New study reveals hidden risks of social capital in microfinance during economic crises

A new study published in the Strategic Management Journal uncovers a significant and often-overlooked risk in microfinance: while social capital fosters financial stability in normal times, it can exacerbate default rates during crises. The research, conducted by Arzi Adbi, Matthew Lee, and Jasjit Singh, examines the loan repayment behavior of nearly two million low-income borrowers in the aftermath of India’s 2016 demonetization policy, revealing the unintended consequences of peer accountability in financial markets.

Over the past fifty years, microfinance has been hailed as a revolutionary tool for financial inclusion, particularly through group-lending models. These models rely on social connections and peer accountability to encourage loan repayment among low-income borrowers. However, as this study demonstrates, the very mechanisms that drive repayment in stable times can accelerate default rates when external crises arise.

The research focuses on the impact of India’s 2016 demonetization, a policy that invalidated 86% of the country’s cash supply overnight. The policy led to a severe liquidity crisis, particularly for those dependent on cash-based economies. As a result, default rates among microfinance borrowers skyrocketed from 2% before demonetization to over 40% afterward. Surprisingly, these defaults were not evenly distributed but disproportionately clustered in certain lending centers.

The researchers conducted an in-depth analysis using data from a leading microfinance institution in India, supplemented by interviews with borrowers and community service officers. Their findings reveal that default decisions were influenced not only by economic hardship but also by social relationships within borrowing groups. In some communities, peer influence led to collective defaults, as borrowers—facing overwhelming financial pressure—chose to default together rather than individually. This social dynamic amplified financial instability rather than mitigating it.

The study highlights an essential risk for community-driven business models: the same social mechanisms that ensure efficiency in stable times can become liabilities in periods of crisis. To mitigate these risks, the researchers propose several key strategies:

• Enhanced Risk Management: Businesses relying on community ties should integrate crisis-focused scenario planning into their operational strategies.
• Context-Specific Approaches: Social and economic dynamics vary across regions and demographics, necessitating localized interventions.
• Stronger Community Leadership: Building positive relationships with community leaders can help stabilize borrower behavior during economic downturns.
• Balanced Financial Inclusion Strategies: Policymakers and business leaders should view community-driven models as valuable but not infallible solutions to financial exclusion.

As financial institutions, policymakers, and businesses work to expand financial access in emerging markets, this study offers critical insights into the complexities of leveraging social capital. Sustainable financial inclusion requires not only innovation but also a deep understanding of the social dynamics that shape economic behavior.

To read the full context of the study and its methods, access the full paper available in the Strategic Management Journal.

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