Journal of Banking & Finance 33 (2009) 415–424

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Journal of Banking & Finance

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Are good or bad borrowers discouraged from applying for loans?

Evidence from US small business credit markets
Liang Han a,*, Stuart Fraser b, David J. Storey b
a
The Business School, University of Hull, Cottingham Road, Hull HU6 7RX, UK
b
Centre for Small and Medium Sized Enterprises, Warwick Business School, University of Warwick, Coventry CV4 7AL, UK

a r t i c l e i n f o a b s t r a c t

Article history: This paper takes the concept of a discouraged borrower originally formulated by Kon and Storey [Kon, Y.,
Received 3 January 2008 Storey, D.J., 2003. A theory of discouraged borrowers. Small Business Economics 21, 37–49] and examines
Accepted 28 August 2008 whether discouragement is an efficient self-rationing mechanism. Using US data it finds riskier borrowers
Available online 6 September 2008
have higher probabilities of discouragement, which increase with longer financial relationships, suggest-
ing discouragement is an efficient self-rationing mechanism. It also finds low risk borrowers are less
JEL classification: likely to be discouraged in concentrated markets than in competitive markets and that, in concentrated
G14
markets, high risk borrowers are more likely to be discouraged the longer their financial relationships.
G21
We conclude discouragement is more efficient in concentrated, than in competitive, markets.
Keywords: Ó 2008 Elsevier B.V. All rights reserved.
Discouraged borrowers
Self-rationing
Information problem

1. Introduction both good and bad borrowers who experience discouragement.

Imperfect and asymmetric information problems lie at the heart
of financing small businesses (Berger and Udell, 1998): small firms
are recognized as more informationally opaque than large firms
and the collection of private information, such as the risk type of
small business borrowers, is more costly (Ang, 1991). In providing
finance for small firms, bank lenders are generally assumed to have
poorer information about the individual small business than the
borrower.1 So, faced by asymmetric information, banks either ration
credit (Stiglitz and Weiss, 1981) or offer a menu of contracts which
act as a self-selection mechanism to distinguish good from bad bor-
rowers (Bester, 1985).
However, in conditions of imperfect information, some small
businesses do not apply for loans, even when they need capital.
These are called ‘Discouraged Borrowers’ and are defined as cred-
itworthy (good) borrowers who do not apply because they feel
they will be rejected (Kon and Storey, 2003). In this paper, our cen-
tral purpose is to test whether discouragement is an efficient self-
rationing mechanism, so we widen their definition by including
* Corresponding author. Tel.: +44 1482 463172; fax: +44 1482 463484.
E-mail addresses: L.Han@hull.ac.uk (L. Han), Stuart.Fraser@wbs.ac.uk (S. Fraser),
David.Storey@wbs.ac.uk (D. J. Storey).
1
The exception, as argued by Storey (1994) is that bank lenders are likely to have
better information than the founders of wholly new businesses.
According to Kon and Storey (2003) discouraged borrowers exist
because of both information asymmetries and positive application
costs. Evidence of discouragement is taken to reflect information
imperfections. They argue that banks do not know borrower types
– either good (low risk) or bad (high risk). If they did, then they
would charge an appropriate premium. This paper however argues
that discouragement can also be viewed as a self-rationing mech-
anism in the application decision, implying that bad as well as
good borrowers can be discouraged. Discouragement is therefore
defined as efficient when ‘bad’ borrowers are discouraged but inef-
ficient when good borrowers are discouraged and/or if bad borrow-
ers get into the loan pool.
Using data from the 1998 US Survey of Small Business Finances
(SSBF) we find that, after controlling for the characteristics of both
the business and the entrepreneur, riskier borrowers are more
likely to be discouraged. As a proxy for information quality, longer
financial relationships mean riskier borrowers are more likely to be
discouraged, suggesting discouragement is an efficient self-ration-
ing mechanism. We also find that low risk borrowers are less likely
to be discouraged in concentrated markets than in competitive
markets. Conversely, in concentrated markets, high risk borrowers
are more likely to be discouraged. However, we find little evidence
that application costs are a key determinant of discouragement
among small businesses. The rest of the paper is structured as fol-
lows. Section 2 reviews both the theoretical and empirical litera-

0378-4266/$ - see front matter Ó 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankfin.2008.08.014
416 L. Han et al. / Journal of Banking & Finance 33 (2009) 415–424
ture on discouraged borrowers. Section 3 introduces the data and
the methodology employed in this paper. Section 4 reports the
empirical findings and Section 5 concludes.
2. Discouraged borrowers – Theories and empirics
Discouraged borrowers are now recognized as important, in
both theoretical and empirical work, for three reasons. Firstly,
small businesses are more likely to report discouragement than re-
port rejection (Levenson and Willard, 2000). Secondly, the likeli-
hood of being discouraged varies with demographic factors (Vos
et al., 2007), especially the ethnic background of the entrepreneur,
with discouragement more likely among ethnic minority groups
both in the US (Cavalluzzo et al., 2002) and in the UK (Fraser, in
press). Thirdly, the examination of discouraged borrowers is actu-
ally a test of the lending efficiency of financial institutions in
financing small businesses in terms of screening errors and appli-
cation costs. According to Kon and Storey (2003) one of the most
important determinants of discouragement is the unobservable
quality of borrowers. Ideally, lenders would like to encourage good
borrowers and discourage bad borrowers, but they do not know, or
do not know exactly, the borrower’s quality because of information
asymmetries. In the empirical literature, borrower quality is mea-
sured in several ways by, e.g., Dun and Bradstreet Scores (Caval-
luzzo et al., 2002) and the variance of returns to equity (Booth
and Booth, 2006).
Imperfect information therefore lies at the heart of the concept
of discouraged borrowers and the acquisition of reliable informa-
tion from informationally opaque small business borrowers is a
concern to lenders. Empirically, opacity is addressed in several
ways, e.g. the age of firms (Hyytinen and Pajarinen, 2008). Petersen
and Rajan (2002) use business credit card and credit lines to mea-
sure the information transparency of the business. Business credit
card holders and lines of credit users are argued to be information-
ally transparent because their creditworthiness has been assessed
in the external credit market. A second measure is relationship
duration. Here longer relationships are argued to reflect reduced
opacity, leading to improved availability (Petersen and Rajan,
1994) and lower cost (Berger and Udell, 1995) of small business
finance.
Another important determinant in Kon and Storey’s model of
discouraged borrowers is the screening errors made by lenders
arising from information asymmetries. However, some lenders
can more easily access private information to overcome asymme-
tries than others. Banks, for instance, may collect information by
monitoring transactions on current accounts held by borrowers
whereas this information is not available to non-bank lenders or
venture capitalists. Their role as the most important and compre-
hensive provider of financial services for small businesses (Bilter
et al., 2001) is clearly linked to their higher acceptance rates on
loan applications from small businesses compared with other fi-
nance sources.2 Small firms seeking funding from their bank are also
likely to have lower application costs than when they apply else-
where for funds. All else equal therefore small firms are less likely
to be discouraged in applying for bank finance.
Physical distance between lenders and borrowers has been ar-
gued to influence the financing of small businesses, but in recent
years this effect has been moderated as a result of the development
of new information technologies. These changes have lowered
search costs enabling easier access to multiple lenders, which are
often located at a considerable distance from the business (Han,
2
We find that 71% of applicants who were always approved borrowed from banks
compared with only 29% of those that borrowed from non-bank institutions.
Unfortunately, we do not know whether banks have a higher or a lower rejection
rate on loan applications.
2008). We recognize these changes but note that our empirical
data are derived from 1998 before the full impact of such changes
were apparent.
Finally, the extent to which financial relationships are concen-
trated with a single lender may also influence discouragement.
Concentrated relationships may: signal higher borrower quality
(Bris and Welch, 2005); help to overcome the free-rider problem;
and reduce transaction and negotiation costs. However, multiple
borrowing relationships provide the opportunity for competition
between finance providers and reduce the possibility of rent
extraction. The empirical evidence suggests a lower borrowing
concentration significantly reduces the cost of borrowing (Repetto
et al., 2004) because a sole lender can charge a premium by ‘lock-
ing in’ the small business (Degryse and Von Cayseele, 2000). Small
businesses that borrow from multiple sources also benefit by
insuring themselves against liquidity shocks that impact individual
banks (Detragiache et al., 2000). In summary, discouragement is
likely to be associated with the demographic profile of the entre-
preneur, the quality of the borrower, information issues (including
screening errors) and application costs.
3. Data and methodology
3.1. Data
This paper examines the effects of demographic profiles, bor-
rower quality, information issues and application costs on the like-
lihood of financial discouragement using the 1998 US Survey of
Small Business Finances (SSBF98). The survey collects information
on the use of credit by small businesses with fewer than 500
employees. The dataset contains 3561 firms of which: 2099 firms
did not apply for external finance, in the 3 years before the survey,
because they had no need for it; 962 firms applied for external fi-
nance; and 500 did not apply because of fear of rejection. The latter
group, around one-third of businesses with a demand for external
finance, is defined as discouraged borrowers. Hence, our definition
of discouraged borrowers encompasses all businesses (both high
and low risk), with capital demands, but which did not apply be-
cause of fear of rejection.
3.2. Variables
To estimate the effects of the determinants of discouragement,
we use a logistic estimation procedure3 on those firms with capital
demands. The dependent variable is coded as one if the firm was dis-
couraged from applying for external funds; zero otherwise. The inde-
pendent variables are divided into four groups: (1) characteristics of
the owner and firm; (2) borrower quality; (3) application costs; and
(4) information issues and the nature of the primary lender. Control
variables on industry and market concentration are also included.
Table 1 provides variable definitions and summary statistics. On
average, a ‘typical’ firm in the whole sample (3561 firms) was fam-
ily-owned, 14 years old and has 26 employees. It was owned by a 51
years old male with a college degree, 19 years of experience in busi-
ness and a total personal wealth of $0.93 million. 41% of the sample
had a demand for external capital and 34% of them (14% of the total
sample) were discouraged borrowers. The capital seekers (1462
firms) are relatively younger (12.6 years old) but larger (27 employ-
ees) on average than the whole sample. Discouraged borrowers (500
3
Another possibility is to conduct a nested logistic model with the upper level
modeling the demands for capital and the lower level modeling the choice between
applying and being discouraged. The authors attempted to construct such a model but
it failed to converge due to non-concavity in the likelihood function. Our interpre-
tation of this outcome is that it suggests the simpler models are more appropriate for
the data.
Table 1
Descriptive statistics: mean of key variables

Variable Definition All samples (N = 3561) Non-capital seekers (N = 2099) Capital seekers (N = 1462) Applicants (N = 962) Discouraged borrowers (N = 500)

MSA Business is in a Metropolitan Statistical Area (0,1) 0.78 0.79 0.77 0.75 0.80
HHI3_B1 Headquartered in a competitive banking market (0,1)1 0.05 0.05 0.05 0.04 0.06
HHI3_B2 Headquartered in a moderately concentrated banking market 0.42 0.43 0.42 0.42 0.41
(0,1)1
HHI3_B3 Headquartered in a highly concentrated banking market (0,1)1 0.52 0.52 0.53 0.53 0.53
Characteristics of the business and entrepreneur
CAPNEEDS Demands for external capital (0,1) 0.41 0.00 1.00 1.00 1.00
DB Discouraged borrower (0,1) 0.14 0.00 0.34 0.00 1.00
C_CORPORATION Business is incorporated (0,1) 0.25 0.24 0.27 0.30 0.22
FAMILY_OWNED Family owned (0,1) 0.85 0.87 0.83 0.80 0.90
FAGE Firm age (years)2 14.44 15.73 12.58 13.15 11.50
TOTEMP Total employment number2 25.53 24.65 26.79 35.90 9.26
GROWTH Sales growth: sales (year t)/ sales (year t 1)2 1.58 1.42 1.80 1.87 1.67
PROFIT Return to assets: total profit/total assets2 21.6521 12.8116 34.2117 50.8930 1.6321
TLBTA Capital structure: total liability/ total business assets2 4520.26 6224.24 2073.85 2848.33 583.74
F4_BCC Business credit card (0,1) 0.40 0.36 0.45 0.53 0.31
F7_CRL Credit lines (0,1) 0.36 0.33 0.40 0.51 0.19

L. Han et al. / Journal of Banking & Finance 33 (2009) 415–424

DEGREE Owner has a college degree or above (0,1) 0.52 0.53 0.51 0.54 0.44
MALE Male owner (0,1) 0.74 0.73 0.74 0.77 0.68
ETHNIC Ethnic-minority owner (0,1) 0.14 0.12 0.18 0.14 0.24
OAGE Owner’s age (years)2 50.72 51.96 48.93 48.88 49.03
EXP Experience of owner in business (years)2 19.21 20.25 17.73 18.45 16.34
PERWEAL Personal assets of owner (million $)2,3 0.93 0.95 0.91 1.22 0.33
Quality of borrowers
DB_SCORE Dun and Bradstreet score: categorical4 2.97 2.84 3.16 3.06 3.35
INST_DB12 Instrumented D& B score: moderate risk (0,1)5 0.21 0.25 0.15 0.19 0.07
INST_DB13 Instrumented D& B score: average risk (0,1)5 0.68 0.70 0.66 0.65 0.67
INST_DB14 Instrumented D& B score: high risk (0,1)5 0.11 0.06 0.19 0.15 0.25
INST_DB 15 Instrumented D& B score: significant risk (0,1)5 0.00 0.00 0.01 0.00 0.01
INST_DB 2 Instrumented D& B score: weighted average5 2.70 2.60 2.85 2.77 3.00
Application costs
DIST_PI Distance to the primary institution (miles)2 17.13 12.73 23.71 25.78 19.68
ONLINE Apply loans online (0,1) 0.04 0.03 0.06 0.07 0.03
Information issues and nature of primary lender
N_FS Number of sources of financial services 2.30 1.94 2.81 3.25 1.96
PITIPE_BANK Primary institution is a bank (0,1) 0.88 0.88 0.87 0.89 0.83
RELATION_PI Length of relationship with primary institution (months)2 97.62 106.46 84.40 85.70 81.88
Interaction terms
DB2LNR INST_DB2
* LOGRELATION_PI 10.99 10.79 11.30 10.93 12.01
DB2LNRHB1 INST_DB2
* LOGRELATION_PI
* HHI3_B1 0.57 0.59 0.53 0.47 0.66
* *
DB2LNRHB2 INST_DB2 LOGRELATION_PI HHI3_B2 4.68 4.66 4.71 4.60 4.92
DB2LNRHB3 INST_DB2
* LOGRELATION_PI
* HHI3_B3 5.74 5.53 6.05 5.86 6.40
Loan application: approval/denial
APPROVED Most recent loan applicants were always approved (0,1) 0.74
DENIED Most recent loan applicants were always denied (0,1) 0.17

This table reports the mean value of key variables in different groups. All samples contain both capital seekers and non capital seekers. Capital seekers are those firms applied for loans and discouraged borrowers. Not reported here,
but available on request from the authors, are other descriptive statistics, e.g. median, standard deviation, of these variables and those of nine dummies representing the industry based on two-digit SIC code.
Note:
1. Concentration in the banking market is measured by the Herfindahl Index which is a categorical variable and measures the degree of competition within the local financial market. It is equal to one when the index is between 0
and 1000, meaning the financial market is less concentrated. It equals two when the index is between 1000 and 1800, suggesting a moderate concentrated financial market. It equals three when the index is larger than 1800,
meaning that the financial market is highly concentrated.
2. In the empirical modeling, these variables are transformed into the natural log of one plus the real value.
3. Personal wealth is defined as the total value of the owner’s home equity and the net worth of other assets.
4. Dun and Bradstreet score on risk is categorical with a range from 1 to 5, where 1 is ‘low risk’, 2 is ‘moderate risk’, 3 is ‘average risk’, 4 is ‘high risk’ and 5 is ‘significant risk’.
5. We estimate the instrumented D& B scores by conducting ordered logistic models on the business and entrepreneur variables and their credit history. One instrumented D& B score (INST_DB1) follows the categorical nature of the
score, ranging from 2 (moderate risk) to 5 (high risk). The score is recoded to a specific category where the sample firm has the highest probability of falling into this category. The other instrumented D& B score (INST_DB2) is

417
continuous and a weighted average of the possible categories where the weight is the probability of falling into a specific category estimated from an ordered logistic model. Details of the instrumentation process are available from
the authors on request.
418 L. Han et al. / Journal of Banking & Finance 33 (2009) 415–424

firms) are younger (11.5 years old) and much smaller (9 employees)
on average than the whole sample. Furthermore, the entrepreneurs
who were discouraged from borrowing, are less experienced
(16 years experience) and much poorer (with $0.33 million personal
wealth) compared to the whole sample. Among the most recent loan
applicants, 74% were always approved and 17% were always denied.
We use instrumented D&B scores to measure the risk levels
(quality) of borrowers in order to overcome the potential problem
of endogeneity, where the credit score is correlated with the error
term or unobservables (e.g., entrepreneurial talent) in the discour-
agement equation. These scores indicate the majority of firms in
the sample are average risks but there are a higher proportion of
high risk firms among the discouraged borrowers (see Table 1).
We follow Petersen and Rajan (2002) in using business credit card
and credit lines to measure the information transparency of the
business. We also measure the severity of the information problem
by the length of relationship with the primary financial service
provider; this measure has been widely used in the existing litera-
ture (e.g. Berger and Udell, 1995). In addition, we measure the con-
centration of creditors by the number of financial service suppliers
used by the sample firm. We expect that, as information improves,
low risk small businesses will be less likely to be discouraged and
high risk borrowers will be more likely to be discouraged. The third
factor influencing discouragement is application costs. These are
proxied using a continuous variable, namely the physical distance
to the primary lender, and a binary variable, whether the business
applied for a loan online. We expect that discouragement is less
likely when application costs are low.
In Kon and Storey (2003), lenders’ screening errors are an
important determinant of discouragement. However, we cannot
directly measure this error because the information used in the
lending decision is not available in the survey so we cannot test
whether a loan application has been mistakenly rejected or mis-
priced. Instead, we use a dummy variable for whether the primary
lender is a bank, to represent the nature of the institution. As ar-
gued earlier, banks make fewer screening errors because of their
advantage in information collection resulting from their ability to
monitor other services used by borrowers such as bank accounts.
Therefore, we expect that small businesses are less likely to be dis-
couraged when the primary lender is a bank due to the likelihood
of fewer screening errors. We also include characteristics of the
entrepreneur (e.g. age, education background and personal wealth
of the principal owner) and of the business (e.g. size and capital
structure). Finally, we include control variables such as sector
and market concentration.
4. Empirical results
4.1. Univariate tests
We begin the analysis with univariate comparisons of the key
variables between the samples with and without external capital
demands and between applicants and discouraged borrowers.
The results are shown in Table 2. It shows that, with higher (instru-
mented) D&B scores, capital seekers are riskier than non-capital
seekers; and discouraged borrowers are riskier than applicants
(p < 0.01). The table also indicates that, on average, non-capital
seekers are older, less likely to be incorporated and have lower
growth rates than firms with capital demands. Discouraged bor-
rowers are younger and smaller (measured by the total number
of employees) than applicants and are less likely to be incorpo-
rated. However, the capital structures and profitability of these
groups do not differ significantly in terms of the ratios of total lia-
bilities to total assets and return to total assets. Regarding the
demographic profile of the entrepreneur, non-capital seekers are:
older; more experienced (measured by the number of years of
experience in business); and less likely to be from an ethnic-
minority. Discouraged borrowers are: less-experienced; poorer
(measured by the total value of the owner’s home equity and the
net worth of other assets); less likely to have a college degree;
and more likely to belong to an ethnic-minority group.

Table 2
Univariate tests on mean and median

Variable Non-capital seekers (N = 2099) Capital seekers (N = 1462) p-Value Applicants (N = 962) Discouraged borrowers (N = 500) p-Value
Characteristics of business and entrepreneur
FAGE 15.7342 12.5848 0.0000 13.1487 11.5000 0.0045
C_CORPORATION 0.2354 0.2688 0.0231 0.2963 0.2160 0.0010
TOTEMP 24.6456 26.7921 0.2485 35.9023 9.2640 0.0000
GROWTH 1.4195 1.8048 0.0404 1.8739 1.6651 0.6172
PROFIT 12.8116 34.2117 0.4487 50.8930 1.6321 0.4756
TLBTA 6224.2350 2073.8450 0.5799 2848.3310 583.7350 0.3998
OAGE 51.9595 48.9289 0.0000 48.8773 49.0280 0.7931
EXP 20.2492 17.7250 0.0000 18.4470 16.3360 0.0003
PERWEAL 0.9456 0.9123 0.7832 1.2156 0.3275 0.0012
DEGREE 0.5331 0.5055 0.1043 0.5395 0.4400 0.0003
ETHNIC 0.1210 0.1758 0.0000 0.1414 0.2420 0.0000
Quality of borrowers
*
DB_SCORE 2.8380 3.1594 0.0000 3.0624 3.3460 0.0000
INST_DB 2 2.5953 2.8466 0.0000 2.7664 3.0008 0.0000
INST_DB12 0.2468 0.1484 0.0000 0.1892 0.0700 0.0000
INST_DB13 0.6965 0.6587 0.0172 0.6518 0.6720 0.4389
INST_DB14 0.0562 0.1867 0.0000 0.1549 0.2480 0.0000
INST_DB 15 0.0005 0.0062 0.0016 0.0042 0.0100 0.1755
Application costs
ONLINE 0.0310 0.0554 0.0003 0.0676 0.0320 0.0048
DIST_PI 12.7335 23.7141 0.0212 25.7837 19.6797 0.5185
Information issues and nature of primary lender
PITIPE_BANK 0.8795 0.8687 0.3380 0.8909 0.8260 0.0005
N_FS 1.9443 2.8112 0.0000 3.2536 1.9600 0.0000
RELATION_PI 106.4608 84.4047 0.0000 85.7010 81.8779 0.4458

t test is conducted for continuous variables on mean and z test for binary variables on median.
*
The Dun and Bradstreet risk score is categorical with a range from 1 to 5, where 1 is ‘low risk’, 2 is ‘moderate risk’, 3 is ‘average risk’, 4 is ‘high risk’ and 5 is ‘significant risk’.
 L. Han et al. / Journal of Banking & Finance 33 (2009) 415–424 419

Table 2 also indicates that the proportion of firms applying for
finance online is higher among capital seekers and applicants
whereas non-capital seekers are closer to their primary financial
service provider. Applicants are more likely to have a bank as their
primary financial service provider. Concentrated financing rela-
tionships are more likely to be used by non-capital seekers and
by discouraged borrowers. However there may be an issue of cau-
sality here because concentrated relationships may stem from
being discouraged from approaching other lenders. Unfortunately,
the data cannot help us resolve this matter. Finally, non-capital
seekers have longer financial relationships than seekers. Table 2
shows that discouraged borrowers do not differ from applicants,
at conventional levels of statistical significance, either in terms of
the length of their financial relationships or their distance from
their primary lender.
4.2. Business/entrepreneur characteristics and application costs
Table 3 shows four logistic models that examine the determi-
nants of discouraged borrowers. Model 1 estimates the probability
of being discouraged in terms of the characteristics of the entrepre-
neur and the business. Differently instrumented proxies for bor-
rower quality are added in Models 2 and 3 and application cost
variables are added in Model 4. Examination of the ‘Pseudo-R2’ sta-
tistic, in the final row of the table, suggests that the percentage of
correctly predicted cases of discouragement increases as explana-
tory variables are added. All models include dummy variables rep-
resenting sector and the concentration of local banking markets.
Model 1 includes only the characteristics of the business and the
entrepreneur (together with industry and market concentration
dummies). The results, reported in the first column, show discour-
agement is less likely in larger firms and in those using external fi-
nance, such as business credit cards and business credit lines. The
business size finding is in line with, for example, Berger and Udell
(1998). The link between credit cards and loans is compatible with
the theory that a good quality borrower is able to signal creditwor-
thiness by demonstrating acceptance from other lenders. Con-
versely, businesses lacking these signals are more likely to be
discouraged. Other business characteristics, such as age, capital
structure and business performance (measured by sales growth
rate and return to total assets), are unrelated to discouragement.
Model 1 also shows that the probability of being discouraged is
positively associated with ethnic minorities, older and poorer
groups of entrepreneurs. Lower confidence, among older entrepre-
neurs, may explain their higher rates of discouragement. We also
find that an increase in the personal wealth of the entrepreneur
significantly reduces the probability of being discouraged. This is
because wealthier entrepreneurs are less likely to be discouraged
by ‘hard’ financial reasons, such as collateral/personal guaranty
requirements or application costs. This highlights the importance
of the personal wealth of the entrepreneur as a primary source of
collateral and again emphasizes that, for small businesses, the per-
sonal wealth of the owner and the assets of the business are diffi-
cult to separate (Ang et al., 1995).
Models 2 and 3 use differently instrumented risk measures. The
first is a probability weighted average of the risk levels (expected

Table 3
Determinants of discouraged borrowers: characteristics and application costs

Model 1 Model 2 Model 3 Model 4

Estimate Std. Err. Estimate Std. Err. Estimate Std. Err. Estimate Std. Err.
INTERCEPT 4.9280*** 1.4680 8.9070*** 1.7324 6.9442*** 1.5970 9.6142*** 1.8884
MSA 0.4508*** 0.1754 0.3849*** 0.1778 0.3984** 0.1776 0.3660* 0.1903
HHI3_B2 0.4556 0.3142 0.4731 0.3184 0.4801 0.3174 0.4429 0.3441
HHI3_B3 0.2911 0.3156 0.2864 0.3197 0.3074 0.3187 0.2165 0.3434
Characteristics of the business and entrepreneur
C_CORPORATION 0.2350 0.1724 0.2337 0.1744 0.2298 0.1737 0.2413 0.1850
FAMILY_OWNED 0.2667 0.2145 0.2547 0.2169 0.2715 0.2165 0.3894* 0.2348
FAGE 0.1782 0.1356 0.3099** 0.1405 0.2791** 0.1407 0.3287** 0.1542
TOTEMP 0.3301*** 0.0651 0.3528*** 0.0664 0.3306*** 0.0659 0.3115*** 0.0718
GROWTH 0.1198 0.1764 0.0836 0.1774 0.0911 0.1772 0.0674 0.1867
PROFIT 0.0196 0.0822 0.0021 0.0826 0.0037 0.0824 0.0026 0.0888
TLBTA 0.1042 0.1029 0.0116 0.1047 0.0583 0.1043 0.0061 0.1103
F4_BCC 0.4268*** 0.1459 0.3067** 0.1497 0.3414** 0.1488 0.3831** 0.1616
F7_CRL 0.8103*** 0.1602 0.8039*** 0.1621 0.8390*** 0.1619 0.7781*** 0.1749
DEGREE 0.2238 0.1512 0.2232 0.1524 0.2407 0.1525 0.2164 0.1646
MALE 0.1323 0.1532 0.1055 0.1553 0.0936 0.1547 0.1719 0.1653
ETHNIC 0.3585** 0.1744 0.1989 0.1794 0.2898* 0.1777 0.1533 0.1940
OAGE 1.4971*** 0.3935 1.8924*** 0.4075 1.7782*** 0.4057 1.9491*** 0.4460
EXP 0.1984 0.1585 0.1982 0.1598 0.2067 0.1598 0.1983 0.1693
PERWEAL 1.0424*** 0.2529 0.8821*** 0.2517 0.9404*** 0.2525 0.8857*** 0.2673
Quality of borrowers
INST_DB2 0.7419*** 0.1635 0.8662*** 0.1748
INST_DB 13 0.6917*** 0.2466
INST_DB 14 1.0724*** 0.2899
INST_DB 15 0.2824 1.0251
Application costs
DIST_PI 0.0646 0.0654
ONLINE 0.3433 0.3391
Number of observations 1275 1275 1275 1129
Log likelihood 663.6059 653.2148 656.295 571.8772
Likelihood ratio v2 274.31*** 295.09*** 288.93*** 269.78***
Pseudo-R2 0.1713 0.1843 0.1804 0.1909

The probabilities modeled by Logit are DB = 1, i.e. a business is discouraged from borrowing. Not reported here, but available on request from the authors, are the results of
eight dummies representing the industry of business based on two-digit SIC code. The base group of market concentration is HHI3_B1 = 1. ***, **, and * denote statistical
significant level of 1%, 5% and 10% respectively.
420 L. Han et al. / Journal of Banking & Finance 33 (2009) 415–424

Table 4
Determinants of discouraged borrowers: information issues

Model 5 Model 6 Model 7

Estimate Std. Err. Estimate Std. Err. Estimate Std. Err. Marginal Effect
INTERCEPT 9.1323*** 1.9769 5.7190** 2.7316 5.8151*** 1.4978
MSA 0.3689* 0.1988 0.3521* 0.1993 0.2679 0.1801 0.0665
HHI3_B2 0.5265 0.3595 0.5070 0.3615 0.6715** 0.3271 0.1668
HHI3_B3 0.2515 0.3589 0.2205 0.3612 0.4200 0.3268 0.1043
Characteristics of the business and entrepreneur
C_CORPORATION 0.3165* 0.1943 0.3346* 0.1949 0.3958** 0.1752 0.0983
FAMILY_OWNED 0.5105** 0.2455 0.5314** 0.2466 0.4779** 0.2150 0.1187
FAGE 0.3703** 0.1616 0.3680** 0.1614 0.1213 0.1144 0.0301
TOTEMP 0.1781** 0.0768 0.1676** 0.0771 0.1899*** 0.0685 0.0472
GROWTH 0.0095 0.1900 0.0040 0.1911
PROFIT 0.0525 0.0906 0.0474 0.0907
TLBTA 0.0971 0.1150 0.1072 0.1150
F4_BCC 0.2750* 0.1680 0.2874* 0.1687 0.1981 0.1528 0.0492
F7_CRL 0.6481*** 0.1833 0.6636*** 0.1842 0.7238*** 0.1667 0.1798
DEGREE 0.1318 0.1716 0.1479 0.1719
MALE 0.1185 0.1725 0.1050 0.1727
ETHNIC 0.1461 0.2031 0.1585 0.2037
OAGE 1.8157*** 0.4578 1.8199*** 0.4581 1.7589*** 0.3755 0.4369
EXP 0.0927 0.1775 0.1068 0.1779
PERWEAL 0.7726*** 0.2705 0.7662*** 0.2697 0.6564*** 0.2317 0.1631
Quality of borrowers
INST_DB2 1.1063*** 0.1868 0.1084 0.6992
Application costs
DIST_PI 0.0605 0.0742 0.0651 0.0744
ONLINE 0.1949 0.3579 0.1759 0.3583
Information Issues and the nature of primary lender
N_FS 0.5085*** 0.0664 0.5067*** 0.0664 0.4983*** 0.0606 0.1238
PITYPE_BANK 0.6859** 0.3281 0.6925** 0.3300 0.4970* 0.2794 0.1235
RELATION_PI 0.0591 0.0837 0.7737* 0.4704 0.6607*** 0.1353 0.1641
DB2LNR 0.2963* 0.1649 0.2644*** 0.0400 0.0657
Number of observations 1129 1129 1280
Log likelihood 535.5517 533.9167 634.085
Likelihood ratio v2 324.43*** 345.70*** 371.28***
Pseudo-R2 0.2423 0.2446 0.2265

The probabilities modeled by Logit are DB = 1, i.e. a business is discouraged from borrowing. Not reported here, but available on request from the authors, are the results of
eight dummies representing the industry of the business based on two-digit SIC code. The base group of market concentration is HHI3_B1 = 1. ***, **, and * denote statistical
significant level of 1%, 5% and 10%, respectively.

risk level) and is thus a continuous variable (INST_DB2 in Model 2).
The other is a group of four dummy variables (Model 3) represent-
ing moderate (base group), average, significant and high risk levels.
These measures address the endogeneity issue relating to firms’
risk levels discussed above. Our key finding is that it is the riskier
borrowers that are most likely to be discouraged, implying that
discouragement is an efficient self-rationing mechanism and im-
plies a low, but nonetheless positive, level of market imperfection
in US small business financial markets. This is because the market
could only be deemed perfect if there were no discouragement
whatsoever among good borrowers.4 Even so, the opportunities
for further improvements seem modest. Application costs are an-
other important potential determinant of discouragement. These
costs are proxied by the physical distance to the primary lender
and whether loan applications were made online. Model 4 indicates
that neither of these two variables have a statistically significant im-
pact on the likelihood of being discouraged.
4.3. Information issues and the nature of the primary lender
Table 4 presents the results of three other logit models which
include variables representing information issues and the nature
of the primary lender/financial service supplier. Model 5 incorpo-
rates the length of the relationship between borrower and the pri-
mary lender (LOGRELATION_PI), the concentration of creditors (N_FS)
and the nature of the primary lender, i.e. whether or not it is a bank
(PITYPE_BANK). Model 6 also includes an interaction term between
risk and relationship lengths (DB2LNR) to examine how the effects
of relationships vary amongst borrowers with different levels of
risk. Model 7 reports a parsimonious version of Model 6 and its
marginal effects because only a subset of the explanatory variables
in the full equation is statistically significant.
Model 5 shows that businesses are less likely to be discouraged
where the primary lender is a bank. This is compatible with the
view that banks have an advantage in private information collec-
tion compared to other lenders, due to their provision of other ser-
vices to borrowers. It is this information advantage which reduces
their screening errors. The significantly negative coefficient on the
number of sources of financial services suggests borrowers with
dispersed financial relationships are less likely to be discouraged.5
This result is reasonable because a borrower can make multiple or
repeated applications from different lenders. Another possible rea-
son is that multiple financing relationships are positively associ-
ated with higher quality borrowers. This interpretation is

4 5
Kon and Storey also note that good (and bad) borrowers are not discouraged A causal problem may exist here because one can argue that small businesses
when ‘‘lottery conditions” exist. However this polar extreme is not relevant in an may have dispersed creditors if they are not discouraged. However, the information
informed credit market such as the US in 1998. collected in the data does not allow us to examine this causal relationship.
 L. Han et al. / Journal of Banking & Finance 33 (2009) 415–424 421

Table 5
Collinearity statistics

Dimension Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8*

MSA 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
HHI3_B2 3.0369 3.1293 2.9514 3.2347 3.5362 3.6108 3.1764 2.2483
HHI3_B3 3.2768 3.4014 3.3244 3.4643 3.8115 3.9217 3.3571 3.0472
C_CORPORATION 3.4937 3.6353 3.3784 3.6519 4.0095 4.1193 4.1934 3.3775
FAMILY_OWNED 3.8738 4.0283 3.4646 3.7480 4.1225 4.2443 4.6484 4.0975
*
FAGE 4.3260 4.5040 3.8380 4.0649 4.4689 4.5926 5.1670 4.7753
*
TOTEMP 4.4970 4.6344 4.0097 4.6382 5.0755 5.1893 6.6529 6.3415
*
GROWTH 4.7205 4.9136 4.4819 4.6753 5.1150 5.2596
*
PROFIT 4.9742 5.1726 4.6116 5.0229 5.5214 5.6842
*
TLBTA 5.4196 5.6429 4.8937 5.2582 5.7797 5.9496
F4_BCC 6.6703 6.9257 5.1472 5.8262 6.3974 6.5416 7.3104
F7_CRL 7.2666 7.5648 5.6202 5.9868 6.4161 6.6031 8.0884 7.0935
DEGREE 7.5830 7.8946 6.7631 7.1397 7.8370 8.0645
MALE 8.0039 8.3272 7.5386 7.6281 8.1817 8.4235
ETHNIC 10.4366 10.8178 7.8232 8.2051 8.5496 8.7643
*
OAGE 13.5745 13.2517 8.3007 8.6237 9.1290 9.3972 9.4225 7.8909
*
EXP 22.2964 18.2067 8.9531 11.0264 10.1281 10.3480
*
PERWEAL 34.0550 24.3336 10.8251 13.6056 11.7634 11.5170 11.4000 9.1715
INST_DB2 43.5320 18.5343 14.5989 14.1328
INST_DB13 15.0665
INST_DB14 23.5123
INST_DB15 36.8981
DIS_PI 25.1129 17.4627 15.1058
ONLINE 44.7433 18.5510 18.0328
N_FS 21.9839 22.5532 12.0682 11.5026
PI_BANK 27.7291 28.3099 14.3095 11.9960
RELATION_PI 51.3988 43.5649 28.8313 16.5238
DB2LNR 137.3694 32.0121
DB2LNRHB1 18.9066
DB2LNRHB2 29.7210
DB2LNRHB3 54.0448
NO. OF OBSERVATIONS 1275 1275 1275 1129 1129 1129 1280 1280

This table reports the Condition index (without an intercept) of the covariates used to specify the empirical models. The dependent variable modeled here is DB (without an
intercept).
*
See Table 6.

compatible with existing theoretical models (e.g. Bolton and Scharf-

1
stein, 1996) and empirical analysis (e.g. Han et al., in press). The Prob (significan risk)
0.9
existing literature has highlighted the importance of relationship
Prob (high risk)
lending in private information acquisition (e.g. Berger and Udell, 0.8
Estimated probability

1995) and thus, we expect that borrower quality would be more eas- 0.7
Prob (average risk)
ily identified, and banks’ screening errors would be reduced, by 0.6
developing a longer relationship. In other words, as relationship 0.5
lengths increase, high (resp. low) quality borrowers would be less 0.4
(resp. more) likely to be discouraged. The results of Models 6 and 0.3 Prob (moderate risk)

7 support our expectation. The most significant difference between 0.2

Models 5 and 6 (Table 4) is that after adding an interaction term be-
tween borrower risk and relationship lengths, the coefficient of bor-
rower quality (INST_DB2) is no longer statistically significant (see
comments below); whereas the coefficients of the other independent
variables change little. This, along with the significance of the coef-
ficient of the interaction term, implies that the ‘relationship effects’
may depend on the borrower’s level of risk.
Before proceeding to the next stages of the analysis we look at
two issues which could affect the robustness of the results. Firstly,
we conducted a missing value analysis on the observations in-
cluded in the models. The results indicate that the missing data
process can be considered to be missing completely at random
(MCAR) and no potential biases exist in the pattern of missing
data.6 Secondly we examined the issue of multicollinearity. Table 5
shows the eigenvalues and condition index (without an intercept)
0.1 Prob (low risk)
0
0 50 100 150
Length of relationship in months
Fig. 1. Estimated probability of being discouraged.
of the covariates used in each of the seven models. The condition
indices suggest that multicollinearity may be a problem for all the
models (i.e., the condition indices exceed 10) and the problem is
greatest for the models which include information issues. In terms
of parameter instability across models, which is a possible conse-
quence of multicollinearity,7 we note that the estimates for Models
1–4 appear to be relatively stable whilst there is evidence of instabil-
ity in the estimates for Models 5–7: notably, as mentioned above, the

6
We include the samples with capital demands in the empirical models and the
number (%) of missing values ranges from 182 (12.45%) to 333 (22.78%) out of 1462
(100%). In the missing data analysis, we firstly compare the observations for each
variable, both with and without the missing data, with each of the other variables. We
also conduct Little’s MCAR test on the data and have a Chi-Square of 185.047 with a
degree of freedom of 169 and ap-value of 0.1624.
7
Multicollinearity affects the precision of the estimates (although estimators
remain unbiased and consistent). Specifically, multicollinearity may lead to inflated
standard errors, reducing the power of hypothesis tests in relation to the coefficients,
and estimates that vary widely in response to small changes in the data
422 L. Han et al. / Journal of Banking & Finance 33 (2009) 415–424

Table 6
Determinants of discouraged borrowers: market conditions (Model 8)

Estimate Std. Err. Marginal effects

***
INTERCEPT 4.3019 1.7015 1.0626
Characteristics of the business and entrepreneur
**
C_CORPORATION 0.4003 0.1750 0.0989
FAMILY_OWNED 0.4777** 0.2146 0.1180
FAGE 0.1115 0.1144 0.0275
TOTEMP 0.1916*** 0.0685 0.0473
F7_CRL 0.2126 0.1525 0.0525
OAGE 0.7215*** 0.1665 0.1782
PERWEAL 1.7067*** 0.3742 0.4216
Information issues and the nature of primary lender
N_FS 0.4955*** 0.0604 0.1224
PITYPE_BANK 0.5220* 0.2801 0.1289
RELATION_PI 0.6158*** 0.1335 0.1521
Market conditions
MSA 0.2621 0.1802 0.0647
HHI3_B2 2.0180** 1.0296 0.4985
HHI3_B3 1.7618* 1.0108 0.4352
DB2LNRHB1 0.1393* 0.0843 0.0344
DB2LNRHB2 0.2565*** 0.0470 0.0634
DB2LNRHB3 0.2557*** 0.0449 0.0632
Number of observations 1280
Log likelihood 635.516
Likelihood ratio v2 368.42***
Pseudo-R2 0.2247

The probabilities modeled by Logit are DB = 1, i.e. a business is discouraged from borrowing. The base group of market concentration is HHI3_B1 = 1. ***, **, and * denote statistical
significant level of 1%, 5% and 10%, respectively.

inclusion of DB2LNR in Model 6 has a dramatic effect on the coeffi-
cient for INST_DB2.8
One solution to the multicollinearity issue would be to drop the
problem variables (in particular, the information/relationship vari-
ables) but this would result in more serious problems of specifica-
tion errors. Alternative solutions, such as ridge regression and
principal components, introduce other serious problems.9 We
therefore support the models, and the parsimonious specification
in particular (Model 7), principally on the basis that the estimates
are consistent with the theory of discouraged borrowers. However,
the problems caused by multicollinearity highlight the need for fu-
ture research to examine the robustness of our findings using other
data-sets.
In the next stage of the analysis, based on the parsimonious
model (Model 7), we plot the estimated probabilities of being dis-
couraged (Fig. 1), for five ‘hypothetical’ businesses, over the length
of their relationships with the primary lender (holding other vari-
ables at either their mean or median); they differ in risk levels only.
The curves plotted in Fig. 1 are the estimated probabilities of being
discouraged by relationship duration, for businesses with low risk
(DB_SCORE = 1), moderate risk (DB_SCORE = 2), average risk (DB_SCORE =
3), high risk (DB_SCORE = 4) and significant risk (DB_SCORE = 5), respec-
tively. Fig. 1 shows that high quality borrowers, i.e. those with a
low or moderate risk level, are less likely to be discouraged by
developing a longer relationship with the primary lender. In con-
trast, low quality borrowers, i.e. those with a high or significant
risk level, are more likely to be discouraged from borrowing as
the length of their relationships increase. Fig. 1 illustrates that
the relationship effects on discouragement depend on borrower
risk levels: a longer relationship, between borrower and lender,
improves the efficiency of the self-rationing mechanism by dis-
couraging bad borrowers and encouraging good ones.
4.4. Market concentration
Existing studies have shown that market conditions play an
important role in financing small businesses (Beck and Demi-
rguc-Kunt, 2006; Heffernan, 2006). Model 7 shows that concentra-
tion in the banking market has a strong impact on the likelihood of
discouragement. For example, a borrower from an institution with
its headquarters in a moderately concentrated banking market, is
nearly 17% points less likely to be discouraged than one borrowing
from an institution with its headquarters in a competitive market
(see Model 7, Table 4). Clearly discouragement is affected by the
degree of concentration in local banking markets. This is consistent
with earlier findings linking access to finance with market concen-
tration. Petersen and Rajan (1995) argued that the ‘market condi-
tion’ effects work through relationship lending because the
extent of market competition is important in determining the va-
lue of lending relationships – indeed they implied it was easier
for lenders to internalize the benefits of lending in a more concen-
trated market. Following this idea, we now examine the effects of
market conditions on discouragement by including interaction
terms between borrower’s quality, relationships and market con-
centration (Model 8). The results of this analysis are reported in Ta-
ble 6 and suggest the likelihood of discouragement is jointly
determined by borrower’s quality, length of relationship and mar-
ket concentration.10
Here, we expect the probability of discouragement to decrease
(resp. increase) among good (resp. bad) borrowers as the length
of their relationships increase (as shown in Fig. 1). However, mar-
ket concentration will affect the bank’s returns from investing in
relationships: in a competitive market there is less incentive to in-
vest in relationships which would be expected to reduce the mag-
nitude of the impact of relationships on discouragement.

8 10
We are especially grateful to an astute referee for highlighting this particular As with the previous models, there appear to be multicollinearity issues with
issue. some of the market condition variables (see Table 6, Model 8). Again, we support this
9
In particular, ridge regression estimators are biased and the interpretation of the model on grounds of its consistency with theory but also propose future research to
coefficients from a principal components estimator is ambiguous. test the model on alternative data-sets.
 L. Han et al. / Journal of Banking & Finance 33 (2009) 415–424 423

0.8 0.95 Prob (highly concentrated market)

0.7 0.85 Prob (moderately concentrated market)

estimated probability
estimated probability

0.6
0.75 Prob (competitive market)
0.5
0.65
0.4
0.55
0.3
Prob (competitive market) 0.45
0.2
Prob (highly concentrated market)
0.1 0.35
Prob (moderately concentrated market)
0 0.25
0 20 40 60 80 100 120 140 160 180 0 20 40 60 80 100 120 140 160 180
length of relationship in months length of relationship in months

Fig. 2. Estimated probability of being discouraged: low risk borrowers. Fig. 6. Estimated probability of being discouraged: significant risk borrowers.

0.85 Accordingly, the joint effect of borrower’s quality, length of rela-

tionship and market concentration are shown in Figs. 2–6. These
0.75 graphs plot the estimated probabilities of being discouraged, over
estimated probability

0.65 the length of relationships, in competitive, moderately concen-

trated and highly concentrated banking markets, for borrowers of
0.55 increasing risk levels. Figs. 2 and 3 show three important results.
0.45 Firstly, the likelihood of discouragement among good borrowers
(with risk levels below average) reduces over the length of the rela-
Prob (competitive market)
0.35 tionship regardless of the degree of concentration in the local
0.25
Prob (highly concentrated market)
banking market. Hence, this result is consistent with our earlier
Prob (moderately concentrated market)
findings as shown in Fig. 1, suggesting that relationships improve
0.15 information quality and reduce the likelihood of discouragement
0 20 40 60 80 100 120 140 160 180
length of relationship in months for good borrowers. Secondly, borrowers in competitive markets
are more likely to be discouraged than in concentrated markets.
Fig. 3. Estimated probability of being discouraged: moderate risk borrowers. Thirdly, there is little difference in ‘market condition effects’ be-
tween moderate concentration and high concentration markets.
The effects are not significant in magnitude in concentrated
0.85 markets.
The fact that relationships reduce discouragement among good
0.75 borrowers in competitive markets suggests banks are able to iden-
estimated probability

tify good borrowers, with increased relationship duration, even

0.65 where there is little investment in that relationship. However,
Prob (competitive market)
the lower likelihood of discouragement, in concentrated banking
0.55 markets, points to the higher value of relationships to lenders
Prob (highly concentrated market)
(and hence higher investment) in these markets and supports Pet-
0.45 ersen and Rajan (1995)’s hypothesis of the beneficial effects of
market concentration for lenders. The similarity of the findings in
0.35 Prob (moderately concentrated market) moderately concentrated and highly concentrated markets sug-
gests that the value of relationships is similar in both types of mar-
0.25
0 20 40 60 80 100 120 140 160 180 ket. In other words, a moderately concentrated banking market is
length of relationship in months sufficient for lenders to invest enough in relationships such that
good borrowers are unlikely to feel discouraged from applying
Fig. 4. Estimated probability of being discouraged: average risk borrowers. for loans.
Fig. 4 shows how the estimated probability of being discour-
aged of an average risk borrower varies over the length of relation-
0.85 Prob (highly concentrated market) ships. This graph indicates that, in a competitive market,
0.75 Prob (moderately concentrated market) relationships reduce the likelihood of discouragement but that
relationships increase the likelihood of discouragement in concen-
estimated probability

Prob (competitive market)

0.65 trated markets. This suggests that banks in competitive markets do
not invest sufficiently in relationships to be able to distinguish
0.55 average/marginal borrowers from good borrowers (compare with
Figs. 2 and 3). However banks in concentrated markets have great-
0.45
er incentives to invest in relationships so that riskier marginal bor-
0.35 rowers are increasingly likely to be identified and become
discouraged.
0.25 Figs. 5 and 6 present the estimated probabilities of bad borrow-
0 20 40 60 80 100 120 140 160 180
length of relationship in months ers (with risk levels above average). In competitive markets, the
likelihood does not change significantly with relationship duration
Fig. 5. Estimated probability of being discouraged: high risk borrowers. whereas in concentrated markets, this likelihood increases signifi-
424 L. Han et al. / Journal of Banking & Finance 33 (2009) 415–424
cantly. This suggests concentrated markets are more efficient than
competitive markets in discouraging bad borrowers from borrow-
ing. Again this points to the higher value of relationships, and
superior information production, in concentrated markets.
5. Conclusions and implications
The importance of discouraged borrowers has been recognized
in both the theoretical and empirical literature. Kon and Storey
(2003) predict that application costs, screening errors, due to infor-
mation problems, and interest rates affect the likelihood of dis-
couragement among ‘good’ borrowers. This paper has conducted
an empirical analysis, based on US data, which encompasses both
‘good’ and ‘bad’ discouraged borrowers so as to examine the deter-
minants of discouragement and test whether discouragement is an
efficient self-rationing mechanism.11 We find that both the demo-
graphics of the entrepreneur and of the business influence discour-
agement. These characteristics include business size, the use of
financial products, age and the personal wealth of the entrepreneur.
Having controlled for them, we then find that riskier borrowers are
more likely to be discouraged. Indeed, among high risk borrowers,
this likelihood increases as information quality improves with longer
financial relationships whereas the likelihood for low risk borrowers
decreases.
The empirical results derived in this paper have three important
implications. Firstly, they imply that discouragement is an efficient
self-rationing mechanism because bad borrowers are more likely
to be discouraged than good borrowers. Discouragement can
therefore reduce banks’ costs in dealing with loan applications
from risky borrowers. It can also help to overcome the problem
of ‘overinvestment’ resulting from the mistaken approval of appli-
cations from risky borrowers due to screening errors. Secondly,
improvements in information quality increase the efficiency of dis-
couragement as a self-rationing mechanism. With longer relation-
ships, for instance, risky borrowers become increasingly
pessimistic about the outcome of their loan applications and so
more likely to be discouraged from applying in the first place. Less
risky borrowers, in contrast, become less likely to be discouraged.
Thirdly, our results suggest that market concentration has a strong
impact on the discouragement of small business borrowers. Dis-
couragement, as a self-rationing mechanism, is more efficient in
concentrated banking markets because lenders have greater incen-
tives to invest in relationships in these markets with the conse-
quence that risky borrowers are more likely to be discouraged.
It would, however, be very unwise to assume our results apply
to small business financing markets in other countries. The US has
a relatively sophisticated small business financing marketplace –
and yet even here we find some good borrowers are discouraged
and some bad ones apply. We expect that in less sophisticated
markets the nature and scale of discouragement would change
and that discouragement itself could become a ‘litmus test’ of mar-
ket imperfections. Testing this view requires more empirical anal-
ysis of discouragement in the context of a diverse range of
countries.
11
One limitation of this paper is that we cannot examine the effects of interest rates
identified in Kon and Storey’s model because of the cross-sectional nature of the data.
Acknowledgement
We are very grateful for the comments of a referee which have
resulted in substantial improvements to the paper. However, we
remain entirely responsible for all remaining errors and omissions.
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