The financial crisis of 2007/08 led to a severe recession and revealed that banks had taken on excessive risk in its run-up. To make the financial system safer regulators introduced stress tests for systemically relevant banks. These tests assume adverse economic scenarios, for example rising unemployment and falling house prices, and predict banks’ hypothetical losses given their asset portfolios. The losses are then projected into minimum capital ratios required to withstand the downturn. While stress tests have the primary goal to increase financial stability, many observers worry about their side effects on the real economy.
This paper shows that stress tested banks have cut back on lending to entrepreneurs, thereby reducing employment and innovation at young firms. Exploiting unique data on business-related home equity loans in HMDA, I first show that stress tested banks cut small business loans secured by home equity by over 30% more than non-stress tested banks. The reduction in lending is not due to differences in loan demand across banks. Importantly, business-related home equity lending declines also on aggregate. The fall in lending is likely an unintended side effect of stress tests: they model a steep collapse in house prices that – although aimed at addressing risk in the residential mortgage market – constitutes an additional cost for small business loans secured by real estate collateral.
To investigate whether the reduction in credit supply has real effects I analyze how the local presence of stress tested banks affects employment and innovation at young firms. I show that in counties where stress tested banks have a higher pre-crisis market share, entrepreneurship declines by more. The decline in entrepreneurship is particularly pronounced in industries in which a higher share of firms relies on home equity financing, i.e., where the reduction in credit likely hits hardest. Counties with higher exposure to stress tested banks also see a decline in patent applications by young firms. Accounting for the quality of patents by taking into account citations leads to an even starker effect. This suggests that innovative firms were starved for credit.
Do these results imply that stress tests lower welfare? Far from it: stress tests have succeeded in reducing banks’ risk-taking and bolstered financial stability. This outcome might have required a reduction in lending to young firms if banks lent imprudently in the run-up to the crisis. And yet, my results suggest that entrepreneurs might have seen a disproportionate decline in credit supply. Due to their outsized importance for aggregate innovation and growth, the credit crunch could have contributed to the anemic recovery from the crisis. This possibly unintended side effect of stress tests has to be taken into account when evaluating the overall impact of post-crisis financial regulation.