The informational wedge between insiders and outsiders is most acute for relatively smaller borrowers (like small businesses and even consumer loans) where the potential lender is unable to readily verify project quality (an adverse selection problem). Not surprisingly, a significant body of empirical research exists in documenting the various ways such adverse selection can be attenuated. However, to examine the borrower-lender loan dynamics in its fullest sense requires the inclusion of those potential borrowers who might want a loan for their businesses but choose to not formally apply because they are sure they will be refused by the bank – otherwise known as “discouraged” borrowers.
While the current body bank lending research, exemplified by the citations in footnote 2, have not included discouraged borrowers in their analysis, there is now a growing body of evidence that appears to suggest that owners of small businesses from certain demographic groups are systematically discouraged from applying for a loan (see, for example, Blanchflower, Levine, and Zimmerman, 2003; and Cavalluzzo, Cavalluzzo, and Wolken, 2002). Given the significant numbers of discouraged borrowers in the population, they cannot be thought of as mere random samples and, thereby, safely ignored from analysis. Ignoring discouraged borrowers from any analysis of credit availability or of the cost of credit is, in fact, likely to bias the relevant parameter estimates since the self selection of applicants may induce lenders to adopt different screening rules than those that would prevail if the discouraged borrowers were to apply.
Even as recent studies have started incorporating discouraged borrowers in examining the loan dynamics (see, for example, Chakravarty and Yilmazer, 2009; and Han, Fraser, and Storey, 2009), there is research investigating the anatomy of discouraged borrowers themselves and certainly none that does so for discouraged small businesses in various emerging economies around the world – economies where adverse selection issues are even more paramount than they are in the United States.
We use data from the Investment Climate Surveys (ICS) launched by the Investment Climate Unit (ICU) of the World Bank to examine discouraged borrowing with an international panorama. As a unique firm-level survey database, ICS provides information on discouraged firms based on individual firm interviews conducted either by World Bank staffers or by organizations sub-contracted by the World Bank. ICS also provides information on firms with different sizes (particularly a large number of small and medium size firms) in various countries. Hence, unlike previous studies that only focus on firms of a certain size (for example, large or publicly traded firms as in Demirgüç-Kunt and Maksimovic, 1998) or on firms in developed countries like the United States, Canada or other European countries (for example, Blanchflower, et al., 2003; Orser, Riding, and Manley, 2006; and Angelini and Generale, 2005), our data allow us to study discouraged firms based not only on firm size, but also on other firm characteristics, as well as across many different emerging economies around the world. In particular, we focus on ten countries spanning four continents: Brazil, China, Eritrea, Ethiopia, Honduras, India, Kenya, Pakistan, Tanzania, and Uganda.
Our main findings can be summarized as follows. Older and larger firms are less likely to be discouraged. The greater the number of competitors a firm faces, the more likely it is that the firm would be discouraged. We also find that relationships with banks and other financial institutions are a key determinant of a firm being discouraged. Specifically, the greater the number of banks with whom the firm has relationships, the less likely it is that such a firm would be discouraged. These variables not only enter significantly in all of the regressions, but also explain large variations in the probability of a firm being discouraged.
