Economic Policy Uncertainty in Banking: A Literature Review

Economic Policy Uncertainty in Banking: A Literature Review

DOI: 10.4018/978-1-7998-6643-5.ch015
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This chapter is a survey of the most important research in the economic policy uncertainty literature. Economic policy uncertainty, although still under-researched relative to mainstream topics in economics and finance, has recently received increased scholarly attention. Through synthesizing common themes in the literature, the chapter highlights the progress made so far and suggests some avenues for future research that allow future researchers to position their research and differentiate themselves from other studies in the literature. The chapter finds that economic policy uncertainty affects banks through a reduction in credit supply and loan re-pricing. High economic policy uncertainty compels bank managers to discretionary distortion of bank financial reporting in ways that help them to mitigate the depressing effect of economic policy uncertainty on banks' financial statements.
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The purpose of this chapter is to review the existing literature on economic policy uncertainty (EPU) and synthesize the insights it provides. I begin by defining the term “economic policy uncertainty”. After this, I present a summary of what we know in the literature, then I discuss how it relates to banking. I end the chapter with a summary of what we do not know about economic policy uncertainty. Hopefully, this will help to set the agenda for future research. The articles selected for this concise review were chosen after applying a high research quality threshold which allows us to focus only on the relevant, recent and high-quality research articles in the literature.

Economic policy uncertainty is defined as uncertainty regarding economic policies such monetary policy, fiscal policy, and regulatory policies, and it derives mainly from whether existing policies will change in the future (Baker et al. 2016; Danisman et al., 2021). EPU describes the unknown impact of new policies on the economy and the private sector (Ng et al. 2020). On the other hand, policy uncertainty is defined as uncertainty about government policies. Economic policy uncertainty is a hot topic in the finance literature, even though ‘policy uncertainty’ is not a new topic. Economic policy uncertainty has been discussed in the past few decades. For example, Hassett and Metcalf (1999) examine the effect of uncertain tax policy on investment decisions and find that uncertain tax policies that follow a jump process have detrimental effects on investments. Hermes and Lensink (2001) show that policy uncertainty, measured by the uncertainty of budget deficits, tax payments, government consumption and inflation rate, leads to higher capital flight. Chen and Funke (2003) analyse the impact of policy uncertainty on foreign direct investment strategies, and show that political uncertainty is detrimental to foreign direct investment decisions. These studies suggest that policy uncertainty has detrimental economic consequences.

Economic policy uncertainty derives from whether existing economic policy will change in the future or what impact a newly introduced economic policy will have on the private sector. Precisely, economic policy uncertainty refers to uncertainty regarding fiscal, monetary, or regulatory policy. One important aspect of economic policy uncertainty is economic policy uncertainty. Understanding the implication of economic policy uncertainty for the financial and economic system is important because it can give an idea of how uncertainty about government’s economic policies affect firms, households, and individuals. The major sources of economic policy uncertainty, according to Baker et al (2016), are: (i) newspaper-based reports on the economy, (ii) tax code expirations, (iii) disagreement over CPI forecasts, and (iv) disagreement over government purchases forecasts. Many recent studies have used these sources as reliable indicators of economic policy uncertainty (see., Bhagat and Obreja, 2013; Brogaard and Detzel, 2015; Gulen and Ion, 2016; Kim and Kung, 2017; Nguyen and Phan, 2017). Other sources of economic policy uncertainty, which are less commonly used in the literature, are increased political polarization, change in governments following elections, budget deficits, trade wars, etc.

Key Terms in this Chapter

Credit Supply: The provision of credit to borrowers.

Banks: Financial institutions that give loans to borrowers and accept deposit from depositors.

Firm Performance: A measure of how well or poorly a firm performed over a period of time.

Economic Policy: A policy that influence the level of economic variables.

Policy Uncertainty: The uncertainty about what future policies might be.

Bank Lending: The process whereby banks issue loans to borrowers.

Economic Policy Uncertainty (EPU) Index: An indicator of economic policy uncertainty.

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