No one would argue that online and mobile banking have transformed the financial services industry. Tech-savvy customers welcome online banking for its convenience, and banks view it as a way to increase efficiency. But despite the rapid growth of digital tools and solutions, personal relationships remain critical in the financial sector.
My research indicates that there are hidden costs to abandoning personalized banking relationships—and that personal relationships between borrowers and lenders benefit both parties. In this article I will summarize my research and show a few important ways that personal ties shape financial intermediation.
Personal Relationships as Liabilities
In finance, personal relationships can have upsides and downsides. One potential downside relates to ‘escalation of commitment,’ or the tendency for individuals to contribute more to failing investments when they feel personally responsible for them. Researchers treat escalation as a ‘decision error’ because the decision to support struggling investments is driven by a sense of personal responsibility rather than by objective performance indicators.
Escalation can manifest itself in both monetary and non-monetary forms. Although Staw first observed it in financial contributions to failing investments, scholars have also examined it in a variety of non-financial situations where actors continue to invest time, social capital and other non-monetary resources in poor-performing investments—including keeping rather than trading professional basketball players. In such cases, actors escalate by continuing to allocate time and effort to a person, product or project that presents signs of poor performance. Whether investments occur in the stock market or on the basketball court, they are subject to escalation tendencies.
Further, scholars have shown that actors who have personal relationships with a subject are less likely to cut ties, even when the relationship becomes problematic. For example, individuals are less likely to cut ties with exchange partners with whom they have personal ties, even when they no longer require their services. Actors resist walking away from problematic exchange relationships because they have difficulty justifying the ‘sunk costs’ associated with developing those relationships, suggesting that relationships with time-intensive, up-front investments can encourage escalation. Personal Relationships as Assets
While the literature on escalation describes some of the costs associated with personal ties, research on ‘embeddedness’ proposes boons associated with personal ties. This work demonstrates that personal relationships can facilitate transactions through heightened trust, information sharing and social control. Let’s take a closer look at each.
Trust. A primary feature of embedded relationships is trust, which allows exchange partners to assume the best when interpreting another’s motives and actions. In times of uncertainty, trust serves as an important lubricant for exchange. For instance, scholars show that bankers rely on those they trust when seeking information in precarious transactions and that, in the absence of formal institutions, agents extend credit only to those they trust. In banking contexts, trust may facilitate timely loan repayment by encouraging lenders to view clients as reliable and work with them productively should they miss payments.
Information Sharing. Researchers have found that actors are more likely to share private information with embedded exchange partners, that information travels more easily via dense relationships, and that fine-grained information sharing among embedded exchange partners allows for effective coordination. Information sharing may encourage compliance by providing lenders with the information they need to work effectively with clients to avoid problems or by helping them overcome problems should they occur.
Social Control. When actors conduct exchanges in the context of personal relationships, partners are more likely to abide by norms of reciprocity and fairness. Research on microfinance demonstrates that borrowers are more compliant when they are accountable to their neighbours in lending groups. Additionally, personal relationships allow actors to sanction one another more effectively for norm violation. For instance, small business owners in tightly knit communities are particularly susceptible to gift and loan requests, as community members can cite norms of generosity and reciprocity. These social control mechanisms should encourage loan compliance through increased possibilities for social sanctioning.My Research
In recent research, I examined personal relationships among loan officers and clients at “MicroBank” (a pseudonym), a commercial microfinance bank in Central America. Specifically, I tested loan officers’ tendencies to cut ties or remain committed to clients and clients’ tendencies to repay loans on time, based on their relationships.
At MicroBank, officers employ ‘relational lending’ evaluation strategies because the majority of new clients do not have credit histories. Facing steep information asymmetries, officers spend time with clients to assess their credit-worthiness. Bank policy dictates that officers visit applicants at their homes and businesses. In these intimate settings, officers talk with clients about their families, financial situations, and plans for the loan. If the applicant has a spouse, the officer meets with him or her as well.
Officers also interview community members to solicit an impression of the applicant’s local reputation. Given the extent of information officers collect, they must spend at least two hours in conversation with applicants and generally make multiple visits. If loans are approved, officers assume responsibility for monitoring the loans, which have a median term of 18 months.
As officers and clients get to know one another, their newly formed relationships contain the key features of embeddedness: familiarity, personal attachment, and fine-grained information sharing.
Microbank officers thus have two types of client relationships:
1. Personal relationships with ‘original clients’ characterized by intensive, familiar interactions during the vetting process and
2. Arm’s-length relationships with ‘inherited clients’, with whom officers communicate only when necessary.
At MicroBank, I found that exchanges are governed not only by formal contracts but also by norms of reciprocity. ‘Original officers’—my term for the individuals who initially meet with the client and approve the loan—incur professional risks when lending to clients whose long-term creditworthiness is uncertain. Clients, in turn, often feel gratitude towards the original officer who approved their loans. As one officer described to me: “The client sees the loan officer as the one who gave him the loan. A lot of my clients will say to me, ‘Thanks so much for what you’ve done. Look at how the money that I asked for has helped my business. I’ve been able to grow it thanks to the opportunity that you gave me’”.
Beyond expressing gratitude, clients can reciprocate by complying with the terms of their contracts. Clients who make timely payments demonstrate appreciation for the risks original officers incurred and prove that the risk was justified.
Personal officer-client relationships can also influence how effectively officers work with clients to get them back on track when they miss payments. For example, officers can activate clients’ sense of personal indebtedness when they miss payments. Specifically, original officers can threaten to withdraw the trust they placed in clients when they approved the loan. Officers explain the tactic in this way: “The loan officer calls a client and says, ‘No, remember, I gave you that loan. I trusted you.’ And it’s like the client has a responsibility not to the bank, but to us [the officers] because we’re the ones who gave them the opportunity to grow their business”.
Importantly, I found that if clients are transferred to ‘inherited officers’—a different individual who takes over the file—the norms of reciprocity no longer apply. Clients feel personally indebted to specific original officers—the people who came to their home, met their family, and approved their loan—rather than to MicroBank itself. As one officer explained, “Sometimes when I talk with [inherited] clients, they say, ‘I didn’t make this agreement with you. I made it with the other guy’”. When personal ties are broken, clients no longer feel as tightly bound to norms of reciprocity that encourage timely repayment.
Original officers also enjoy higher levels of information sharing with clients, which facilitates collaboration in difficult times. They regularly talk with clients who miss payments to uncover the source of the problem and offer potential solutions. Because original officers established personal ties with clients during the vetting process, they have a foundation of previous interactions on which to gather information and offer suggestions. Additionally, inherited officers may view inherited clients as simply irresponsible when they miss payments.
Overall, the literature on embeddedness suggests that clients should be more compliant when they have personal relationships with officers. Original clients are more likely to adhere to norms of reciprocity, which demand timely repayment on loans approved by original officers. If clients fail to abide by these norms, original officers can leverage clients’ sense of social indebtedness, pressuring them to repay. Original officers also have heightened trust and more information, tools that make them more effective collaborators with problematic clients.
Drawing on the theories of escalation described earlier, I hypothesized that officers would be less likely to send original than inherited clients to collections, given the personal relationship and heightened sense of responsibility officers feel toward original clients. Because the models control for missed payments, they evaluate officers’ commitment to original and inherited clients with similar missed payment histories.
My hypothesis was confirmed: Officers were 60.5 per cent less likely to send original clients to collections. This result is consistent with officers’ assertions that they feel a heightened sense of responsibility for their original clients. As one officer said, “The difference between inherited clients and my clients [original clients] would be the responsibility I have because I gave the loan.”
I also examined whether relationship duration significantly moderates the effect of having an original or inherited officer. I anticipated this effect to be non-significant because officers’ greater sense of professional responsibility to original clients should not fade over time.
As expected, original officers were less likely to send original clients to collections, suggesting that their tendency to remain committed does not significantly diminish as the relationship weakens. Officers had greater odds of sending clients to collections even when more time had elapsed since loan origination, implying that both original and inherited officers tend to ‘walk away’ later rather than earlier in the loan. Officers also had greater odds of sending clients to collections when they had higher remaining balances, more cumulative missed payments, more debt, and larger families. Officers had lower odds of sending clients to collections as loan size increased.
Additionally, officers had greater odds of sending clients to collections when they had automobile loans rather than working capital loans. Because cars are valuable and easily moved, collections officers can repossess these items relatively easily. By comparison, collections officers may need to repossess a variety of smaller items from working capital clients.
Although escalation research traditionally views such commitment as erroneous, it is possible that officers persist with original clients because they view them as more reliable. Indeed, the qualitative data suggest that, as a result of their personal relationships, officers may communicate with and pressure original clients more effectively, and clients may be more inclined to uphold their obligations to the bank when paired with officers who approved their loans. Thus, original officers’ heightened commitment may be matched by heightened compliance from original clients.
I also anticipated that original clients would be less likely to miss payments than inherited clients. I proposed that the main effect of having an original officer would be temporary, with original clients missing more payments over time as the relationship weakened.
The results supported this hypothesis. Original clients had significantly lower odds of missed payments: They had a 9.9% predicted probability of missed payments, while inherited clients had a 21.7% probability of the same. These findings show that clients are more compliant with their contractual terms when paired with original officers.
As anticipated, original clients missed significantly fewer payments in the early months of their officer pairings when the relationships are strongest. As the relationship weakens through infrequent interaction, original clients become increasingly likely to miss payments. The findings suggest that original clients’ heightened compliance can be temporary, fading as the relationship weakens.
The data also show that clients’ tendency to comply in the context of personal relationships can fade over time. Original clients missed significantly fewer payments in the months immediately after the initial vetting, as compared to later in the loan. These findings are particularly striking given MicroBank’s competitive landscape. MicroBank competes against a handful of other microfinance institutions that clients can approach for future loans. The presence of such institutions should encourage clients to repay loans diligently. Once clients begin repayment, they develop formal credit scores that other financial institutions use to assess their creditworthiness. As such, clients should be concerned about developing healthy credit scores independent of their officer relationships, as these scores are the key to future loans. Despite the strong incentives for timely repayment, my results show that clients’ repayment depended on the type and strength of their officer relationships.
Taken together, my results reveal the shifting costs and benefits of personal ties as relationships between clients and intermediaries evolve. When exchanges are embedded in personal relationships, intermediaries are more likely to remain committed and clients are more compliant. However, clients’ compliance tendencies hinge on the strength of the relationship, which in this setting fades predictably over time. The results suggest shifting (dis)advantages associated with personal relationships, as intermediaries may continue to show heightened commitment even after they no longer enjoy compliance advantages.
My study provides a new lens for thinking about escalation of commitment. By incorporating insights from economic sociology, it demonstrates that remaining committed to a struggling investment can be a rational choice, depending on the nature of the relationship between the investor and investee. Escalation of commitment is generally viewed as a decision error, since actors who escalate appear to overlook objectively negative feedback about struggling investments. ‘Investments’ in this sense refer not only to traditional stock or equity investments but to any act of resource allocation in which actors hope that marginal gains will exceed marginal costs. Although some scholars have speculated that remaining committed to a struggling investment is not always problematic, this study is the first to my knowledge that systematically considers the conditions under which remaining committed to a problematic investment may constitute a strategic choice, rather than a decision error.
When viewing escalation as erroneous, scholars adopt the implicit assumption that all struggling investments are equally likely to continue on downward trajectories. Such an assumption is reasonable when investors and investments cannot influence each other, as when individuals invest in stocks. In most circumstances, individual investors cannot intervene to shape a stock’s performance. If the stock plummets and has little likelihood of recovery, investors would be wise to walk away rather than persist. Escalation, in this case, would constitute a decision error because the investor’s heightened commitment is unmatched by reasonable expectations of improved future performance.
Nevertheless, in many contexts, investors and investees do influence one another. When investors and investees are human and have personal ties, they can shape one other’s behaviour. For example, consider the case of venture capitalist (VC) investors and their investees. When vetting target firms, VC investors often spend time with leadership teams in informal settings and, in doing so, establish personal relationships. The personal ties between VC investors and firm leaders may influence firm performance. When relationships are new and strong, firm leaders might work harder to ensure excellent performance and justify the VC investment. And should the firm flounder, the investors are likely to show greater commitment than they would in the absence of personal ties.
Results from this study also show that investors’ tendency to heighten commitment can outlast the point at which they enjoy improved relational returns. This finding, then, adds new reason to worry about escalation: when personal ties weaken, investors may overestimate investees’ future performance as well as their ability to influence it.
For instance, if VC investors rarely interact with members of the target firm after committing funding, team members in the target firm may exert less effort to prove the firm’s worth, and investors may have less capacity to influence performance.
Overall, this research highlights the importance of viewing escalation decisions in their relational context. Strong, personal relationships benefit intermediaries by facilitating heightened commitment matched by heightened performance. Yet in the absence of sustained contact, personal relationships can become problematic when investors continue to remain committed even when weakened ties no longer generate improved outcomes from investees.Beware of Front-Heavy Relationships
This research also offers reason to exercise caution with what I call “front-heavy relationships.” In a front-heavy relationship, intermediaries and clients have intense personal contact at the outset. Examples include relationships between parole officers and offenders at initial home visits, social workers and clients at the first intake meeting, and mortgage lenders and prospective home buyers during the loan application phase.
By establishing personal relationships at an early stage, intermediaries solicit fine-grained, tacit information about clients, and clients gain a personal representative within an organization. Unlike friendships formed on the basis of affinity, intermediaries and clients have ‘complex relations’ in which personal ties serve to achieve utilitarian objectives. Once they achieve those objectives, both parties have little reason to maintain the initial intensity of contact. As time passes, personal relationships that began with frequent contact begin to wane. Whereas most research on personal relationships focuses on ties that become stronger over time, many organizationally mediated relationships unfold predictably in the opposite direction.
Rather than becoming stronger, front-heavy relationships between intermediaries and clients decay over time. The extent to which clients and intermediaries enjoy advantages via front-heavy relationships may hinge on the strength of that relationship.
This observation complicates a common perception that personal relationships between intermediaries and clients tend to facilitate improved organizational outcomes. For example, scholars of public service organizations have argued that more relational, humane approaches to client-facing interactions can foster more effective service delivery. The current study suggests that such benefits may be limited to a ‘honeymoon period’ immediately after relationship formation. As front-heavy relationships weaken with decreased interaction, clients may feel less inclined to display the heightened levels of compliance and collaboration that they demonstrate at the outset.In closing
By examining how relationships affect both intermediaries’ commitment and client compliance, my research demonstrates how personal ties generate shifting costs and benefits as relationships evolve.The takeaway:
Those of us who do most of our banking online should develop a relationship with someone at our primary bank—and it should consist of more than just email. It should begin with an in-person meeting. My research suggests that if you retain this relationship, your banker will cut you some slack when you need it—and you will become a more reliable customer.
It is unlikely that we will ever return to the days of It’s a Wonderful Life, where banker George Bailey greeted each customer by name. But my research suggests that maintaining some form of personal connection is a wise choice for customers and bankers alike.Laura Doering is an Assistant Professor of Strategic Management at the Rotman School of Management. This article summarizes her paper, “Risks, Returns and Relational Lending: Personal Ties in Microfinance, which was published in the American Journal of Sociology. The complete paper can be downloaded online.
Rotman faculty research is ranked in the top 10 worldwide by the Financial Times.
[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]