The Effect of Economic Policy Uncertainty on Banks: Distinguishing Short and Long-Term Effects

We investigate the impact of government economic policy uncertainty (GEPU) on bank risk, distinguishing short- and long-term effects. We argue that heightened GEPU increases bank risk in the short run by raising borrowers’ default probabilities under adverse economic conditions, while reducing risk in the long run by discouraging banks from extending risky loans due to the higher option value of waiting under uncertainty. Using bank-level data from 22 countries over 1998–2017, we find that elevated GEPU raises bank risk contemporaneously but lowers it with a lag of two to four years. These results are robust to endogeneity concerns, alternative measures of bank risk and GEPU, variations in sample composition, and different estimation techniques. Our findings highlight the dual role of policy uncertainty in shaping bank risk-taking behavior and have implications for regulatory design and macroprudential policy.