Abstract

Using loan-level regulatory data, this paper finds that banks reduce risk-taking in their loan book after positive bank-level uncertainty shocks, as measured by the idiosyncratic volatility of the bank’s stock price. Interest rates and the use of collateral in loan contracts also increase after positive uncertainty shocks. These precautionary responses are strongest among banks with less regulatory capital that are also subject to mark-to-market accounting regulations. Public firms react to bank-level uncertainty shocks by holding more cash, reducing share repurchases, investment and employment. Riskier private firms that are exposed to these uncertainty shocks turn to shorter-term higher cost credit, such as credit cards and trade credit, increasing illiquidity. We also find that local employment declines after bank uncertainty increases. Taken together, uncertainty shocks in the banking system significantly affect the economy.