Banks’ stock market reaction to prudential policy announcements: The role of central bank independence and financial stability sentiment

We leverage differences in central bank independence and financial stability sentiment across countries to investigate the variability in banks’ stock market reactions to prudential policy announcements during the COVID-19 crisis. Our findings reveal that the relaxation of both macro- and micro-prudential policies leads to negative cumulative abnormal returns (CARs), the reaction being attenuated in countries where the central bank is more independent or communicates deteriorations in financial stability. The CARs around the announcement dates are 0.75 percentage points (pp) and 6.89 pp higher for macro- and micro-prudential policy announcements, respectively, in countries with greater central bank independence compared to those with lesser independence. The difference is approximately 3.73 pp and 5.65 pp between banks located in countries where the central bank communicates a negative sentiment about financial stability, compared to those where a positive sentiment is conveyed. The positive impact of higher degrees of central bank independence and deteriorations in financial stability sentiment on bank market valuation is enhanced for smaller banks, as well as for banks in countries with greater fiscal flexibility and a higher prevalence of privately owned banks. (181 words)