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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.
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.