Economic policy uncertainty, bank competition and financial stability

Abstract

Purpose This study aims to examine the impact of economic policy uncertainty and bank competition on the financial stability of the Chinese banking industry. This study answers two fundamental questions. First, does economic policy uncertainty (EPU) affects the financial stability of banks in China? Second, does competition affect the financial stability of the Chinese banking sector? Design/methodology/approach The sample includes all commercial banks to provide a full picture of the Chinese banking sector. This study covers the time between 2011 and 2019. The sample period captures different EPU spikes and key policy changes. This study used different econometric methodologies such as the generalized method of moments and the fixed effect and ordinary least square estimation models. Furthermore, this study used the Instrumental Variable model to solve endogeneity, autocorrelation and unobserved heterogeneity concerns. Besides, alternative EPU and financial stability measures were used. Moreover, this study reestimates the model after dropping the big five state-owned banks. Findings This study found that both EPU and competition reduce financial stability. This implies that EPU has a negative impact on financial stability. This shows that uncertainty distorts resource allocation efficiency and creates confusion, leading to financial instability in the banking sector. Besides, this study found that competition negatively affects financial stability. This result implies that high competition pushes banks toward riskier activities that ultimately lead to increased financial instability. Originality/value This study is the first of its kind that examines the impact of EPU and competition on the financial stability of the Chinese banking sector. This study conducted several robustness tests such as the instrumental variable model, alternative measurement and sample construction methods. This study brings policy implications and lessons for the banking sector.