ABSTRACT. This paper examines the implications for the
SME financing market of Application costs that vary between
firms, and of imperfect screening of applicants by Banks.
Under these conditions ‘Discouraged Borrowers’ can exist.
These are good borrowers who do not apply for a bank loan
because they feel they will be rejected. The paper shows that,
under a range of assumptions, the scale of discouragement in
an economy depends upon the screening error of the banks,
the scale of Application costs and the extent to which the bank
interest rate differs from that charged by the moneylender.
Discouragement is shown to be at a maximum where there is
some, but not perfect, information.
The central issue addressed in the literature
on financing SMEs is that of credit rationing
stemming from asymmetric information (Stiglitz
and Weiss, 1981; De Meza and Webb, 1987).
These papers argue that, in equilibrium, markets
are imperfect since credit is allocated by rationing,
rather than by price. The difference between the
two papers is that, whereas Stiglitz and Weiss’
assumptions lead to credit rationing, those of De
Meza and Webb lead to over-supply. The theoret-
ical issues addressed in these papers underpin a
huge raft of empirical papers on credit rationing
in many countries, of which those by Berger and
Udel (1992) and by Petersen and Rajan (1994) are
Stiglitz and Weiss discuss adverse selection and
incentive (moral hazard) effects and say “Both
effects derive directly from the residual imper-
fect information which is present in loan
after banks have evaluated loan appli-
cations” (our emphasis)
The current paper has a different theoretical
focus. It examines the implications for the SME
financing market of Application costs that vary
between firms and of imperfect screening of
applicants by Banks. Application costs can be
considered as financial, in-kind, or psychic. We
show that positive Application costs mean that a
good borrower may not apply for a loan to a bank,
because they feel they will be rejected. This is
defined as a Discouraged Borrower. Such bor-
rowers are ignored in the Stiglitz-Weiss model
since they do not make applications to the bank.
Until very recently, this topic generated little
interest amongst scholars but is now recognized
as important in the financing of small businesses
in developed and less developed economies.
For example, Raturi and Swamy (1999) quantify
its significance in Zimbabwe,
and Willard (2000) examine it for the USA.
Importantly, in the current context, the latter paper
finds more than twice as many small firms are
“discouraged” as are rejected for loans from finan-
cial institutions in the United States, implying that
“discouragement” is more important than credit
restrictions of the Stiglitz-Weiss form.
This paper provides a theoretical base for “dis-
couragement”, using an institutional framework
that is, in principle, applicable to a developed or
a less developed economy, although generally we
predict discouragement to be higher in less devel-
oped countries. A standard static adverse selection
A Theory of Discouraged Borrowers
Small Business Economics 21: 37–49, 2003.
2003 Kluwer Academic Publishers. Printed in the Netherlands.
Final version accepted on 1 November 2001
Faculty of Management and Economics
Aomori Public College
University of Warwick
Warwick Business School
Centre for Small and Medium Sized Enterprises
Coventry CV4 7AL, UK