This study examines whether the mitigating impact of regulation in the relationship between Economic Policy Uncertainty (EPU) and banking instability differs systematically between market discipline mechanisms and structural regulatory instruments, a distinction that, to our knowledge so far, is yet to be previously examined in the literature on EPU and banking stability. Using a sample of 225 banks from eight developed economies (G7 + Australia) for the period 2005–2020 we employ a fixed-effects estimation augmented by System GMM (Blundell & Bond, 1998; Windmeijer, 2005), we advocate for a theoretically informed disaggregation of the regulatory landscape grounded in the tripartite Basel framework (BCBS, 2004, 2010, 2017).
The empirical analysis yields four principal findings. First, we document that the heightened EPU exerts a positive and significant effect on bank instability across all three-instability metrics (Z-score, σ(ROA) and σ(NIM)), thereby verifying our hypothesis that “a higher level of economic policy uncertainty increases banks’ instability”, and corroborating the relevant uncertainty-stability literature (Phan et al., 2022; Shabir et al., 2023; Wu et al., 2020). Contagion functions via three empirically documented channels: the diminishment of profitability and value, deterioration of loan portfolio through increased risk of default, and herd behavior stemming from information asymmetry.
Second, both market discipline mechanisms and structural regulatory instruments exert significant mitigating effects on the relationship between EPU and bank instability, confirming our hypotheses that “Market discipline mechanisms significantly moderate the relationship between economic policy uncertainty (EPU) and bank instability”, and “Structural regulatory mechanisms significantly moderate the relationship between economic policy uncertainty and bank instability”, and suggesting that well-designed regulatory frameworks act as institutional shock absorbers that cushion the contagion of economic policy uncertainty to bank risk-taking.
Third, we document that the moderating capacity of the regulatory framework is countercyclically amplified during Global Financial Crisis, confirming our fourth hypothesis that “The moderating effect of regulatory mechanisms on the relationship between EPU and bank instability is countercyclically amplified during the Global Financial Crisis”. Regulatory mechanisms, therefore, seem to provide a stronger stabilizing shield just when the EPU reaches its peak with banking institutions facing the most intense systemic pressures. This finding is fully consistent with the macroprudential logic behind the Basel III provisions (BCBS, 2010, 2017), which institutionally recognize the time-shifting nature of regulatory effectiveness in the financial cycle through the introduction of the counter-cyclical capital buffer (CCyB) and additional capital requirements for global systemically important banks (G-SIBs). In this sense, our results provide systematic empirical confirmation of the counter-cyclical regulatory architecture defined after the global financial crisis.
Fourth, and constituting the study's primary theoretical and empirical contribution, we establish that structural regulatory instruments exert a substantially stronger moderating effect than market discipline mechanisms across all instability metrics, model specification, and estimations approaches, confirming fifth hypothesis that “Structural regulatory mechanisms have a stronger moderating effect on the relationship between EPU and bank instability compared to market discipline instruments”. The superiority of structural regulatory instruments over market discipline regulatory mechanisms is further reinforced during the global financial crisis. This finding reflects the fundamental asymmetry in operational logic between the two regulatory dimensions: market discipline instruments operate ex-post, reacting to emerging risk signals whose informational quality deteriorates precisely under conditions of elevated uncertainty, while structural regulatory instruments operate ex-ante, shaping market incentives and institutional constraints independently of the prevailing informational environment, thereby generating a stabilizing capacity that is structurally more resilient to the informational deterioration characteristic of high-uncertainty episodes. The superiority of structural regulation is further corroborated when we substitute the economic policy uncertainty index with the world uncertainty index.
These findings have immediate and substantial implications for macroprudential policy design. Policymakers seeking to establish regulatory frameworks resilient to exogenous economic policy uncertainty should prioritize ex-ante structural instruments over market discipline mechanisms, the effectiveness of which depends on the quality of information deteriorating precisely during the episodes of uncertainty they are intended to address. This recommendation is particularly relevant in the context of the post-Global Financial Crisis period reform agenda, where the Basel III framework has already advanced significantly in this direction through the introduction of structural macroprudential instruments that collectively implement the ex-ante stabilization logic that our empirical analysis highlights as superior. Nevertheless, the existing EPU and banking stability literature has yet to furnish systematic empirical evidence for this regulatory design alternative, and our research comes to fill this gap. Future research may investigate the varying mitigating efficiencies of structural versus market mechanisms by altering the size of banks, the existing legal system by country as well as extending the analytical framework to emerging market banking systems where convergence with Basel III remains incomplete.

JEL Codes: G21; G28; E32; G01