Unintended side effects of stress tests on American banks

Unintended side effects: stress tests, entrepreneurship, and innovation
 
BIS Working Papers  |  No 823  |  22 November 2019
by  Sebastian Doerr

Focus
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.

Contribution
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.

Findings
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.

Abstract
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]

Be sure of what you want. You may get it.

Based on the current repo rate of 5.4 per cent, the impact on SBI’s profitability is compressed to 10 basis points (bps). Home loans offered by the bank now start at 8.1 per cent. However, we are in a declining repo trajectory.

Therefore, if the central bank announces another rate cut anywhere between 25 and 40 bps — in October or later — profitability or net interest margin (NIM) may take a huge knock. At 3 per cent in the June quarter, numbers have just about started firming up and looking better.”

Source: “Linking loans to external benchmark may delay SBI’s profit revival – Profitability may take further hit on policy rate cut of 25-40 bps [Link]

The Chinese proverb I have used in the header is a very profound one.

A template on how to merge

Tamal Bandyopadhyay not only writes interestingly but he also writes about good stuff being done. This piece is an example. He had written on how the Bank of Baroda went about merging Dena Bank and Vijaya Bank into itself. A good read.

It comes across as a good template for other PSU CEOs to follow. May be worthwhile to ask P.S. Jayakumar and the CEOs of the other two banks to hold workshops (half-a-day seminars?) for the entities being merged now (announced in late-August by the Finance Minister) on what they did and how they did it.

Just so that we know

The most popular Mudra loans, given to micro and small units, have three segments — Shishu (up to Rs 50,000), Kishore (between Rs 50,001 and Rs 5 lakh) and Tarun (beyond Rs 5 lakh and up to Rs 10 lakh).

As on March 2019, 16.2 per cent of the Shishu loans have turned bad (for Bank of Maharashtra, it’s 48 per cent and for BoI and Punjab National Bank and a couple of others, at least 25 per cent); the bad loans in the Kishore scheme are 13.22 per cent (four banks, including SBI, have more than 20 per cent bad loans) and Tarun scheme, 9.61 per cent.

We are yet to know the state of affairs at the 59-minute loans (Rs 1 lakh to Rs 5 crore), as loans disbursed on the fast lane are not a year old as yet. [Link]

Incentivising malpractice

The mind-bending complexities of the new financial technology combined with the modern practice of incentive payments that reward employees for particular deals practically invites malpractice, whatever the pious institutional statements about the priority placed on client relationships and an ethical culture. In fact, rewards for successful proprietary transactions, inherently speculative and often in conflict with client interests, will tend eventually to color the overall atmosphere and the reward systems in banks, even beyond the trading rooms.

Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (p. 216). Public Affairs. Kindle Edition.

The emphasis was mine and that is the key part of that comment.

Wake up, gentlemen. I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.”

Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (pp. 216-217). Public Affairs. Kindle Edition.

… concerns about regulatory complexity are common and not limited to financial regulation. Pictures of the thousands and thousands of pages of federal regulation are grist for election campaign mills. I cringe, like others. But then I also cringe a bit when I receive, each year, the eighty or so pages explaining precisely my rights and the policy limitations in my “simple” household insurance policy.

Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (p. 218). Public Affairs. Kindle Edition.

India’s banking trilemma

Notwithstanding the controversies that dogged his tenure at the Reserve Bank of India as its Governor, Urjit Patel has made an important and interesting presentation at the Stanford-India conference in June on India’s banking sector problems. As Urjit Patel frames it, the ‘Impossible Trinity’ of Indian banking is this: Dominance of government-owned banks in the banking sector, independent regulation and adherence to public debt-GDP targets. India can have only two of the three.

But, in fact, political economy considerations dictate that India follows only the first of the three. In the presence of the first, the other two are impossible, except in terms of appearances.

India’s banking crisis is a huge opportunity missed.

His presentation is worth going through and storing for reference. Lots of good tables and charts.

An institution learns humility

Whoever chose this header for the story – whether the journalist herself or her Editor – he or she deserves praise for doing so. The header of the article is “RBI’s 12 February circular makes a comeback with a dash of humility”. Nice.

All institutions need to go through the cycle of competence – confidence – overconfidence-overreach-setback-humility. Probably, RBI had to have its moment. Its circular of 18th February 2018 was an over-reach. I went through the circular (‘Prudential framework for resolution of stressed assets’, June 7, 2019) It does not relax the credit discipline and yet it provides time for resolution before the non-performing debt goes before the bankruptcy court.