BIS on Impact of Stress Tests on Entrepreneurship and Innovation in US

To quantify the overall impact of stress tests, regulators have turned to evaluating the effects of stress tests on financing and the real economy. This paper contributes to the literature that highlights some negative consequences of stress tests on credit supply to small businesses and 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. These effects should be taken into account when evaluating the overall consequences of financial regulation or higher capital requirements, especially in light of the current debate on declining dynamism and the post-crisis productivity slowdown. The contraction in lending has the potential to stymie entrepreneurship and innovation. The idea that stress tests dampen economic dynamism could help to explain the persistent decline in entrepreneurship since the crisis.

The banks that have undergone stress tests have sharply reduced home equity loans to small businesses, which is 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 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 labor productivity. The fall in labor productivity 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 do highlight a possible trade-off between financial stability and economic dynamism.

Related Links

• Press Release
  
• Working Paper (PDF)

Keywords: Americas, US, Banking, Stress Testing, Small Business Lending, Loan-Level Data, Credit Risk, Post-Crisis Reforms, BIS