Research Findings

Risks, returns, and relational lending: Personal ties in microfinance

January 3, 2019

As borrowing rates climb to record highs, one could say that consumers and their banks have never been closer. Generally, we consider these ties to be very formal, with banks and consumers connected only at arm’s length.

Yet in many settings, lenders and borrowers do develop personal relationships. For example, small business owners establish personal relationships with bankers in an effort to secure loans, and lenders build personal relationships with borrowers as a way of gaining access to private information that may affect loan repayment.

These relationships can shape the nature of financial transactions – with important consequences. On the one hand, these ties may encourage the borrower to share relevant, personal information with the lender. It may also encourage communication between the two parties, should the borrower fall behind on his or her loan repayments. In both cases, these outcomes are good for lenders.

But personal ties to borrowers can also be costly. When borrowers repeatedly miss loan payments, lenders must deliver the consequences; personal ties may make them reluctant to do so.

In a recent study, I investigated the effect of personal ties on transactions between lenders and borrowers at a commercial microfinance bank in Latin America. I was especially interested in how these ties affect lenders. Are they an asset or a liability?

Personal relationships play an important role in microfinance, making it a useful setting to explore this question.

When clients apply for micro-loans, loan officers visit them at their homes and workplaces. They even meet with their family and neighbors. The hope is that borrowers will more freely disclose information when they have personal relationships with loan officers. As a result, officers can evaluate them more accurately.

At the microfinance bank I studied, officers had both personal and impersonal relationships with borrowers. Due to staffing fluctuations, officers occasionally assumed responsibility for borrowers they did not vet personally. This arrangement offered a useful comparison point, allowing me to examine how loan officers and borrowers behaved differently when they had personal ties, versus when they had only arm’s-length connections.

Initially, it seemed like relationships between borrowers and loan officers produced a win-win scenario. If they shared personal ties, loan officers were less likely to send non-compliant borrowers to the collections department, allowing borrowers to remain in good financial standing.

Conversely, borrowers who had personal ties with loan officers were more compliant and repaid their loans more readily, as opposed to those who had more formal relationships.

Both of these trends conform to expectations in social psychology and economic sociology. Individuals are more likely to “escalate commitment” when they feel personally responsible for an investment, as loan officers did for their clients. Moreover, individuals tend to be more responsive and compliant in the context of personal relationships, as was the case with borrowers who had personal ties to their loan officers.

However, after the initial vetting process, contact dropped off between the borrowers and loan officers who at first developed personal ties. Their relationship weakened. I observed borrowers’ and officers’ behavioral changes as their relationships weakened.

This change did not affect loan officers’ commitment to borrowers. When borrowers missed loan payments, officers were still reluctant to send them to the collections department. Borrowers’ behavior, on the other hand, did change.

 Infrequent interactions with loan officers made them less compliant. Over time, those borrowers with personal ties to their officers began to miss payments with increasing frequency. They eventually come to resemble those who never had personal ties to their loan officers in the first place.

Therefore, over time, these personal relationships became costlier for loan officers. Even as they continued to show forbearance to borrowers, borrowers began to miss more payments.

The results of these observations, suggest that the “relational lending” approach is beneficial to lenders only if relationships with borrowers are established and maintained. Unless these relationships are strengthened through regular contact, they are less valuable for lenders in the long term.

For banks, these findings offer a useful lesson. Relationships with clients can be beneficial, but more so when they are characterized by high contact. Low-contact relationships erode over time, and personal ties evolve into a liability.

To many, the machine-like inner workings of financial institutions may appear too formal to be swayed by personal attachments and obligations. My study suggests otherwise. Personal relationships can have important implications, even within the seemingly cold, impersonal realm of finance.

Read more

Laura Doering, “Risks, Returns and Relational Lending: Personal Ties in Microfinance,” American Journal of Sociology 2018.

Image: via pxhere (CC BY 1.0)

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