Who Needs Credit and Who Gets Credit? Rebel A. Cole DePaul University and Krähenbühl Global Consulting For presentation at a Symposium on Small Business Financing Sponsored by SBA Office of Advocacy July 9, 2009

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary: Who Needs Credit and Who Gets Credit? This study uses data from the 1993, 2998 and 2003 Surveys of Small Business Finance to explore, among privately held small firms, who needs credit and who gets credit. This study uses data from the 1993, 2998 and 2003 Surveys of Small Business Finance to explore, among privately held small firms, who needs credit and who gets credit. We break the credit allocation process down to three steps: We break the credit allocation process down to three steps: Who needs credit?Who needs credit? Who applies for credit?Who applies for credit? Who gets credit?Who gets credit?

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary: Who needs credit? There are three groups of firms that need credit: There are three groups of firms that need credit: Firms that apply for credit.Firms that apply for credit. Firms that apply for and are granted credit. Firms that apply for and are granted credit. Firms that apply for and are denied credit. Firms that apply for and are denied credit. Firms that need credit but do not apply.Firms that need credit but do not apply. Who doesn’t need credit? Who doesn’t need credit? All other firms.All other firms.

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary: Why is this study important? No study of which we are aware analyzes the “No-Need” firms. No study of which we are aware analyzes the “No-Need” firms. Almost half of all small firms. Almost half of all small firms. Many existing studies ignore “discouraged” firms that need credit but don’t apply. Many existing studies ignore “discouraged” firms that need credit but don’t apply. “Discouraged” firms are more than twice as numerous as “Denied” firms. “Discouraged” firms are more than twice as numerous as “Denied” firms. To improve availability of credit, it is critically important to better understand these firms. To improve availability of credit, it is critically important to better understand these firms. Many studies pool “discouraged” firms with “denied” firms to analyze credit allocation. Many studies pool “discouraged” firms with “denied” firms to analyze credit allocation. This can lead to faulty inferences if the two groups differ systematically. This can lead to faulty inferences if the two groups differ systematically.

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary: Key Findings “No Need” firms look a lot like “Approved” firms and appear to follow the Pecking- Order theory of capital structure. “No Need” firms look a lot like “Approved” firms and appear to follow the Pecking- Order theory of capital structure. Firms use internal rather than external finance if they areFirms use internal rather than external finance if they are Larger Larger More Profitable More Profitable More Liquid More Liquid Less highly levered Less highly levered Higher credit quality at both firm and owner level. Higher credit quality at both firm and owner level.

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary: Key Findings “Discouraged” firms look a lot like “Denied” firms but show significant differences: “Discouraged” firms look a lot like “Denied” firms but show significant differences: SmallerSmaller More liquidMore liquid YoungerYounger Have controlling owners who:Have controlling owners who: are female, are female, Are Black Are Black Have less personal wealth Have less personal wealth

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary: Key Findings Results for “Denied” firms vs. “Approved” firms are consistent with existing literature, esp. studies using the 1993 SSBF. Denied firms are more likely to be: Results for “Denied” firms vs. “Approved” firms are consistent with existing literature, esp. studies using the 1993 SSBF. Denied firms are more likely to be: SmallerSmaller More highly leveredMore highly levered Worse firm and owner credit qualityWorse firm and owner credit quality Less personal wealthLess personal wealth Black-ownedBlack-owned

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Methodology: Classification of Firms First, we classify firms into one of four categories of “borrower” types based upon their responses to three questions about their “most recent loan requests” during the previous three years: First, we classify firms into one of four categories of “borrower” types based upon their responses to three questions about their “most recent loan requests” during the previous three years: Did they apply?Did they apply? Were they approved or rejected?Were they approved or rejected? Did they need credit but not apply because they feared rejection?Did they need credit but not apply because they feared rejection?

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Methodology: Three-Step Selection Process (1) Need Credit? (2) Apply for Credit? (3) Get Credit? No Yes No Non-Borrower Discouraged Borrower Unsuccessful Borrower Successful Borrower

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Methodology: Univariate and Multivariate Test Once we have classified each firm, we calculate univariate statistics for each group and test for significant differences in means across groups. Once we have classified each firm, we calculate univariate statistics for each group and test for significant differences in means across groups. We then run a sequence of three logistic regression models to explain each step of the credit approval process: We then run a sequence of three logistic regression models to explain each step of the credit approval process: 1. Need credit? (Yes or No?)1. Need credit? (Yes or No?) 2. Apply for credit? (Yes or No?)2. Apply for credit? (Yes or No?) 3. Get credit? (Approved or Denied?)3. Get credit? (Approved or Denied?)

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Key Results: Credit-Market Outcomes

Rebel A. Cole: Who Needs Credit and Who Gets Credit?

Rebel A. Cole: Who Needs Credit and Who Gets Credit?

Rebel A. Cole: Who Needs Credit and Who Gets Credit?

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Key Results: Percentage of Loan Applications Denied

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Explanatory Variables: To select our explanatory variables, we rely upon the existing literature on the availability of credit, along with capital structure theory. To select our explanatory variables, we rely upon the existing literature on the availability of credit, along with capital structure theory. We group these variables into three vectors: We group these variables into three vectors: Firm CharacteristicsFirm Characteristics Market CharacteristicsMarket Characteristics Owner CharacteristicsOwner Characteristics

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Explanatory Variables: Firm Characteristics Size Size Age Age Organizational form Organizational form Creditworthiness Creditworthiness Financial performance and condition Financial performance and condition

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Explanatory Variables: Market Characteristics Banking concentration Banking concentration Urban/Rural Location of the Firm Urban/Rural Location of the Firm

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Explanatory Variables: Owner Characteristics Age Age Experience Experience Education Education Personal Wealth Personal Wealth Personal Creditworthiness Personal Creditworthiness Race, Ethnicity and Gender Race, Ethnicity and Gender

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Key Results: Probability of Loan Approval by Race, Ethnicity and Gender Controlling for Firm, Market and Owner Characteristics

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary and Conclusions: In this study, we examine the availability of credit to small privately held U.S. firms using data from the SSBFs. In this study, we examine the availability of credit to small privately held U.S. firms using data from the SSBFs. We make at least three important contributions to the literature. We make at least three important contributions to the literature.

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary and Conclusions First, we provide the first rigorous analysis of the differences in our four types of firms: non- borrowers, discouraged borrowers, denied borrowers and successful borrowers. First, we provide the first rigorous analysis of the differences in our four types of firms: non- borrowers, discouraged borrowers, denied borrowers and successful borrowers. Our findings have important implications for interpreting previous research that has combined these groups in ways that our results suggest are inappropriate, such as pooling discouraged borrowers with denied borrowers in analyzing availability of credit. Our findings have important implications for interpreting previous research that has combined these groups in ways that our results suggest are inappropriate, such as pooling discouraged borrowers with denied borrowers in analyzing availability of credit.

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary and Conclusions Second, we provide an analysis of credit availability that properly accounts for the inherent self-selection mechanisms involved in the credit application process: Second, we provide an analysis of credit availability that properly accounts for the inherent self-selection mechanisms involved in the credit application process: Who needs credit?Who needs credit? Who applies for credit,Who applies for credit, conditional upon needing credit? Who receives credit,Who receives credit, conditional upon applying for credit?

Rebel A. Cole: Who Needs Credit and Who Gets Credit? Summary and Conclusions Third, we provide the first evidence from the 2003 SSBF on the availability of credit to small firms. Third, we provide the first evidence from the 2003 SSBF on the availability of credit to small firms. This survey includes methodological improvements on the previous SSBFs (1987, 1993 and 1998) that enable us to better address the issue of availability of credit to small firms. This survey includes methodological improvements on the previous SSBFs (1987, 1993 and 1998) that enable us to better address the issue of availability of credit to small firms.