Rising concerns about policy uncertainty

By | April 22, 2021

Both the Federal Open Market Committee and the International Monetary Fund have blamed uncertainty about fiscal, regulatory, and monetary policy decisions as a major contributor to the 2008-09 global financial crisis and the slow recoveries afterwards. Recently, due to trade tensions and the pandemic, concerns about policy uncertainty have intensified. As a result, the ability to operate amidst an uncertain economic policy environment is becoming indispensable for any modern firm. Therefore, market participants need to adjust their actions when they face significant uncertainty regarding the timing, content, and impact of policy decisions by regulators. 

The adverse effects of policy uncertainty on the economy may reflect both the direct effects on firms and the indirect effects of reduced bank output. That is, part of the observed reductions in economic activity may be due to changed bank behavior. But we still know relatively little about how policy-induced economic uncertainty might influence the decision-making of financial institutions. 

Our study 

Our recent work, “Connected Banks and Economic Policy Uncertainty”, documents that the adverse effects of policy uncertainty on banks can be mitigated via political connections, both ex ante and ex post. 

Ex ante, access to political insiders can directly reduce the level of policy uncertainty that banks face. Uncertainty comes from the heterogeneity in policy alternatives that regulators face and the difficulty in predicting regulators’ response to these alternatives. When considering the choice among various policy alternatives, regulators face difficulties over how the market will react and what the real impacts of their decisions are. To reduce these difficulties, regulators tend to engage in communication with market participants to discover their thoughts and reactions. However, it is unlikely that all market participants will have an equal opportunity for communication. In practice, better access is often granted to banks that maintain good relationships with regulators. Therefore, political connections can provide banks with superior access to legislative information and reduce the level of policy uncertainty they face. 

Ex post, politically connected banks are better protected even if they have made the “wrong” decision when facing economic policy uncertainty. Empirical evidence has shown that politically connected banks enjoy a higher probability of bailout in times of distress. Taking the Troubled Asset Relief Program as an example, studies find that banks’ connections to powerful government officials in Congress and to the Federal Reserve System correspond to a higher likelihood of receiving capital from the Troubled Asset Relief Program. In other words, banks with political connections are more likely to be saved when they are in distress. Therefore, connected banks would be, ex post, less affected by policy uncertainty because the cost of making the “wrong” decision is lower. 

Using a sample of commercial banks and savings’ institutions in the US over a 29-year period, our empirical study finds that, in general, banks are more conservative when facing policy uncertainty. Economically, a one standard deviation increase in policy uncertainty increases banks’ loss provision to loan volume ratio by 15 percent. Importantly, the adverse effect of policy uncertainty on banks is partially alleviated when banks are politically connected. To capture banks’ political connections, we use a geographic-based measure of political connections; that is, whether a bank is headquartered in a state with a senator on the Senate Committee on Banking, Housing, and Urban Affairs. For an increase of one standard deviation in policy uncertainty, connected banks would maintain a loss provision to loan volume ratio that is almost 7 percent lower compared to the unconnected banks. 

We then conduct several robustness checks to validate our findings. First, we apply a geographical regression discontinuity design to address the potential endogeneity concern that Senate Banking Committee representation might not be randomly assigned across states. Specifically, we restrict our sample to counties that are geographically close to either side of a state border. These nearby counties are more similar to each other than they are to counties farther away from the borders. When we compare these border counties, it is less likely that our state-level political connections capture some omitted across-state differences. The findings are very similar, both statistically and economically. 

Second, we conduct a placebo test where the Senate Committee on Banking, Housing, and Urban Affairs is replaced by other powerful, but unrelated, committees, such as the Senate Committee on Agriculture, Nutrition, and Forestry and the Senate Committee on Energy and Natural Resources. The rational is that if our prediction is correct, the mitigation impact should come only from connections to relevant politicians, and not from committee representations that are irrelevant to the banking sector. The estimates are in line with the expectation that connections to unrelated committees do not contribute to the mitigation of policy uncertainty. 

Through additional analyses, we shed light on two fundamental features on political connections. First, compared to smaller banks, larger banks often operate beyond state borders and are able to exert influence over senators in other states. Larger banks may also have connections with regulators at the Federal Deposit Insurance Corporation and the Federal Reserve System. In contrast, smaller banks, which operate mostly within their home states, are more likely to be affected by their home state representation in the Senate Committee on Banking, Housing, and Urban Affairs. Indeed, we find our results to be driven mainly by small banks. 

Second, banking regulation has evolved dramatically in the US. The Gramm–Leach–Bliley Act, enacted on November 12, 1999, repealed part of the Glass–Steagall Act of 1933, removing barriers to consolidation among commercial banks, investment banks, securities’ firms, and insurance companies. Since 2000, the banking market in the US was less regulated and became more volatile, leading finally to the 2008-09 global financial crisis. In response to the crisis, the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted on July 21, 2010. The law overhauled financial regulation and it made changes affecting all federal financial regulatory agencies and almost every part of the nation’s financial services’ industry. Once again, regulation of the banking market became stricter.  

Relying on this over-time variation in banking regulations, we expect the rents arising from political connections to decrease during times of loosened regulations. This is supported by our findings that the impact was stronger before 2000 and after 2010, but somehow disappeared in between. 

Implications 

Regulators around the world have realized the detrimental impact of economic policy uncertainty for firms and the economy as a whole, and government authorities are taking various actions to reduce the level of uncertainty in their legislative processes. However, little is known about how financial institutions react to these uncertainties, and even less is known about how to mitigate the potential adverse impacts on financial institutions. In our study, we show that the detrimental impact of policy uncertainty on banks varies significantly based on whether a bank is politically connected or not. This finding yields valuable information for regulators to customize their strategies when addressing policy uncertainties. 

One thought on “Rising concerns about policy uncertainty

  1. Tim

    A noticeable finding. Policy uncertainty may create inequality across firms.

    Reply

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