Economic freedom and banks' risk-taking in Japan: a tale of two sides

Purpose: This study examined how economic freedom and its related components, such as open markets, regulatory efficiency, rule of law and the size of government, affect bank risk behavior, focusing on the Japanese context. Design/methodology/approach: The study employs a two-step GMM framework on the annual data of Japanese banks ranging from 2005 to 2020 to empirically test the hypotheses. Furthermore, we also use the ordinary least square method to ensure the robustness of our mainline findings. Findings: The finding suggests that economic freedom increases the banks' risk-taking, thus making them fragile. The results also highlight that out of the four main subcomponents of economic freedom, regulatory efficiency and government size increase bank risk-taking, while the rule of law and open markets decrease banks' risk-taking. Additionally, we examine how the banks' specific characteristics affect the results by creating a subsample based on capitalization and liquidity ratios. Overall, the results are consistent with the baseline findings. Moreover, the results are robust to alternative proxy measures of risk. Practical implications: The study's findings have several implications for regulators and policymakers. The results suggest that regulators and policymakers should reconsider their strategies for economic freedom to ensure that they promote stability in the banking system and reduce banks' risk-taking inclinations. Originality/value: Although previous studies have examined the impact of economic freedom on bank stability and risk-taking, this study is the first to do so in the Japanese context, contributing to the literature by providing new insights and empirical evidence.