A recently published article in the Strategic Management Journal reveals a significant yet often overlooked risk associated with microfinance. While social capital contributes to financial stability under normal conditions, it may lead to higher default rates during economic crises. This research, led by Arzi Adbi, Matthew Lee, and Jasjit Singh, studied the repayment behaviour of nearly two million low-income borrowers following the 2016 demonetisation policy in India. This event inadvertently highlighted the double-edged nature of peer accountability in financial settings.

For over five decades, microfinance has been lauded as a transformative strategy for enhancing financial inclusion, mainly through group lending frameworks. These models capitalise on social bonds and peer pressure to promote loan repayment among low-income borrowers. However, the study indicates that the same factors that facilitate repayment in stable times might accelerate the incidence of default during external shocks.

The research focused on the 2016 demonetisation initiative in India, which invalidated 86% of the nation’s currency overnight. This drastic policy led to a severe liquidity crisis, primarily affecting those dependent on cash transactions. As a result, default rates among microfinance borrowers soared from a mere 2% before the demonetisation to over 40% afterwards. Interestingly, these defaults were not uniformly distributed but were notably concentrated in specific lending centres.

In-depth analysis using data from a leading microfinance institution in India, supplemented by interviews with borrowers and community service officers, helped the researchers understand that the decision to default was influenced by economic hardship and social relationships within the borrowing groups. In several communities, peer influence led to collective defaults, as borrowers, overwhelmed by financial duress, chose to default together rather than individually. This social dynamic exacerbated financial instability rather than mitigating it.

The research underscores a critical vulnerability inherent in community-based business models: the social mechanisms that ensure operational efficiency in stable times can transform into liabilities during crises. To counteract these risks, the authors recommend several strategic interventions: enhanced risk management with crisis-focused scenario planning, context-specific approaches due to varying social and economic dynamics, and fostering more decisive community leadership to stabilise borrower behaviour during economic downturns.

As financial institutions, policymakers, and corporate leaders strive to expand financial access in emerging markets, the insights from this study provide a crucial understanding of the complex interplay between social capital and economic behaviour. Achieving sustainable financial inclusion demands innovative approaches and a profound comprehension of the social dynamics at play. These findings serve as a valuable guide for crafting policies that recognise the strengths and potential pitfalls of leveraging social capital in financial systems.

More information: Arzi Adbi et al, Community influence on microfinance loan defaults under crisis conditions: Evidence from Indian demonetization, Strategic Management Journal. DOI: 10.1002/smj.3558

Journal information: Strategic Management Journal Provided by Strategic Management Society