Capital and profitability: The moderating role of economic freedom

Abstract

Using the GMM framework, this paper examines the nexus between capital and profitability in the presence of economic freedom using annual data of US banks ranging from 2002 to 2022. consistent with both the financial stability and regulatory hypotheses, the present study's empirical findings reveal that economic freedom exerts a positive moderating influence on the relationship between bank capital ratio and profitability. The findings are heterogeneous across banks' specific characteristics and market conditions. Furthermore, the results are robust to alternative proxies of profitability. The study's finding is beneficial for policymakers and regulators as liberalization is not always adversely impact the economy; rather, it's a double-edged sword, and they must maintain that delicate balance. The conclusions of this study have meaningful implications for senior bankers and policymakers when formulating strategies for preserving bank value. Specifically, it highlights the importance of considering the interactive role of economic freedom in their decision-making process.