The spillover effects of currency demonetization and social embeddedness of MFIs

Abstract

Hybrid organizations like microfinance Institutions (MFIs) work at the interface of the formal and informal economy by providing access to credit to the underbanked members of the economy who typically work outside the economic mainstream. Two approaches dominate the working of MFIs—a transactional approach where MFIs strictly focus on the banking aspect selecting the more credit worthy borrowers to grow and scale. Alternately, they could adopt a relational approach and embed themselves with various social programs to better understand their borrowers but expose themselves to greater liability and risk. Using a proprietary data of MFIs that operated in India during the policy shock of currency demonetization aimed at curbing the informal economy, we found that contrary to expectations, socially embedded MFIs increased their borrowers post demonetization compared to those strictly focused on banking possibly due to preference for trustworthy lenders. The risk of default for socially embedded MFIs due to exposure to the informal economy also reduced post demonetization due to greater digitalization. Our results suggest that differential spillover effects from policy shocks on firms at the interface of the formal and informal economies.