Aurora Borealis
1 March 2017 CFA Institute Journal Review

Discouraged Borrowers: Evidence for Eurozone SMEs (Digest Summary)

  1. Butt Man-Kit, CFA

The authors explore the factors that discourage small firms from applying for bank loans in nine European countries. Borrower discouragement can be explained by firm characteristics, macroeconomic factors, and banking industry factors. The results also show that a borrower’s perception of a bank’s unwillingness to provide credit discourages the borrower from applying, especially during a financial crisis.

How Is This Research Useful to Practitioners?

When evaluating loan applications, banks rely on borrowers’ business and financial information. Compared with larger firms, small and medium-sized enterprises (SMEs) have greater difficulty and higher costs in providing this information and thus face higher hurdles in obtaining bank financing.
Even if they have potentially profitable projects, SMEs may be discouraged from applying for debt financing because of worries that they may be refused. As a result, SMEs obtain no funding for their projects and banks lose the opportunity to make potentially profitable loans. Discouraged borrowers lead to inefficient capital flow and a suboptimal level of investment.
The fear-of-refusal problem arises from information asymmetry. Because borrowers have more information about their financial prospects than do lenders, banks are unable to clearly distinguish between good and bad SME borrowers and may make screening errors (i.e., reject good borrowers but accept bad ones).
The authors investigate the determinants of borrower discouragement by looking at three types of explanatory factors: firm-level characteristics, macroeconomic and regulatory factors, and banking industry factors. They find that smaller and younger firms, as well as those with higher debt ratios and less capital, are more reluctant to apply for bank loans. The authors also explore how SME perceptions affect their decisions. When SMEs perceive that banks are unwilling to lend or when they have liquidity pressure, they are discouraged from applying. When firms have a strong need to borrow, however, they are less likely to be discouraged, because the acute need to survive outweighs the discouragement.
Another important finding is that when the banking sector is more concentrated, borrowers are less likely to be discouraged. A less competitive banking environment provides incentives for banks to build relationships with borrowers, which reduces information asymmetry, resulting in less discouragement. In addition, when there is stress in the financial sector, such as higher government bond yields and less private market credit, borrowers are more likely to be discouraged, which shows the procyclical nature of debt markets.
The results from this study imply that merely increasing the supply of financing by the government does not encourage firms to borrow. More policy and regulatory measures are needed to overcome the barriers that discourage borrowers.

How Did the Authors Conduct This Research?

The authors empirically investigate the factors that cause SMEs to become discouraged from seeking financing. The authors use a sample of SME responses to a particular questionnaire: “Survey on the Access to Finance of SMEs” (SAFE), which was conducted by the European Commission and the European Central Bank. The sample covers nine European countries over 2009–2011. Particular firms in the sample were randomly selected from the Dun & Bradstreet firm database. The firms selected all had fewer than 249 employees. After excluding firms in the financial services, nonprofit, and public administration sectors, there are 6,287 firm-level observations. Cross-country differences are observed: Firms in Ireland have the highest rate of discouraged borrowers (44%); firms in Spain have the lowest rate (17%).
The authors use binomial logit regression to analyze the survey responses. Survey responses are either (1) yes, applied for financing, or (2) no, did not apply due to possible rejection. To explain these responses, the authors use four types of explanatory variables: firm characteristics, macroeconomic conditions, regulatory factors, and banking industry factors. Industry sector and time dummy variables are included for control.
The authors’ methodology is novel in the sense that the owner’s “perceptions” of the firm’s condition and the bank’s willingness to lend are considered. The results are significant, suggesting that both objective factors and subjective perceptions affect the SME’s decision whether to apply for a loan.

Abstractor’s Viewpoint

This survey is useful. When good borrowers are discouraged from applying for loans, a government’s expansionary monetary policy becomes less efficient and effective because SMEs do not make potential investments.
Readers should note that self-selection of discouragement may not be bad if only bad borrowers are discouraged. This kind of discouragement makes the financing market for SMEs more efficient.
One possible way to improve access to financing for good borrowers is to reduce the likelihood that borrowers will become discouraged—for example, by reducing the costs incurred when applying for a loan. From basic economics, we know that resources are allocated more efficiently when transaction costs are lowered. Thus, regulators might consider simplifying loan application procedures and thereby lowering transaction costs.
Because of information asymmetry, banks are more likely to make screening errors and thus disappoint good borrowers. Reducing information asymmetry can also help reduce borrower discouragement. In recent years, technology has been deployed to lower information costs. For example, the credit performance of an SME can be synchronized both in a timely manner and anonymously among financial institutions. In addition, “big data” techniques can be used to analyze the cash management, trade records, and creditworthiness of SMEs’ trading partners as well as provide a tailor-made debt solution. By using technology, banks are likely to make fewer screening errors in reaching loan decisions and good borrowers are less likely to be discouraged.

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