Unintended side effects: stress tests, entrepreneurship, and innovation
BIS Working Papers | No 823 | 22 November 2019
by Sebastian Doerr
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.
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.
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. [Link]
This is the non-technical summary of the paper from NBER digest November 2019:
A study of Indonesian reforms finds that sharpening focus and boosting staff-to-taxpayer ratios produced major revenue gains at minor expense.
Most low-income countries collect between 10 and 20 percent of their GDP in tax revenue, in comparison to high-income countries’ average of nearly 40 percent. This may in part be due to fundamental characteristics of developing economies, such as their less sophisticated banking systems or prevalence of informal labor market relationships. These considerations suggest that there is little these nations can do to increase tax revenues.
The findings of a study by M. Chatib Basri, Mayara Felix, Rema Hanna, and Benjamin A. Olken, Tax Administration vs. Tax Rates: Evidence from Corporate Taxation in Indonesia (NBER Working Paper 26150), challenge this idea. The study focuses on how two corporate tax reforms in Indonesia affected tax revenues.
In the first decade of this century, Indonesia established a number of Medium Taxpayer Offices (MTOs) and transferred responsibility for overseeing tax administration with respect to large corporations in each region with an MTO to that office. The MTOs had the same structure as the country’s regular tax offices, which are called Primary Taxpayer Offices (PTOs), but boasted higher staff-to-taxpayer ratios, allowing for better customer service and tax administration. The country’s several hundred largest taxpayers were serviced out of a central Large Taxpayer Office in Jakarta.
The researchers found that assignment to an MTO, as opposed to a PTO, increased tax revenue significantly — by 128 percent for the firms affected — at a cost of less than 1 percent of the increase in revenues. The increases were broad, occurring across corporate income taxes, VAT payments, and other kinds of tax payments. The MTO policy raised at least $4 billion from the firms it affected — just 4 percent of Indonesian corporations. The researchers also found that the establishment of the MTOs resulted in an increase in the reported number of permanent employees, and in reported wages, at the affected companies, perhaps because increased administration increased formalization.
The positive effect of MTOs on tax revenue increased over time. The researchers hypothesize that, before the advent of MTOs, overburdened tax workers may have focused more on larger corporations than on their smaller counterparts, effectively levying an additional “enforcement tax” on growth. The MTOs may have eliminated this tax, equalizing effective tax rates across different-sized firms.
The researchers also study a second tax reform: a 2009 change from a progressive corporate income tax rate to a flat rate of 28 percent with revenue-based discounts, and a 2010 tax cut of the flat rate to 25 percent. Reported taxable income increased as the tax rate declined: a 10 percent increase in the share of after-tax profits retained by firms — equivalent to a tax rate cut from 30 to 23 percent — is associated with an increase of about 6 percent in reported taxable income. This response is similar to the value found in many developed countries; it implies that Indonesia’s revenue-maximizing corporate tax rate is 56 percent.
Benchmarking the MTO reform against a counterfactual tax rate increase, the researchers find that the increased corporate income tax revenue from improvements in tax administration would be equivalent to raising the marginal corporate tax rate on affected firms by about 23 percentage points.
The findings indicate that tax administration improvements can be effective in raising revenue in developing nations. “Meaningfully large increases in tax revenue from medium-sized firms can be obtained through feasible administrative improvements in a relatively short period of time,” the researchers conclude.
CNN has a long article on the travails of the pension system in The Netherlands in a world of zero to negative interest rates [Link]
Indonesia supposedly has an advantage in a world where fashions are disappearing fast (or changing fast?). I am not sure I understand this world, however:
The journey of an Adidas or Nike garment produced by Tuntex in Indonesia, for instance, can begin almost 4,000 km away in the company’s textile plant in Taiwan. The fabrics can take nearly a week to reach the sewing factories. The model worked well enough when retail stores dictated trends and operated in clearly delineated seasons. But when clothing retailers need to react to a sudden trend driven by Instagram, it creates a daunting barrier. [Link]
Simon Kuper lists eight things we could learn from beautiful minds. I like the list [Link]. Good read.
Brilliant article in ‘The Guardian’ (ht: my former student Arjun) on what home delivery mean to the world and what ‘last mile’ really means:
Progress today consists of having our food and materials wing their way to each of us individually; it is indexed to our immobility. ….
Implicit in this fixation with time is the thesis that the opportunity cost of regular shopping is too high – that the hours spent driving to the better bookstore in the next town can be spent doing something more valuable. …..
Of course, the principle of opportunity cost assumes that we will earn the value of that fee back in some way in those 12 minutes – whereas the truth is that we are most likely to squander them on Instagram. The internet promises us time, then takes it right back….
…. Online, each of us functions as a one-dimensional identity: as consumer or vendor, to consume or sell in our own bubbles, unaware of the other except as a clump of anonymised data. Even with free shipping, that is the transaction cost. …
The final triumph of home delivery will be when we forget that anything is being delivered at all. [Link]
This is similar to an article in New York Times that I had blogged on earlier, I think. The NYT article appeared in October. The story in ‘The Guardian’ appeared few days ago. My feeling is that the piece in ‘The Guardian’ is more effective. It forces reflection.
Good article in New York Times on whether reducing travel via airplanes does good things for the environment or not. I love such articles because they point out the flaws of lazy activism partly also based on ‘holier than thou’ attitudes. Remember Melisa Kwasny’s beautiful piece blogged here.
The relationship between the Czech Republic and China – good to see the changes happening. [Link]
Some very interesting recommendations for reading here.
In May 2019, ‘The Economist’ wrote thus:
Global meat-eating is on the rise, bringing surprising benefits: As Africans get richer, they will eat more meat and live longer, healthier lives [Link]
Fast forward, more than six months later,
How much would giving up meat help the environment?: Going vegan for two-thirds of meals could cut food-related carbon emissions by 60% [Link] – ht: Saurabh Mukherjea of Marcellus Investments
On July 8, 2019, I had done this blog post when the Finance Minister appeared to walk back on her silently profound announcement in the budget that the government, going forward, would maintain its stake in central public sector undertakings at 51% taking into account the stake held by goverment-owned financial institutions. Now, few months later, she has managed to get it cleared by the Cabinet Committee. See the press release here. Kudos for her persistence.
Then, the government had announced strategic sale in select public sector enterprises. See press release here.
The Cabinet has approved the Taxation Laws (Amendment) Bill 2019.
Last week, the government had announced a resolution mechanism for financial service providers. Dewan Housing Finance will be a test case. Andy Mukherjee wonders if it might work. Reading between the lines, he is not sure that it would not.
Together with the Supreme Court decision on the sale of Essar Steel to Mittal Steel, it has been a good week for the government and for the Finance Minister.
The demons of fiscal deficit and goverment borrowing for the reminder of 2019-20 and that of government data are the two big ones that remain be slayed.
An opinion piece written by Dr. Manmohan Singh has justifiably attracted a lot of eyeballs and nods of approval. Written by a ‘student of economics’ as he describes himself, it is a well written essay. He has also zeroed in on some answers. Restore trust and confidence in administration, in the institutions and unleash massive fiscal stimulus.
He is right to call for an elimination of the atmosphere of fear. Some of us had written about it much earlier. See here and here. The government too has recognised the problem. That is why the Finance Minister recently announced a remote system for the issuing of notices and summons. She said that permission from a two-member collegium was necessary to prosecute tax defaults below Rupees 25.0 lakhs. To be sure, Revenue might resist and is resisting the changes. That behavioural issue transcends this government. On its part, the government has recognised the problem. The government-constituted panel has proposed decriminalizing many of the offences under the Company Law. The sooner its recommendations are implemented the better.
More importantly, the reposing of trust in industry was exemplified by the new corporate income tax regime the Finance Minister announced in September. It provided for low tax rates with fewer exemptions and announced a very low rate of 15% for new manufacturing oriented companies commencing production from 2023. Yours truly wrote that the significance of that measure was not the measure itself but the signal it sent. The government was no longer bogged down by the ‘Suit boot ki Sarcar’ jibe. Indeed, that jibe should remind Dr. Manmohan Singh as to the role of the Congress Party in creating an atmosphere of distrust between the government and the industry. That deserves some further explanation.
As a student of economics, Dr. Singh should note that economies and societies rarely settle at an equilibrium and stay there for extended periods. Humans, societies and economies, more often than not, swing between extremes. In that sense, he should reflect on the factors that created the atmosphere of distrust. What role did his government play and the industry play in engendering an atmosphere of distrust?
The Supreme Court took the extreme step of cancelling the coal mining licenses and the telecom spectrum licenses. It was probably too extreme but, perhaps, the Court thought that it was necessary because of the extreme breach of trust, good governance and probity in the award of such licenses. The economy is still hurting from both the action and the reaction.
An excellent article by Aarati Krishnan for BusinessLine documents the failure of many private sector agencies leading to retail and institutional creditors incurring losses on their loans to Dewan Housing Finance Limited (DHFL). After reading the article, I asked another journalist-friend as to whom he would consider responsible for India’s economic slowdown, he said he would place promoters of India Inc., on top of the list.
Abheek Bhattacharya has a review of ‘Bottle of lies’ and calls an Indian pharma company the ‘Theranos before Theranos’. It is useful to reflect on why it had taken 3 years for the acquisition of Essar Steel by the Mittal group. Is it the flaw of the Insolvency and Bankruptcy code or is it the disruptive behaviour code of promoters.
Internationally, in Financial Times today, there is a report on whistleblowers in the ‘Big Four’ audit companies facing a ‘disturbing pattern’ of harassment, bullying and discrimination.
The purpose of pointing out these is not to suggest that one mistake or one wrong justifies another mistake or wrong but to remind ourselves that backlashes inevitably follow egregious behaviour and the longer the original behaviour lasted, the reaction tends to last as long. Nonetheless, it is good to recall that the government is walking back on some of the measures, even if well-intended, that have proven to be inimical to legitimate economic activity.
Dr. Singh does not train his spotlight on the Reserve Bank of India, an institution that he once headed. RBI introduced inflation targeting in 2015, through an agreement with the Government of India. Let us not forget that it was a response to five years of double-digit retail price inflation under the government led by Dr. Singh. Unfortunately, for a better period of the last four+ years since the inflation targeting regime came into existence, the central bank has been more religious rather than pragmatic in its adherence to the inflation targeting regime. It has forgotten that all economics is about context.
Many theories that policymakers from developing countries at the feet of their Gurus in American Universities are abandoned by them before they start implementing them here. Inflation targeting of 2% is open to review there. It might even be replaced with nominal GDP targeting which is nothing but targeting a cumulative inflation rate rather than an annual rate of 2%. Central bank printing money to fund government deficits is now going mainstream. Since negative interest rates are not working to boost economic activity, economists call upon Western governments to splurge borrowing at low interest rates at which markets are willing to lend to fiscally insolvent governments.
In India, whether or not demonetisation of high-denomination notes was a sound or an unsound decision, the textbook response of a central bank to the sudden withdrawal of massive liquidity would be to lower rates. In 2017, RBI cut rates only once and that too in August. Then, in 2018, partly due to international pressure, it raised rates twice and has liberalized external commercial borrowings instead of lowering cost of capital at home.
More recently, it has not unequivocally reassured markets and Non-Banking Finance Corporations with liquidity backstops. It has allowed uncertainty to linger and the problems to fester. Its record in preventing frauds in banks has been spotty at best and sloppy, at worst. Its blanket and indiscriminate adoption of norms for recognition of non-performing loans was struck down by the Supreme Court.
I hope that when future students of economics write the history of India’s economic performance in the second decade of the millennium, they will subject the central bank to far greater scrutiny than current and former students of economics have done. Janmejaya Sinha of the Boston Consulting Group has been an exception. His critique of the Indian central bank can be found here and here.
Dr. Singh has called for a fiscal boost to the economy. He is right. There again, advisors to the government – from within RBI and outside – have made fiscal prudence a cult or a religion. That is why the NDA government of 2014-19 had to undertake a pro-cyclical fiscal tightening when it came to office. It did not demand a longer time frame to set right the fiscal imbalance it inherited from Dr. Singh’s government. Now, when the same advisors turn around and demand fiscal pump-priming, politicians are confused legitimately.
Students of economics should resist and challenge economic theories from becoming creeds if they want governments not to stand in the way of economic activity.
He writes that India is at risk of stagflation. He is partially right. India is at risk of economic stagnation. That said, considering the economic growth rates in many emerging economies, it does not seem to be the only country facing that risk. That is no consolation but it helps to remind ourselves that India’s economic growth troubles are not unique to India. There could be other forces at work. As for inflation risk lurking always in the corner, he may have been prompted by the most recent consumer price inflation rate. However, the core inflation rate is plumbing new lows and monetary dynamics are so poor that the inflation genie might stay in the bottle after popping its head for a few months.
Finally, he says that India has to grasp the opportunity of lower oil prices and a higher domestic political capital. Again, he is partly right. The considerable political capital that the government has accumulated has to be deployed to set the economy on a sustainable and slightly higher growth path than what obtains now. The government is beginning to do the right things but more can be done and faster too. But, will lower oil prices really help? It is not that easy to burn fossil fuels anymore.
The European Investment Bank has announced that it would stop funding fossil fuel companies. That also means that projects that depend on fossil fuels will find it tough to be financed in the years to come. This is a new instalment of ‘kicking the ladder’ that keeps divergence in economic attainments between the developed and developing nations from closing. Be that as it may, it is a growth hurdle that needs to be recognised by policymakers and commentators in India. Climate change and extreme weather events are becoming more frequent in India. That too is not growth-friendly development.
The high growth years of 2004-08 coincided with rising oil prices and were due to global economic boom that boosted India’s export growth. Global demand has languished since then and so has India’s export performance. This is not to deny the abundant scope that exists in India for improving productivity and export competitiveness. Unsustainable capital inflows and malformation of capital were short-term contributors to economic growth in that era. They are now headwinds.
In short, India faces newer growth challenges on top of the ones that have existed. It might have missed the low-hanging growth that was available in the last century.
Finally, Dr. Singh has done a useful service to the nation in reminding us all that economic activity is founded on trust between all participants. Yours truly had written a fortnight ago that restoring trust could be an effective economic stimulus. Hence, I agree with Dr. Singh that trust and confidence are central to economic activity. Further, the weight he has thrown behind fiscal expansion is doubly welcome.
In this essay, he has focused on what the government should do. Given his vast experience, his observations should not be ignored. At the same time, as a keen and perceptive student of economics, he should know that there are other stakeholders in the economic system. If he subjects them to as much scrutiny as he has done the government, the economy would benefit. At a minimum, he should write on the many acts of omission and commission on the part of the central bank in the last five years. Then, he should exhort India’s corporate leaders to reflect on their contribution to India’s economic malaise. That would be a useful service to the country which he has served with distinction in many capacities in the years gone by.
(These are my personal views)
Been more than two weeks since I wrote a blog post. By my standards, it has been crazy travel. The book that Gulzar Natarajan and I wrote, ‘The Rise of Finance: Causes, Consequences and Cures’ was launched by the Honourable Finance Minister of the Government of India, Ms. Nirmala Seetharaman on Nov. 10 in Delhi. After that, my travels took me to Madurai, Mumbai and Ahmedabad with a day in between at Sri City!
I do not understand many things, in any case, let alone I can blog about them. I do not understand what is happening in Hong Kong.
I do not know why the Indian Sensex Index is trading at 40K points.
I do not know why Chile has erupted.
Sandipan Deb does not know why Aatish Taseer’s OCI card was revoked and having done that, why it cannot be explained cogently, either.
Gulzar Natarajan and I thought that India was not financialised (negative connotation) so much as the West had. But, Ashoka Mody knows better. A ‘must-read’ article.
Nor do people seem to know why they are empathetic. Or, if they are empathetic at all.
Fama does not know why he wants behavioural economists should produce an alternative model of the financial market. If it is possible to show that financial markets are not sane, that should suffice because it is impossible to model insanity. There is no cap on insanity.
So, I am not sure if I would have been able to blog even if I had time on my hands. I do not seem to be able to make sense of many things.
The first op.-ed., I wrote, after being appointed as a part-time member to the Economic Advisory Council to the Prime Minister (of India) on October 16 is this one.
Randomised Control Trials are not the panacea for development questions. But, they may be useful if they pose the right questions. The conclusions may still have to be tempered and tailored to suit different contexts.
RCTs cannot reveal very much about causal processes since at their core they are designed to determine whether something has an effect, not how. The randomistas have attempted to deal with this charge by designing studies to interpret whether variations in the treatment have different effects, but this requires a prior conception of what the causal mechanisms are. The lack of understanding of causation can limit the value of any insights derived from RCTs in understanding economic life or in designing further policies and interventions. Ultimately, the randomistas tested what they thought was worth testing, and this revealed their own preoccupations and suppositions, contrary to the notion that they spent countless hours listening to and in close contact with the poor. It is not surprising that economists doing RCTs have therefore been centrally concerned with the effects of incentives on individual behavior—for instance, examining the idea that contract teachers who fear losing their jobs will be more effective than those with a guarantee of employment. [Link]
The long piece in opendemocracy.net has a wealth of links. These paragraphs are very good:
… the narrowness of the randomized trials is impractical for most forms of policies. While RCTs tend to test at most a couple of variations of a policy, in the real world of development, interventions are overlapping and synergistic. This reality recently led 15 leading economists to call to “evaluate whole public policies” rather than assess “short-term impacts of micro-projects,” given that what is needed is systems-level thinking to tackle the scale of overlapping crises. Furthermore, the value of experimentation in policy-making, rather than promoting pre-prescribed policies, should not be neglected.
The concept of “evidence-based policy” associated with the randomistas needs some unpacking. It is important to note that policies are informed by reflections on values and objectives, which economists are not necessarily well-suited to intervene in. Of course, evidence should be a part of a policy-making process, but the pursuit of ineffective policies is often driven by political priorities rather than lack of evidence…..
… While the Nobel Prize does leave those of us concerned with broader political economy challenges in the world anxious, not everything is doom and gloom. Firstly, the Nobel directs attention to the persistence of poverty in the world and the need to do something about it. What we as critical development economists now need to do is to challenge the fact that the Prize also legitimizes a prescriptive view of how to find solutions to global problems.
Secondly, the fact that a woman and a person of color were awarded a prize that is usually reserved for white men is a step forward for a more open and inclusive field. [Link]
Interesting that one of the links that Ingrid Harvold Kvangraven provides is an opinion-piece ‘written’ by fifteen economists last year. In that, they ‘anticipate’ the Swedish Riksbank Prize for RCT and ‘caution’ against it. Obviously, not directly.
Lastly, from Andrew Batson’s blog post on who should be awarded the Nobel Prize (Swedish Riksbank Prize) for Economic Development in China:
The contribution of randomized controlled trials to China’s poverty reduction has been, to a first approximation, zero. Yao Yang, the dean of the National School of Development at Peking University, wrote in an English-language op-ed that “Experiments might help policymakers improve existing welfare programs or lay the foundation for new ones, but they cannot tell a poor country how to achieve sustained growth.” In a similar vein, Harvard professor Dani Rodrik tweeted: “Remarkable how little today’s development economics has to say about the most impressive poverty reduction in history ever.” [Link]
My appointment to EAC-PM also reminded me of this column I wrote way back in May 2009: that op.-eds., did not bring change.
I was also reminded of this famous advice by Larry Summers to Yanis Varoufakis and quoted in his book, ‘Adults in the Room’:
‘There are two kinds of politicians,’ he said: ‘insiders and outsiders. The outsiders prioritize their freedom to speak their version of the truth. The price of their freedom is that they are ignored by the insiders, who make the important decisions. The insiders, for their part, follow a sacrosanct rule: never turn against other insiders and never talk to outsiders about what insiders say or do. Their reward? Access to inside information and a chance, though no guarantee, of influencing powerful people and outcomes.’ [Link]
A long New York Times article on the ‘chaos’ created by ordering from home which is about avoiding the chaos of shopping in real brick-and-mortar shops. Quite apart from the emptying out of High Streets in many cities, this has other costs too, as the article says. So, in the end, who bears the costs? Consumers actually pay less for their product. But, who pays for the associated costs. They are externalised. Neither party to the transaction bears it but the society. What is the answer? Collect more taxes from both?
Africa has lots of land and let us plant trees there. It will absorb global CO2. That is the thought process. Is that really correct? Another instance of unintended consequences or the road to hell being paved with good intentions. Article here (ht: my former student Arjun Aathish)