Policy Uncertainty: Implications for Financial Sector Stability

The recent market turmoil and political situation in the U.S. and in the rest of the world, raised questions about the effect of policy uncertainty on the stability of the financial system. Do the rise of political polarization, the increase of populism and nationalism and the country-specific political events (i.e. Greek or Brexit referendum) impact the financial sector? This thesis focuses on the consequences of economic policy uncertainty on the capital shortfall of Global financial firms, the short- and long-term liquidity needs of U.S. Bank Holding Companies and the distance-to-default and capital shortfall of Greek firms. This thesis provides evidence that have meaningful implications to both practitioners and policymakers on understanding the effects of the uncertainty that arises from both politicians and regulators. This thesis consists of three main chapters corresponding to three research papers. In the second chapter, we examine how policy uncertainty affects firm's capital shortage in the case of a financial crisis. Employing a Global Economic Policy Uncertainty index, we show that an increase in policy uncertainty leads to future capital shortfall increases in case of a severe market decline. Moreover, we find that the effect of policy uncertainty is not dependent on the severity of the crisis. A significant policy effect is prevalent for North America, European, and Asian companies, and for different financial sectors. Financial firms that have already capital shortage are significantly affected by policy uncertainty, whereas, well-capitalized financial firms are less affected. Overall, these findings have implications for policymakers and politicians since if their response during a severe market decline is not timely and decisive it does not come without a cost and for firms' managers, as we show that in periods of elevated policy uncertainty and a severe market downturn, firms will face additional capital requirements than expected. In the third chapter, we examine how policy uncertainty affects the Basel III Liquidity Coverage Ratio and the Net Stable Funding Ratio for US Bank Holding Companies. First, we construct two proxies, one for the Liquidity Coverage Ratio and one for the Net Stable Funding Ratio. Then, we use the US Economic Policy Uncertainty Index of Baker, Bloom and Davis (2016) and show that an increase of policy uncertainty leads in the next period to an increase of banks' liquidity ability. This increase is due to the negative relation between economic policy uncertainty and total net cash outflows and the required amount of stable funding (denominators). Our results are robust to the level of the ratios and the size of banks. The instrumental variable analysis and the placebo tests we conduct, confirm our evidence. The final chapter examines the relationship between Greek Economic Policy Uncertainty and the Distance-to-Default and Capital Shortfall of firms in Greece. We follow the work of Baker, Bloom, and Davis (2016) to construct the Greek Economic Policy Uncertainty index and we show that an increase in policy uncertainty is related to a decrease (increase) of Distance-to-Default (Capital Shortfall). We demonstrate that the effect is essential for many sectors in Greece. The results point out that the increase of policy uncertainty depresses the stability of the financial system and it is the uncertainty that arises from policymakers and politicians that affects the financial health of firms and not from the uncertainty that arises from the economic conditions.