How small business lending survives big bank stress tests

Research reveals other players are stepping in to provide credit

Stress tests have been a key factor in shoring up confidence in banks following the global financial crisis (GFC).

But what if these market tools – which test the resilience of financial institutions in the face of hypothetical adverse conditions that may threaten their viability – were to potentially put the brakes on small business lending?

In a research paper, Stress Tests and Small Business Lending, a team of international researchers builds on literature which suggests that banks facing regulatory capital constraints are likely to cut their lending supply. 

At the same time, they examine the notion that stress tests, or at least banks’ responses to possible tighter lending requirements, could contribute to a shortage of credit for small businesses, which are widely regarded as the engine room of many economies.

Kristle Cortés, a co-author of the research and a senior lecturer in the school of banking and finance at UNSW Business School, believes the US-based research confirms that post-crisis bank stress tests have altered banks’ credit supply to small businesses. 

A typical scenario is that larger banks most affected by stress tests reallocate credit away from riskier markets and toward safer ones, while they also raise interest rates on riskier small loans. Such a combination could hurt smaller enterprises.

“But one of our key findings is that stress tests do not reduce aggregate credit for small businesses,” says Cortés, who notes that smaller financial lenders often step up to fill any funding gaps. 

“Small banks seem to increase their share in geographies that were formerly reliant on stress-tested lenders.”

'A decision by a bank to increase or reduce lending to a certain segment, such as small business, is more likely to be driven by expected outcomes ...'

GREG MONAHAN

The loans picture

The researchers evaluated whether banks respond to stress tests by “rebalancing away from risky loans”, and they analysed the small business loan originations data collected under the Community Reinvestment Act (CRA). 

As part of their work, they note that credit to all classes of borrowers grew sharply during the run-up to the GFC in 2007, including loans to large and small businesses. 

However, during the early years of the crisis, bank originations of business loans fell by as much as 40%. Since the GFC, lending to large businesses has rebounded; in 2016, for example, total real commercial and industrial loans on bank balance sheets were more than 50% higher than in 2007.

“Those loans bounced back fairly quickly and, when they did, they just skyrocketed,” Cortés says. 

By contrast, the recovery of small business lending continues to be slow; in 2016, small business loans on bank balance sheets remained lower than in 2007.

The authors conclude that stress tests conducted by the Federal Reserve result in a decrease in affected banks’ small business credit supply. 

“Banks more affected by stress tests price the implied increase in capital requirements into loan rates in markets where they have local knowledge, and exit markets where they do not. These effects are concentrated among risky borrowers,” they state. 

Despite this supply reduction by stress-tested banks, they find no evidence of aggregate declines in small business loan originations due to stress tests. 

Cortés and her fellow authors suggest it is apparent that the smaller non-stress-tested banks fill the gap and claim a larger market share in geographies formerly reliant on stress-tested lenders. 

“We see that this is the case – that the small business lending increases at the banks that would be considered to be smaller, more local banks.” 

Global action

In the aftermath of the GFC, banks across the world have been subject to various forms of stress testing. In the US, the Dodd-Frank Act requires the Federal Reserve to conduct annual stress tests on a select group of large bank holding companies and non-bank financial institutions. 

Since 2011, European Union authorities have run a series of stress tests, though critics have suggested that they have not been stringent enough. 

In Australia, the Australian Prudential Regulation Authority (APRA) has recently imposed more stringent bank credit requirements following the banking royal commission.

Greg Monahan, associate partner, Banking and Capital Markets, at EY, says there is no doubt that stress testing, when done properly, is a powerful risk-management tool that complements other market tools. 

“The heightened focus on responsible lending is one of the positives to come out of the banking royal commission,” he says. “We’ve already seen a response to this – not only by the banks, but also by non-bank lenders.”

In line with the findings of Cortés et al, Monahan says he has not observed a reduction in the provision of credit to small business in response to the results of stress tests. It would be difficult, he observes, to isolate stress testing as a cause for a decline in small business loan originations. 

Furthermore, he says it would be unlikely that a bank would use stress testing to drive such a lending decision.

“A decision by a bank to increase or reduce lending to a certain segment, such as small business, is more likely to be driven by expected outcomes, and these are not considered in stress testing,” Monahan says.

'We find that [stress testing] does not lead to a reduction in small business lending, which is what you would hope'

KRISTLE CORTÉS

Role for fin-techs

In modern banking markets, innovative fin-techs are playing an increasingly important lending role, either directly with customers or through collaboration with traditional banks. It makes sense, then, that they could conceivably fill part of any potential lending gap to small businesses.

While financial markets are “very fluid”, Cortés says there is always the potential for lending bottlenecks. In countries such as China and Australia, where fin-tech markets are relatively strong, she says it is more likely that they could play a significant lending role rather than in the US, where business customers have the choice of thousands of banks, large and small.

Monahan agrees that fin-techs are one potential solution in markets where lending is tight.

“[But] the important point is that whenever someone lends money to someone else, they need to do so with a complete understanding of the risks involved,” he says.

“There are a number of elements that need to form part of such an understanding, including complete and accurate disclosure by the borrower, and sufficient expertise in the measurement and management of risk by the lender.”

One factor that could make it more difficult for small businesses to obtain credit, according to Monahan, is their ability to demonstrate a capacity to meet repayment obligations. 

To help address this scenario, small businesses could benefit from some form of support in the development and articulation of their business strategy and financial performance forecasts – “both of which are critical inputs to a bank’s credit approval process”.

Doing their job

In their paper, the authors conclude that stress tests work as intended, with tested lenders either reducing their exposure to risk or, in cases where they do not, increasing the compensation for bearing that risk. 

“We think that’s effectively the channel that has occurred here – that is, the banks have said that they are better informed (because of stress testing) and that they were going to increase interest rates on any risky loans,” Cortés says.

The findings also indicate that the movement of credit supply from large, non-local lenders to smaller banks with more local knowledge may help enhance financial stability and the efficiency of credit allocation.

Although the research is based on US data, Cortés is confident it contributes to ongoing debate as to whether bank stress tests can have an adverse impact on the credit flow of small businesses.

“And we find that it does not lead to a reduction in small business lending, which is what you would hope.”

The co-authors with Kristle Cortés were Yuliya Demyanyk, associate professor of finance at University of Illinois; Lei Li, senior economist at the Federal Reserve Board; Elena Loutskina, Bank of America associate professor of business administration at the University of Virginia; and Philip E. Strahan, the John L. Collins, S.J. Chair in finance at Boston College and research fellow at the National Bureau of Economic Research.