding or raising its cost, financial institutions can pressure firms engaged in environmentally harmful activities to change course. Yet beneath this transformation lies a critical, yet often overlooked, vulnerability: replacing exiting creditors with new ones, or “credit substitution.” In a recent article, I argue that credit substitution weakens the effect of exit and results in the migration of risk to less regulated and less transparent parts of the financial system.
Theoretical Foundations, Mechanisms and Evidence
Credit substitution rests on established principles of corporate finance. The Modigliani-Miller theorem demonstrates that in perfect markets, firms remain indifferent to financing sources as capital structure does not affect firm value. While market frictions introduce preferences between different forms and providers of capital, the fundamental principle persists: Firms optimize their financing mix based on relative costs and availability. This becomes particularly relevant when sustainable finance policies attempt to constrain capital access for environmental objectives.
Credit substitution operates through three mechanisms. First, heterogeneity across financial institutions creates substitution opportunities. Institutions diverge in their evaluation of climate risks, susceptibility to stakeholder pressures, preferences, and expectations about the pace and trajectory of the green transition, generating variation in credit pricing and availability and enabling firms to substitute between sources.
Second, differences in regulations among jurisdictions create arbitrage opportunities. The EU has generally integrated climate considerations into financial regulation. The UK pursues ambitious objectives but has been slow to implement them. The U.S. explicitly rejects climate-specific financial regulation, and a broader anti-ESG backlash has pressured major U.S. banks and asset managers to exit net-zero alliances and drop fossil fuel-related pledges, widening the transatlantic gap. Asian countries take mixed approaches—Japan implements some measures while remaining a major fossil fuel financier, and China combines green directives with continued support for coal.
These disparities create powerful incentives for international credit substitution. When institutions subject to stringent regulation restrict lending to carbon-intensive companies, borrowers access capital from more permissive sources. Evidence confirms this: As European banks retreat from fossil-fuel financing, institutions from other regions expand it. North American and Japanese banks lead in sectors abandoned by European lenders, while U.S. regional banks have dramatically increased their participation. Australia’s coal sector exemplifies this, too: After domestic banks ceased financing the sector, companies secured funding from Japanese and Chinese lenders.
Third, cross-sector regulatory asymmetries enable substitution between financial intermediaries. This is evident in the EU’s divergent treatment of bank lending and market-based financing that can facilitate credit substitution. Banks face comprehensive regulation aimed at reducing climate risk and complying with Paris-Agreement goals while non-bank entities operate under lighter regimes.
A significant divergence concerns transition plans. The EU’s banking package mandates that banks develop transition plans for climate-friendly strategies. These undergo rigorous scrutiny and banks are subject to penalties and stiff capital requirements when the plans fall short. Market-based actors face no equivalent obligations. While disclosure regulations require transparency about sustainability risks, they neither mandate transition plans nor grant supervisors wide-ranging enforcement powers. The EU Corporate Sustainability Due Diligence Directive initially imposed weak transition-plan requirements on asset managers, but even these have now been removed, widening the gap further. Banks under pressure might find clients turning to bond markets or private credit providers without comparable scrutiny. Banks could also transfer their non-compliant exposures to non-banks.
Empirical evidence demonstrates credit substitution occurs in various ways. Banks use a variety of mechanisms to rid themselves of assets related to fossil fuels, including loan sales, securitization, and synthetic risk transfers. Private credit funds pursue opportunities banks abandon, explicitly targeting sectors with restricted access. Research also documents substitution between bank lending and bond markets, and instances of inter-bank substitution driven by differences in the pressure on certain banks to promote sustainability.
Credit substitution in this context also avoids the usual frictions that make switching lenders difficult. When banks typically exit a lending relationship, new lenders worry that the borrower was dropped for undisclosed credit problems – a classic adverse-selection concern. But in sustainable finance, banks exit entire sectors rather than individual borrowers, so no such negative signal attaches. Fossil fuel companies are typically large borrowers that can use their proven reserves – whose value is relatively easy to verify – as collateral. The prevalence of syndicated lending further reduces information barriers, as remaining syndicate members can vouch for borrower quality.
While some research finds creditor exits constrain financing, those studies are in the minority. This variation stems from context-specific factors. Coal financing illustrates this—studies may find limited substitution where the declining economic viability of coal affects all lenders equally. However, exits in markets where demand remains robust likely result in successful substitution.
Implications for Financial Stability
Credit substitution also has implications for financial stability. When banks exit climate-risky loans, risks migrate to shadow banks, private credit funds, and less regulated institutions operating with reduced transparency and oversight. This parallels pre-2008 dynamics when securitization moved risks into shadow banking, ultimately amplifying systemic vulnerabilities. The Financial Stability Board has warned more generally that when risks migrate from banks to non-bank entities, the stability impact is difficult to assess, as it remains unclear whether those entities are well-placed to bear such risks given their funding structures and capacity to withstand losses under stress. This concern applies with equal force here. While individual banks may improve their own resilience by shedding climate-risky assets, the financial system does not become safer if those risks simply concentrate in less supervised corners.
Policy Implications and Regulatory Responses
Regulators must establish comparable requirements across all forms of credit. Stringently regulating banks while leaving other financial institutions unconstrained creates arbitrage opportunities that undermine stability and environmental objectives. Policymakers should evaluate second-order effects, tracking whether aggregate credit to carbon-intensive sectors declines or migrates.
Several proposals appear problematic. Using capital requirements to favor pro-environment practices and penalize pro-fossil fuel behavior would accelerate substitution, as banks forced to exit would transfer assets to unconstrained investors. Reviving securitization markets – —an agenda being pursued by both EU and UK regulators – risks making it easier for banks to offload carbon-intensive exposures to less supervised entities while retaining incentives to originate such loans.
Given credit’s international mobility, effective policy requires coordinated action. The Basel Committee represents the natural forum for harmonizing standards, yet progress remains stalled by disagreements, particularly U.S. opposition. Without coordination, unilateral efforts will redistribute rather than reduce harmful financing.
Conclusion
Credit substitution reveals a fundamental tension: In integrated markets, targeted interventions may redistribute rather than reduce environmentally harmful financing. This demands sophisticated policy design that anticipates substitution dynamics. Only comprehensive approaches addressing the full financial system – across sectors, jurisdictions, and types of institutions – can ensure that efforts to promote sustainable finance succeed.
Alperen Afşin Gözlügöl is an assistant professor of law at the London School of Economics. This post is based on his recent article, “Credit Substitution in Sustainable Finance: An Achilles Heel?,” published in the Journal of Financial Regulation and available here. A version of this post appeared on the Oxford Business Law Blog.