Sebastian Doerr, University of Zurich

“No Risk, No Growth: The Effects of Stress Testing on Entrepreneurship and Innovation”

Abstract

This paper shows that post-crisis financial regulation reduces bank credit to young firms and leads to a decline in entrepreneurship and innovation. I provide evidence that banks subject to stress tests strongly cut small businesses lending, in particular lending secured by real estate collateral. Lower credit supply leads to a relative decline in the number and share of entrepreneurs during the recovery in counties with high exposure to stress tested banks, relative to counties with low exposure.

Since real estate collateral is an important source of financing for young firms, the decline in entrepreneurship is stronger in sectors with a higher share of firms using home equity financing, i.e. where the reduction in credit hits hardest. Counties with higher exposure also see a decline in innovation: patent applications by young firms fall significantly, but not by old.

As young firms contribute disproportionately to aggregate growth, my findings suggest that financial regulation reduces dynamism and innovation in the U.S. and contributes to the post-crisis productivity slowdown. Results are robust to controlling for unobservable local and industry characteristics through granular fixed effects and an instrumental variable approach that predicts county exposure with a gravity model of bank expansion.

Contact person: Peter Norman Sørensen