A Study On The Impact Of Economic And Monetary Uncertainty On Bank Risk

While uncertainty has been a ubiquitous concern of economists and policy makers,its economic implication captures rapidly increasing attention in the aftermath of the global financial crisis.There has been a vastly growing body of research that addresses the effects of uncertainty on real economic activities such as production,investment,consumption and international trade.Extant results commonly find a counter-productive force of economic uncertainty to dampen entrepreneurs’ incentive to investment,delay their hiring decisions,increase households’ precautionary saving and reduce the volume of international trade,all suggesting economic uncertainty as one of the main causes to the depth and length of economic slump.However,in stark contrast to the abundant literature on the impact of uncertainty on the real economy,whether and how uncertainty affects the fragility of banks,remains a question that is only understudied.As a core component of the financial system and an important pillar of the economy,banks play a crucial role in financial and economic stability.Owing to the deficiency of sophisticated financial instruments to absorb potential risks,the detrimental impact of uncertainty is likely more fully exposed in emerging economies.Based on the perspective of emerging economies,this paper explores the impact of economic uncertainty on bank risk.In addition to broad macroeconomic uncertainty,banks may be more concerned about the narrower monetary uncertainty,because fluctuations in the monetary environment(such as interest rates or monetary aggregates)directly affect bank profits.Therefore,this paper further studies the impact of monetary uncertainty on bank risk.In order to identify whether the impact of uncertainty on bank risk is mainly attributable to the demand-side effect(i.e.,the deteriorated asset quality due to higher odds of borrower default)or the supply-side effect(i.e.,the risk-taking decisions of banks),this paper introduces a bank-level characteristic variable,namely bank opacity.The strategy this paper pursue to identify supply-side effect relies on finding a differential response in bank risk to monetary uncertainty shocks according to banks’ oapcity.With the process of economic globalization and financial liberalization,more and more banks have established branches or subsidiary banks abroad.The impact of a country’s uncertainty is no longer limited to its own country,and may have spillover effects.Under this trend,monetary uncertainty in one country may be transmitted to another country through foreign banks,and the impact of monetary uncertainty may no longer be limited to domestic banks.Therefore,this paper also explores the cross-country spillover effect of monetary uncertainty,that is,whether monetary uncertainty in the home country of foreign banks affects the risk of subsidiary banks operating in emerging host countries.Based on the perspective of emerging economies,this paper focuses on the relationship between uncertainty and bank risk,and adopts a layer-by-layer approach to discuss three key issues:(1)whether economic uncertainty has an impact on bank risk;(2)Whether monetary uncertainty has an impact on bank risk,and whether the impact of moneatry uncertainty on bank stability varies by bank opacity;(3)Whether there is a cross-border spillover effect of monetary uncertainty,that is,whether the monetary uncertainty of the home country will affect the risk of foreign subsidiaries in the host country.This paper construct country-level economic and monetary uncertainty by GARCH-in mean model.To measure bank opacity,this paper estimate a model of loan loss provision(LLP)and use the absolute value of the residual as indicator of the “abnormal” accrual of LLP.Bank risk proxies are based on Z-score.Using bank-level panel data approximately 1500 banks in 39 emerging economies,This paper finds the following results:First,bank risk increases with the level of economic uncertainty.Economic uncertainty exerts its impact by affecting banks’ return and its volatility,and the effect of nominal uncertainty is seemingly more conspicuous relative to that of real uncertainty.In addition,this papers find the underlying mechanisms whereby the negative shocks in economic uncertainty is translated into adverse effects on financial stability.Along with the risk-decreasing effect of “option value of waiting”,the incentive of “search for yield” and the herding behavior of banks may be conducive to more conspicuously adverse outcomes of uncertainty on bank risk.Second,monetary uncertainty also increases bank risk,and bank opacity exacerbate this effect.Specifically,when monetary uncertainty rises,more opaque banks are riskier.This finding suggests that the increase in bank risk caused by monetary uncertainty is due to the fact that banks are actively taking risk,rather than passively taking risk.Further analysis shows that the amplifying effect of bank opacity on the relationship between monetary uncertainty and bank risk comes from banks engaging in earnings-decreasing manipulation(i.e.,the actual accrual of loan loss provisions is more than the accrued accrual).In additional analysis,this paper finds that banks motived by “big bath”(profit is relatively lower)to manipulate earnings downward take more risk than banks motived by“cookie jar”(profit is relatively higher).Finally,monetary uncertainty of the home country can significantly increase the risk of the host country’s subsidiaries.This splliover effects is channeled through the parent bank.Specifically,Monetary uncertainty in the home country increase the parent bank risk,and the parent bank risk is transmitted to the foreign subsidiries,which eventually leads to higher risk of foreign bank in the emerging host country.In addition,foreign subsidiaries with higher hierarchy,higher income diversification,and lower capital adequacy ratios are more affected.The macroprudential policy of host country has a counterproductive effect on the spillover of monetary uncertainty.Host country’s tighter macroprudential policies aggravate the impact of home country’s monetary uncertainty on foreign bank risk.There are four main contributions of this paper:First,distinct from most of the extant research that identify the response of macroeconomic variables to the changes in uncertainty,this paper asks whether uncertainty leads to any impact in the financial sector,in particular the banking market.Some existing works only studied the effect of uncertainty on the quantity of bank credit,but seldom on its quality.Despite the well documented evidence that financial condition tightens amid increased uncertainty,whether such a credit crunch secures a bolstered stability of banks is still a question to be answered.With consistent evidence in this research,this paper finds bank stability is deteriorated,instead strengthened,with uncertainty,which suggests dual adverse effects associated with uncertainty: not only a recessionary impact on real economic activities as many prior works have revealed,uncertainty also weakens the soundness of financial markets.Second,in addition to examining whether there is a link between uncertainty and bank risk,this paper explores how uncertainty affects bank risk,i.e.,answers whether the negative relationship between monetary uncertainty and bank stability is largely attributable to the deterioration of asset quality due to higher borrower riskiness or banks’ own risk-taking decisions.Due to the limitations of loan data,most of the existing literature fails to distinguish the demand effect and supply effect of uncertainty on bank risk.By exploring how the relationship between monetary uncertainty and bank risk is affected by the degree of bank opacity,this paper provides evidence to support that the impact of monetary uncertainty on bank risk comes from the supply side,i.e.,banks’ own risk-taking decisions.Third,by examining the effect of home country’s monetary uncertainty on foreign bank risk,this paper enriches the literature on how foreign banks transmit home country shocks.But most of the existing research analyzes the transmission of home country shocks in terms of loan volume: i.e.,how a shock to the parent bank causes foreign subsidiaries to reduce their lending in the host country during a crisis.Also,unlike most research that study the spillover effects of financial crises,this paper focuses on the spillover of monetary uncertainty,which may exist in crisis times as well as in normal times.Forth,this paper studies the impact of uncertainty based on the perspective of emerging economies,while most literature on uncertainty is based on the perspective of advanced economies,probably due to the shortage of data on the uncertainty in developing and emerging countries.In this work,based on the information in key macroeconomic variables such as output growth,inflation and exchange rate depreciation,this paper use the univariate-GARCH-in-mean generated conditional variance of innovation to build time-varying indicator of economic uncertainty.And based on information in key monetary variables such as interest rate change and monetary aggregate growth,this paper use the multivariate-GARCH-in-mean generated conditional variance of innovation to build time-varying indicator of monetary uncertainty.The two uncertainty indicators enables this paper to explore the impact of uncertainty from economic and monetary perspective.Unlike Economic Policy Uncertainty(EPU)or Monetary Policy Uncertainty(MPU),the economic and monetary uncertainty indicators in this paper reflect the uncertainty prevailing in the macroeconomic environment and the money market environment,respectively,describing the the volatility of the objective economic sequence,while the uncertainty of economic policy or monetary policy emphasizes the unpredictability of the frequency,size,and direction of relevant policies to be introduced or adjusted.