Rethinking Escalation of Commitment: Relational Lending in Microfinance Laura Doering Booth School of Business and Department of Sociology University of Chicago [email protected] Social relationships are an important component of lending and investing. Nevertheless, investors who embed market transactions in social relationships run the risk of “escalating commitment” to struggling investments. When investors feel personally committed to a client, they may ignore negative feedback about that client’s performance. Previous literature on escalation of commitment argues that such behavior constitutes a judgment error and hinders actors from achieving their goals. However, I argue that escalation of commitment can be an effective strategy for achieving organizational goals. I utilize a detailed, proprietary database from a commercial microfinance institution, along with ethnographic observations from the same organization, to demonstrate the conditions under which escalation helps investors realize their goals. The qualitative data show that committed investors often have “soft” information about clients and leverage over client actions; these tools help investors evaluate and manage struggling investments. The quantitative data confirm that committed investors secure better long-term outcomes for the bank than their less-committed peers. This paper demonstrates how actions that might be labeled “decision biases” constitute rational, appropriate behavior when viewed in their social context. 1 Many scholars within both sociology and economics recognize the pervasiveness and importance of social relationships in the financial sector (Sharpe, 1990, Petersen & Rajan, 1994, A. Berger & Udell, 1995, Abolafia, 1996, Mizruchi & Stearns, 2001). Social ties between investors and their clients can have a strong influence on how financial institutions distribute capital and overcome information asymmetries (Uzzi, 1999, A. Berger, Klapper, & Udell, 2001). Although such ties may promote beneficial outcomes for both investors and clients (Boot, 2000, Gibbons & Henderson, 2012), they can also expose financial institutions to certain risks. When investors feel personally committed to their clients, they may fall victim to judgment biases that promote sub-optimal decision-making. Specifically, financial institutions run the risk that investors will “escalate commitment” to poor-performing clients. Escalation of commitment, or “escalation,” refers to the tendency to remain committed to an investment even after receiving objectively negative feedback about that investment (Staw, 1976, Kelly & Milkman, 2013). Actors who feel personally responsible for investments are more likely to escalate commitment (Staw, 1976). Indeed, actors across a variety of financial institutions escalate commitment to the struggling investments for which they feel personally responsible (Staw, Barsade, & Koput, 1997, Guler, 2007, Beshears & Milkman, 2011). In these contexts, escalation of commitment is seen as a detrimental decision bias. Otherwise-rational investors remain committed to poor-performing investments and, in doing so, act against the best interests of their organizations. Yet findings from other streams of research suggest that organizations benefit when their agents remain committed to struggling investments. For instance, indigenous investors demonstrate greater commitment to domestic firms than their foreign counterparts; as a result, those firms experience greater stability and growth following market fluctuations (Schrank, 2 2008). Firms that make the tumultuous transition from private to public ownership under the guidance of highly committed founder CEOs have higher survival rates than firms led by less committed executives (Fischer & Pollock, 2004). Additionally, firms can suffer if they show little commitment to new practices. When they hastily reject innovations perceived as failures, firms may become trapped in fad-like waves of adoption and abandonment (Strang & Macy, 2001). These findings suggest that organizations achieve better results when their agents remain committed to tenuous investments. Paradoxically, the same mechanism—commitment in the face of objectively negative feedback—can lead to both favorable and unfavorable organizational outcomes. This paper aims to resolve that apparent inconsistency. Specifically, it asks, “Under what conditions does escalation of commitment lead to favorable organizational outcomes?” Successfully addressing this question requires examining the social processes that parallel the development of commitment. As investors become committed to an investment, they gain tools that help them evaluate and manage struggling investments. First, investors generally vet potential investments before committing resources. Those who have personal ties with clients gain access to soft information—informal, qualitative information about an investment that supersedes the “hard facts” of the case (Petersen, 2004). Investors with soft information are better able to evaluate negative feedback because they have a more global understanding of the investment (A. Berger & Udell, 1995, Uchida, 2011). Second, the act of investing resources into a project often confers some degree of control to the investor (Bygrave & Timmons, 1992, Campbell, 2003). Investors who have leverage over their investments can correct the problems signaled by negative feedback. For individuals with the capacity to shape their investments, negative feedback can serve as a call to action. When actors have soft information and leverage 3 over an investment, remaining committed to a faltering investment may be a wise decision, rather than a judgment error. In this paper, I examine the consequences of escalation for loan officers in a commercial microfinance bank. This setting is particularly appropriate for two reasons. First, microfinance loan officers are encouraged to engage in relational lending practices. As officers vet new clients, they become personally familiar with clients, their families, and their communities. However, officers also work with clients to whom they have no personal ties. Occasionally, loan officers are assigned responsibility for clients of officers who have left the bank. Since officers do not vet or approve the clients they inherit, they have no personal ties to them. Thus, officers have embedded relationships with some clients, and arms-length ties (Uzzi, 1999, Uzzi & Lancaster, 2003) with others. Such natural variation in officer-client relationships allows for an examination of the social conditions under which escalation of commitment benefits the financial institution. Second, this setting is appropriate because it bears striking resemblance to the financial context in which Staw, Barsade, and Koput (1997) conducted the hallmark field study of escalation of commitment. In that study, the authors demonstrated that managerial turnover in banks resulted in de-escalation to struggling loans. They showed that less committed managers who assumed control of loan portfolios were more likely to write-off poor-performing borrowers than more committed managers. The authors assumed that less committed managers acted in their organizations’ best interests when they cut ties with struggling borrowers; however, they did not demonstrate that fact empirically. Nevertheless, they argued that less committed actors handle struggling investments more effectively than their more committed peers. Many scholars 4 take this study as evidence that individuals who escalate commitment do so to the detriment of their organizations (e.g. Kelly & Milkman, 2013). The commercial microfinance bank analyzed in this study offers a useful comparative site from which to challenge the assumption that escalation of commitment necessarily produces detrimental results. Much like Staw et al.’s managers, the loan officers at the focal microfinance bank have varying degrees of commitment to their clients. And, like those managers, they must decide whether to cut ties with poor-performing borrowers. In this setting, however, the longitudinal nature of the data provides an opportunity to observe the long-term effects of escalation of commitment on the bank’s bottom line. Moreover, because more is known about officer-client relationships in this setting, we can better understand the specific social conditions under which escalation of commitment helps investors achieve their organizational goals. Data for this study consist of interviews and ethnographic observations with the commercial microfinance bank, as well as the bank’s proprietary database of over 100,000 loan- month observations. The qualitative data reveal that loan officers feel greater responsibility for clients whom they approve for loans. Through the vetting process, officers gain soft information about these clients and leverage over their performance. I use the proprietary database to test the hypotheses that loan officers will escalate commitment to the clients they vet and that escalating officers who have soft information and leverage will secure more favorable outcomes for the bank. I find that highly committed loan officers do escalate commitment to struggling clients more frequently, but they also achieve better long-term outcomes for the bank than less committed officers. This paper builds our theoretical understanding of both embedded market relationships and decision biases within firms. First, it demonstrates that actors do not necessarily become 5 trapped by decision biases when they feel highly