Relationship Collateral - The Future of Microeconomics

November 2017

Jeff Paddock

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An influential tool for grassroots development is one the most basic human capacities, relationships. One might expect to find relationship building in the development field under psychology or empowerment, but where they’re most innovative today is in finance. Micro-finance, to be exact. 

 

The microfinance revolution started with Muhammad Yunus in 1976 when he founded the Grameen Bank in Bangladesh. As a high-ranking professor, no one expected him to begin working with unfortunate rice farmers and stool makers, but that's exactly what he did. With easy loans as little as $25, he could support an entrepreneur in a rural community to increase her production and grow her own business. The banking industry balked at his project (a game changing innovation in its own right at the time). No institution worth its name would lend to someone with unstable, minimum income levels. Not to mention the poor traditionally have nothing to offer for collateral in case they can't repay. As a result, there was no access to credit. Yunus essentially said it didn't matter: a low-income client would make their payments regardless, because it was their only way to access the capital they needed to break the cycle of poverty. 

 

In a few short years the Grameen project had grown into a full fledged bank devoted to development. In the 1980s it went international. In 1999, Yunus published his first book Banker of the Poor, and later won the Nobel peace prize. In the 40 years since, microfinance has become the silver bullet to ending poverty through economic development. That is, until, it wasn't.

 

Scores of impact studies have demonstrated that microfinance is not effective in all cases. Furthermore, it can even be harmful when lenders use predatory collection practices. The most famous case occurred in Andhra Pradesh, India, when more than 200 residents of a farming community committed suicide in 2010. Loan officers at the local microfinance were paid based on the repayment rates of their clients. This caused them to pressure and threaten borrowers, over-indebt them, and when they couldn’t repay, strip them of all their worldly possessions i.e. collateral. 

 

By this point, there was growing criticism of the viability microfinance offered to the development sector. Yunus was quick to explain that Grameen did not condone these methods and has since worked to combat the negative effects of micro lending and commercial microfinance institutions (MFIs). It was clear that microfinance was in need of some better principles to guide it forward. MFIs all over the world began finding innovative solutions to the default problem, and in the midst of that movement, one process is setting itself apart. 

 

Relationship Collateral is exactly how it sounds. Low-income families can take out loans to grow their small businesses and support their families without putting their assets, their savings, or their lives at risk. Instead, they stake the trust bestowed upon them by the institution as well as their reputation in the community. This is to say, ‘if you don’t repay, we won’t lend to you anymore and everyone will know’. The idea relies heavily upon Yunus' vision that says small businesses are a good investment because they want to work and break free from poverty. Instead of risking what little capital they have, micro businesses can use social capital as collateral. It's a unique concept built on the ideal of equality. It’s a mutual agreement where the lender charges a fair interest rate and does not participate in aggressive collection practices, and the borrower agrees to use the money effectively and do everything in their power to repay it.

 

At its core, Relationship Collateral relies on open communications, repeated interactions, and explicit terms – the foundations of any sound development project. It takes the long-term view with the basic assumption that development requires decades not years. If a client knows the lender will leave in a few months, the relationship falls apart and the model becomes redundant. If lending is to reach its full potential and alleviate poverty, we’re going to have to bring the MFIs closer to the targeted communities, both literally and figuratively.

 

One might want to point out that MFIs collect on collateral to cover their losses. How can a bank function without it? Yet, there are a number of projects and institutions out there innovating and operating in this space, relying on relationships to fund small businesses in the developing world from the grassroots up. La Ceiba Microfinance, for example, is our start up in Honduras that champions this concept. We’ve been lending to six communities for the past nine years. We do nothing when people find themselves unable to repay. We understand that income is irregular in low-income households and economic shocks can strike at any time. We absorb it instead and seek other ways to be sustainable. Clients repay when they can and we forge ahead, staying in close contact for years to ensure the relationship wins out over the transaction.

 

Zidisha is another organization that uses trust as a key component for its grassroots lending. They run the first person-to-person online lending platform where people can loan directly to small businesses in seven developing nations with no collateral and no interest. Grassroots development, in spurts and bounds, is beginning to integrate relationships into the very structure of its models. Sustainable Harvest, for example, pioneered Relationship Coffee, a direct trading model that aims to understand the coffee farmer’s point of view while helping them to understand the market. All around the world, the beneficiaries are being connected straight to the benefactors and changing the face of grassroots development. Relationship Collateral is just the beginning.

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About the Author

Jeff works on the ethical considerations of economic development and cash aid programs around the world. He currently works in Honduras, supporting local community projects through micro-finance and holds two degrees in Philosophy and International Affairs.