Economic policy uncertainty and bank stability: Size, capital, and liquidity matter

Abstract

We examine the impact of economic policy uncertainty on bank stability post-2007-2008 global financial crisis and how bank size, capital, and liquidity mitigate this relationship. We use 176,477 quarterly observations for US commercial banks over the period from 2011Q1 to 2020Q3 and find consistent and robust evidence that bank stability decreases as the level of economic policy uncertainty increases. We show that bank size, capital, and liquidity matter, i.e., the negative impact of policy uncertainty on bank stability is stronger for larger banks and weaker for highly capitalized banks as well as for more liquid banks. Our channel analysis shows that the increase in the level and volatility of lending and deposit rates, and the decrease in risk-adjusted capitalization and risk-adjusted profitability might to some extent explain the decrease in bank stability in times of higher economic policy uncertainty. Additional analysis reveals that higher market power mitigates the negative impact of EPU on bank stability. Our findings support the Basel II and III regulatory reforms aimed at tightening the capital levels with stricter rules for the larger banks and the implementation of the newly introduced liquidity rules.