The Effects of Business Experience on Discouraged Borrowing and Efficiency in the Credit Market

Abstract While asymmetric information causes discouraged borrowing, understanding of how firm‐side learning and cognitive bias affects discouraged‐borrowing dynamics is limited. We therefore develop and test a dynamic Bayesian‐learning model of firm‐borrowing decisions incorporating cognitive bias. We show while credit‐rejection experiences increase discouragement probabilities, this effect is nonhomogeneous over firm life cycles. The effect of rejection on discouragement initially decreases with age but increases among older businesses suggesting confirmation bias affects learning (as increasing pessimism with age causes over‐weighted rejection experiences). Discouragement also increases with age as businesses learn prior rejection‐probability beliefs were over‐optimistic. Moreover, discouraged borrowers have, on average, the same approval probability as loan applicants, and this probability does not decrease with age. Thus, while experiential learning reduces asymmetric information, we show firm‐side learning neither reduces discouraged borrowing nor improves credit‐market efficiency.