In this study, we use data from the Federal Reserve’s 1993, 1998 and 2003 Surveys of Small Business Finances to classify small businesses into four groups based upon their credit needs and to model the credit allocation process into a sequence of three steps. First, do firms need credit? We classify those that do not as “non-borrowers;” these firms have received scant attention in the literature even though they account for more than half of all small firms. Second, do firms need credit but fail to apply because they feared being turned down? We classify such firms as “discouraged borrowers.” Like non-borrowers, discouraged borrowers have received little attention in the literature and often are pooled with firms who applied for, but were denied, credit. Discouraged borrowers outnumber firms that applied for, but were denied, credit by more than two to one. Third, do firms apply for credit, but get turned down? We classify such firms as “denied borrowers.” Finally, we classify firms that applied for, and were extended, credit as “approved borrowers.” Our results reveal strong and significant differences among each of these four groups of firms. Non-borrowers look very much like approved borrowers, consistent with the Pecking-Order Theory of capital structure. Discouraged borrowers resemble denied borrowers in many respects, but are significantly different along a number of dimensions. This finding calls into question the results from previous studies that have pooled together these two groups of firms in analyzing credit allocation. Finally, we find strong evidence that denied borrowers differ from approved borrowers across numerous characteristics, as previously documented in the literature. Of particular note, minority owned-firms, and especially Black-owned firms, were denied credit at a far higher rate than firms with owners who were white.
