Optimal loan contracting under policy uncertainty: Theory and international evidence

Abstract

This paper provides comprehensive theoretical and empirical analyses on bank lending under macro-policy uncertainty. Our theory differentiates uncertainty from risk and endogenizes banks’ loan contracting under uncertainty. We show that banks demand a higher loan rate and grant a smaller loan size when uncertainty increases. To test our theoretical predictions, we construct a cross-country sample of syndicated loan contracts in 18 major economies over 2000–2015 and proxy the policy uncertainty with the Economic Policy Uncertainty (EPU) index for the same objects and period time. Evidence confirms our theory. Fixed effects estimation and an instrumental variable estimation with the inverse distance weighted EPU as an instrument further corroborate with our results.