Impact of Economic Freedom and Its Subcomponents on Commercial Banks’ Risk-Taking

Abstract

We hypothesize that both liberalization and economic freedom are double-edged swords for the banking industry because they can increase both stability and fragility of the banks. To test our hypotheses, we use the two-step GMM technique to examine the impact of economic freedom and the impacts of all of its sub-components on the risk-taking behavior of US commercial banks for the period from 2003 to 2019. We find that economic freedom adversely affects banks’ risks, and therefore, increases the stability of the banking system. We observe that not all types of freedoms have positive outcomes in the banking sector, both investment and trade-related deregulation increase the fragility of the banking sector, and any type of relaxation in which banks play a direct role has a negative influence on the characteristics of banks like capital control or trade. Consistent with the competition stability theory, our findings conclude that higher economic freedom will yield higher stability in the US commercial banks. Whereas our findings are heterogeneous across all of its sub-components, all the sub-components expect investment and trade freedom positively influence the banks’ stability. Additionally, the result of this study remains consistent across well-, and under-capitalized banks, and the outcome of this study remains robust to the alternative measures of risk. Regulators, policymakers and bank managers could draw implications from the results in this paper in deciding how much liberalization the banks can handle and they also must consider the heterogeneity in the impacts from all of the sub-components because not all of them generate favorable outcomes for banks.

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