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

The interplay between government economic policy uncertainty (EPU) and bank risk remains a key concern in the financial stability literature. This study advances the field by examining the dynamic, time-varying impact of EPU on bank risk, explicitly differentiating between short- and long-term effects. We posit a dual hypothesis: heightened EPU increases short-run bank risk by raising borrower default probabilities while decreasing long-run risk as banks adopt more conservative lending strategies, given the option value of waiting under high uncertainty. Analyzing bank-level data across 22 countries from 1998 to 2017, we find robust empirical support: EPU exerts an immediate positive effect on bank risk and a significant negative effect with a lag of two to four years. These findings are robust to endogeneity and multiple sensitivity checks. Our results explicitly demonstrate the dual role of policy uncertainty in shaping bank risk-taking and offer timely guidance for the design of regulatory and macroprudential frameworks.