Page 1 of 27 Economic policy uncertainty and banks’ loan pricing Abstract Using news-based government economic policy uncertainty index (EPU) of Baker et al (2016) and bank-level data from 17 countries over the period 1998-2012, we find that government economic policy uncertainty has significant positive association with interest rates on bank gross loans. Specifically, a one standard deviation increase in EPU leads to 21.84 basis points increase in average interest rates on bank gross loans. We conjecture the economic policy uncertainty boosts banks’ loan prices by increasing the borrowers’ default risk. The impact of EPU on banks’ loan pricing remains persistent after controlling for banks’ own idiosyncratic default risk and the political risk variables from ICRG database. Results remain robust when we use general elections as an alternative proxy of government economic policy uncertainty. Overall, our results suggest that government economic policy uncertainty is an economically important risk factor for banks’ loan pricing. Keywords: economic policy uncertainty; EPU; banks’ loan pricing; political risk
27
Embed
Economic policy uncertainty and banks’ loan pricingcirforum.org/2019forum_papers/CIRF2019_paper_151.pdfEconomic policy uncertainty and banks’ loan pricing Abstract Using news-based
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Page 1 of 27
Economic policy uncertainty and banks’ loan pricing
Abstract
Using news-based government economic policy uncertainty index (EPU) of Baker et al (2016)
and bank-level data from 17 countries over the period 1998-2012, we find that government
economic policy uncertainty has significant positive association with interest rates on bank
gross loans. Specifically, a one standard deviation increase in EPU leads to 21.84 basis points
increase in average interest rates on bank gross loans. We conjecture the economic policy
uncertainty boosts banks’ loan prices by increasing the borrowers’ default risk. The impact of
EPU on banks’ loan pricing remains persistent after controlling for banks’ own idiosyncratic
default risk and the political risk variables from ICRG database. Results remain robust when
we use general elections as an alternative proxy of government economic policy uncertainty.
Overall, our results suggest that government economic policy uncertainty is an economically
important risk factor for banks’ loan pricing.
Keywords: economic policy uncertainty; EPU; banks’ loan pricing; political risk
Page 2 of 27
1. Introduction
Government, through her policies, has widespread effects on overall economy of a
country (McGrattan & Prescott 2005). Individuals and firms can make more informed
decisions if government policy making process is smooth. On the contrary, uncertainty about
government policies has severe implications for both real and financial sectors. In this regard,
uncertainty in government regulatory, fiscal and monetary policies, usually referred to as
economic policy uncertainty, is the special focus of recently heated debate. Considering the
impact of policy uncertainty on real economic outcomes, extant literature finds that due to
higher economic policy uncertainty: firms would delay their investments (Bernanke 1983;
Baker et al. 2016; Azzimonti 2018), firms would involve less in new merger and acquisition
deals (Bonaime et al. 2018), industrial production and employment would suffer (Baker et al.
2016), foreign direct investment would decrease (Julio & Yook 2016) and finally the gross
domestic product of a country would drop substantially (Bloom et al. 2018). Focusing on
financial consequences, a parallel literature finds that higher policy uncertainty leads to both
the higher spreads on corporate bonds (Waisman et al. 2015; Bradley et al. 2016) and the
higher cost of equity capital (Pástor & Veronesi 2013; Brogaard & Detzel 2015; Pham 2019)
for firms. Significantly absent from this literature is how economic policy uncertainty would
impact the banks’ loan pricing. Filling this void is the aim of this study.
This question is important because of several reasons: First, bank loans are a major
source of external financing for the real sector around the world. Low cost bank financing can
contribute to real sector growth by capital formation by businesses and promoting
consumption from households. Thus, the performance of real sector, in large part, depends on
the cost of bank financing.
Second, government economic policy uncertainty increases financial constraints for
borrowers by deteriorating the overall external financing environment. For example, as the
degree of economic policy uncertainty increases, the leverage ratios of corporate firms tend to
decrease due to tight financing environment (Zhang et al. 2015). Similarly, the share prices of
firms also tend to decrease and Liu et al. (2017) showed that share prices during political
uncertainty fall due to increase in discount rate rather than the decrease in expected cash flows.
The increase in discount rates, in turn, is an indication that firms’ cost of capital increases
during the episodes of higher economic policy uncertainty. Considering the supply-side, the
Page 3 of 27
question whether banks charge higher rates on loans during the periods of higher economic
policy uncertainty is largely unexplored.
We postulate that economic policy uncertainty affects banks’ loan pricing by
changing the default risk of borrowers. Underlying economic intuition is that policy
uncertainty risk shock increases the probability of a bad state, and risk-averse banks increase
loan prices to cover the resulting costs (Bloom 2014). This is consistent with Pástor and
Veronesi (2013), to the extent, that policy uncertainty commands a risk premium. More
specifically, banks face asymmetric payoffs because their share in borrowers’ income
remains restricted to the repayment of principal and interest amount, while they may lose all
if borrowers get into financial difficulties. Therefore, banks price the borrowers’ default risk
in loan prices to protect themselves against the higher downside risk due to asymmetric
payoffs. And, the borrowers’ default risk in turn, to the large extent, depends on political
factors. In this context, government economic policy uncertainty increases default risk of
both firms and households. It increases firms’ default risk by increasing the idiosyncratic
dispersion in firms’ productivity (Brand et al. 2019). And this effect is not limited to few firms,
rather an economic policy uncertainty shock increases the variance of firms’ productivity at
individual-, industry- and aggregate-levels (Bloom 2009). Likewise, it will boost household
default risk by increasing not only the volatility of household incomes due to higher
unemployment and less new hiring, but also the volatility of wages of those who remain
employed (Bloom 2014; Li et al. 2018).
For the analysis, we use bank-level data from 17 countries over the period 1998-2012.
Measuring aggregate economic policy uncertainty with the news-based policy uncertainty
index of Baker et al. (2016), we find that banks’ average interest rates include the premium
for economic policy uncertainty; that is, banks charge significantly higher interest rates on
loans during the periods of higher economic uncertainty. We also observe that the impact of
economic policy uncertainty on banks’ loan pricing remains persistent after controlling for
banks’ own idiosyncratic default risk and the political risk variables from ICRG database. We
also confirm the main results using the elections as an alternative proxy of future policy
uncertainty.
Our study is different from a related paper by Francis et al. (2014) in at least two ways.
First, they use individual loan-level data and examine the impact of firm-level political
uncertainty on the cost of individual bank loan facilities. In contrast, we use bank-level data
Page 4 of 27
and examine the impact of country-level aggregate policy uncertainty on average bank interest
rates. Thus, they only examine the impact of economic policy uncertainty on interest rates
charged on corporate loans, while in our bank-level data, average interest rates not only
include the interest rates on corporate loans but also the interest rates on household loans.
Second, their sample is from the single country e.g., the USA, while we extend the analysis to
a cross-country sample of 17 countries.
We contribute to the existing literature in several ways: First, our paper complements
the recent studies which investigate the impact of government economic policy uncertainty on
the different practices of corporate firms. So far, the major focus of this literature is industrial
firms. We extend this debate to financial firms by analyzing the impact of economic policy
uncertainty on banks’ loan pricing decisions. Second, we contribute to the literature which
explores the determinants of banks’ loan interest rates. We add to this literature by identifying
that government economic policy uncertainty has significant impact on banks’ loan interest
rates. Third, we also add to the studies which explore the impact of politics in banking. In this
regard, we find that the policy uncertainty caused by political process affects banks’ loan
pricing.
The paper is organized as follows. In Section 2, we briefly review the related literature.
Note: This table reports pair-wise Pearson correlations between variables.
Page 23 of 27
Table 5 Economic policy uncertainty and banks’ loan pricing: main specification
Variables Interest income to gross loans ratio
Model (1) Model (2)
EPU 0.842***
(0.000)
Return on equity ratio 0.009** 0.010**
(0.017) (0.011)
Equity to total assets ratio 0.033*** 0.036***
(0.006) (0.003)
Interest expense to total liabilities ratio 0.582*** 0.583***
(0.000) (0.000)
Deposit interest rate 13.973** 15.606**
(0.042) (0.024)
Loan loss provisions to total assets ratio 0.491*** 0.498***
(0.000) (0.000)
Lending interest rate 12.928*** 12.081***
(0.000) (0.000)
Non-interest expenses to total assets ratio 0.304*** 0.307***
(0.000) (0.000)
Operating profit to total assets ratio 0.838*** 0.830***
(0.000) (0.000)
Bank size -0.300*** -0.292***
(0.000) (0.000)
Loans to deposits ratio -0.007*** -0.007***
(0.000) (0.000)
Banking industry concentration -0.016*** -0.014***
(0.000) (0.000)
Inflation 0.060** 0.061**
(0.042) (0.039)
GDP growth rate 0.126*** 0.106***
(0.000) (0.000)
Developing countries dummy 0.842*** 0.940***
(0.005) (0.002)
Financial crises dummy -0.792*** -0.853***
(0.000) (0.000)
Year dummies Yes Yes
Constant 7.703*** 3.774***
(0.000) (0.000)
Observations 21,747 21,747
R-squared 0.777 0.778
Note: This Table reports the results for the impact of economic policy uncertainty on banks’ loan pricing. Banks’ loan pricing is dependent variable in all Models and is proxied by annual ‘interest income to gross loans ratio’ of each bank. EPU is news-based economic policy uncertainty index of Baker et al. (2016). Others are control variables. Detailed definitions of variables are given in Table 2. The results are estimated with pooled OLS estimator using heteroskedasticity robust standard errors. P-values are given in parenthesis. ***, **,* represent statistical significance at 1%, 5%, and 10% levels, respectively.
Page 24 of 27
Table 6 Economic policy uncertainty and banks’ loan pricing: controlling for banks’ own idiosyncratic risk
Variables Interest income to gross loans ratio
Model (1) Model (2) Model (3)
EPU 0.721*** 0.726*** 0.717***
(0.001) (0.001) (0.001)
Return on equity ratio 0.010** 0.012*** 0.012**
(0.031) (0.009) (0.014)
Equity to total assets ratio 0.023 0.032* 0.019
(0.156) (0.066) (0.248)
Interest expense to total liabilities ratio 0.556*** 0.551*** 0.547***
Note: This Table reports the results for the impact of economic policy uncertainty on banks’ loan pricing. Banks’ loan pricing is dependent variable in all Models and is proxied by annual ‘interest income to gross loans ratio’ of each bank. EPU is news-based economic policy uncertainty index of Baker et al. (2016). Others are control variables. Detailed definitions of variables are given in Table 2. The results are estimated with pooled OLS estimator using heteroskedasticity robust standard errors. P-values are given in parenthesis. ***, **,* represent statistical significance at 1%, 5%, and 10% levels, respectively.
Page 25 of 27
Table 7 Economic policy uncertainty and banks’ loan pricing: controlling for EPU’s effect on banks’ credit growth
Variables Interest income to gross loans ratio
Model (1) Model (2) Model (3)
EPU 0.889*** 0.859*** 1.049***
(0.000) (0.000) (0.000)
Return on equity ratio 0.009** 0.010** 0.009**
(0.025) (0.014) (0.015)
Equity to total assets ratio 0.037*** 0.039*** 0.013
(0.001) (0.001) (0.241)
Interest expense to total liabilities ratio 0.588*** 0.581*** 0.610***
(0.000) (0.000) (0.000)
Deposit interest rate 16.318** 18.091*** 17.171**
(0.016) (0.008) (0.013)
Loan loss provisions to total assets ratio 0.492*** 0.531*** 0.664***
Note: This Table reports the results for the impact of economic policy uncertainty on banks’ loan pricing. Banks’ loan pricing is dependent variable in all Models and is proxied by annual ‘interest income to gross loans ratio’ of each bank. EPU is news-based economic policy uncertainty index of Baker et al. (2016). Others are control variables. Detailed definitions of variables are given in Table 2. The results are estimated with pooled OLS estimator using heteroskedasticity robust standard errors. P-values are given in parenthesis. ***, **,* represent statistical significance at 1%, 5%, and 10% levels, respectively.
Page 26 of 27
Table 8 Economic policy uncertainty and banks’ loan pricing: elections as alternative proxy of policy uncertainty
Variables Interest income to gross loans ratio
Model (1) Model (2) Model (3) Model (4) Model (5) Model (6) Model (7) Model (8)
EPU 0.891*** 0.829*** 0.870*** 0.820***
(0.000) (0.000) (0.000) (0.000)
Return on equity ratio 0.008** 0.009** 0.009** 0.008** 0.009** 0.009** 0.010** 0.009** (0.035) (0.025) (0.021) (0.037) (0.025) (0.017) (0.014) (0.026)
Equity to total assets ratio 0.032*** 0.030** 0.030** 0.033*** 0.035*** 0.033*** 0.033*** 0.036***
(0.009) (0.015) (0.015) (0.007) (0.004) (0.008) (0.007) (0.003) Interest expense to total
Note: This Table reports the results for the impact of economic policy uncertainty on banks’ loan pricing. Banks’ loan pricing is dependent variable in all Models and is proxied by annual ‘interest income to gross loans ratio’ of each bank. EPU is news-based economic policy uncertainty index of Baker et al. (2016). Others are control variables. Detailed definitions of variables are given in Table 2. The results are estimated with pooled OLS estimator using heteroskedasticity robust standard errors. P-values are given in parenthesis. ***, **,* represent statistical significance at 1%, 5%, and 10% levels, respectively.
Page 27 of 27
Table 9 Economic policy uncertainty and banks’ loan pricing: controlling for ICRG political risk variables
Variables Interest income to gross loans ratio
Model (1) Model (2) Model (3) Model (4) Model (5) Model (6) Model (7)
Note: This Table reports the results for the impact of economic policy uncertainty on banks’ loan pricing. Banks’ loan pricing is dependent variable in all Models and is proxied by annual ‘interest income to gross loans ratio’ of each bank. EPU is news-based economic policy uncertainty index of Baker et al. (2016). Others are control variables. Detailed definitions of variables are given in Table 2. The results are estimated with pooled OLS estimator using heteroskedasticity robust standard errors. P-values are given in parenthesis. ***, **,* represent statistical significance at 1%, 5%, and 10% levels, respectively.