Navigating bank risk-taking under excess liquidity: the moderating role of economic policy uncertainty and lessons from the Global Financial Crisis

The study investigates the moderation effect of economic policy uncertainty (EPU) towards the relationship between excess liquidity and bank risk-taking as well as explores its stronger impact in countries severely affected by the 2008 Global Financial Crisis (GFC). Using System Generalized Methods of Moments (SGMM) on an unbalanced dataset for 33 countries from 2000 to 2019, the study finds that an increase in the EPU index attenuates the positive impact of excess liquidity on bank risk-taking. The study also finds that the attenuating effect of EPU on the relationship between excess liquidity and bank risk-taking is stronger in countries that were most severely affected by the GFC. It argues that the mechanisms by which excess liquidity induces risk-taking are disrupted under high EPU. Our study also extends behavioral theories to shed light on how the GFC altered bank risk-taking in the presence of excess liquidity and high EPU.This study examines the influence of economic policy uncertainty (EPU) on the relationship between excess liquidity and bank risk-taking, particularly in countries that were severely impacted by the 2008 Global Financial Crisis (GFC). Utilizing the System Generalized Method of Moments on data from 33 countries, the research indicates that elevated levels of EPU dampen the risk-taking incentives typically associated with excess liquidity. Remarkably, this moderating effect of EPU is more pronounced in nations significantly affected by the GFC, suggesting that historical crises shape current banking behaviourin the face of economic uncertainty. The study enhances the Excess Liquidity Theory by incorporating behaviouralinsights from Prospect Theory, illustrating that economic uncertainty can function as a stabilizing force against liquidity-driven risk. These findings highlight the urgent need for policymakers to customize financial stability measures, particularly in managing liquidity levels and timing policy actions during times of heightened uncertainty. Ultimately, this research offers valuable insights into how regulatory strategies can utilize economic policy uncertainty to promote prudent banking practices, fostering stability in an increasingly volatile global financial environment.