Unintended side effects: stress tests, entrepreneurship, and innovation

Focus

Regulators have introduced stress tests for the largest banks with the aim of ensuring that they hold enough capital to withstand another crisis. Stress tests have effectively reduced systemic risk and improved risk management and capital planning at individual institutions. However, policymakers and academics worry about the potential negative effects on credit and the real economy. This paper investigates how regulatory stress tests may have affected entrepreneurship in the United States.

Contribution

Contributing to the literature that highlights some negative consequences of stress tests on credit supply to small businesses, this paper presents new evidence on the real effects of financial regulation. Regulatory stress tests for the largest banks might have an unintended side effect by curtailing credit to young businesses, which are especially dependent on external financing. The contraction in lending has the potential to stymie entrepreneurship and innovation. This novel channel, through which stress tests dampen economic dynamism, could help to explain the persistent decline in entrepreneurship since the crisis.

Findings

Stress-tested banks have sharply reduced home equity loans to small businesses, an important source of financing for entrepreneurs. The resulting contraction in loan supply has affected the real economy. By exploiting geographical variation in county exposure to stress-tested banks, the paper shows that counties with a higher exposure have experienced a relative decline in employment at young firms during the recovery, especially in industries that rely more on home equity financing.

Additional findings also suggest that counties with a higher exposure to stress-tested banks have seen a decline in patent applications by young firms, as well as a fall in labour productivity. The latter finding reflects the disproportionate contribution of young firms to innovation and growth. While the results do not imply that stress tests have reduced overall welfare, they highlight a possible trade-off between financial stability and economic dynamism.

Abstract

Post-crisis stress tests have helped to enhance financial stability and to reduce banks' risk-taking. In order to quantify their overall impact, regulators have turned to evaluating the effects of stress tests on financing and the real economy. Using the U.S. as a laboratory, this paper shows that stress tests have had potentially unintended side effects on entrepreneurship and innovation at young firms. Banks subject to stress tests have strongly cut small business loans secured by home equity, an important source of financing for entrepreneurs. Lower credit supply has led to a relative decline in entrepreneurship during the recovery in counties with higher exposure to stress tested banks. The decline has been steeper in sectors with a higher share of young firms using home equity financing, i.e. where the reduction in credit hit hardest. Counties with higher exposure have also seen a decline in patent applications by young firms. I provide suggestive evidence that the decline in credit has negatively affected labor productivity, reflecting young firms' disproportionate contribution to growth. My results do not imply that stress tests reduce welfare, but highlight a possible trade-off between financial stability and economic dynamism. The effects of stress tests on entrepreneurship should be taken into account when evaluating their effectiveness.

JEL codes: G20, G21, L26

Keywords: stress tests, small business lending, entrepreneurship, innovation, productivity slowdown