On the Existence of Relationship Lending in Islamic Microfinancing
Wildan Syahid and Zuliani Dalimunthe
Faculty of Economics and Business, Universitas Indonesia, Depok, Indonesia
Keywords: Relationship Lending, Islamic Microfinance, Indonesian Cooperatives, Wilcoxon Sign-rank Test.
Abstract: Relationship lending is an innovation measure to reduce credit constraint to micro firms. It refers to a process
to build a robust and long-term relationship between financier and entrepreneurs by putting more trust in the
prior relationship compared with the traditional financing process. This research aims to examine the existence
of relationship lending in Islamic microfinance institutions in Indonesia and how it will affect the financing
terms. This research is conducted using surveys of Islamic microfinancing institutions in 2017, which consist
of Islamic cooperatives, BMTs, and Islamic rural banks. We found that relationship lending exists in the
funding process of Islamic microfinancing institutions. Islamic micro finance tends to rely on a long-term
friendly relationship to collect soft information regarding the development of the business as well as
trustworthiness of entrepreneurs. Using Wilcoxon signed-rank test, the results show a positive difference in
the maximum financing provided and a negative difference in the length of processing time if the credit officer
knows the entrepreneur as well as his or her relatives. However, findings regarding terms of the collateral
requirement are not conclusive.
1 INTRODUCTION
Development of micro and small enterprises has
become a crucial government policy around the
world, both in developing countries or developed
countries. Micro financing has become the most
important measure to alleviate poverty, especially in
developing countries. Torre et al. (2010) stated that
the rising attention to micro and small enterprises
development because of this sector is covering a
large part of business unit in a country and provide
the biggest part of employment opportunity.
Moreover, many of big corporations in developed
countires were come from small or medium firms. In
Indonesia, the ministry of cooperatives and SME’s
report of year 2012 shows that there more than 56
million or 99% of business units categorized as micro
and small firms. Moreover, these sectors provide
more than 107 million jobs or about 93% employment
opportunity in Indonesia.
The development of micro and small firms needs
a strong financial support to survive and to expand
their business scale. However, commercial banks
reluctant to provide funds for these sectors. Micro and
small firms contain high information asymmetric thus
formal financial institution difficult to assess whether
the firm has enough capacity to repay the loan or
whether the entrepreneur has enough willingness to
make the repayment as promised (Torre et al., 2010).
Credit constraint in micro and small firm has
become major concern among scholars and policy
makers as well. Many measures have been taken to
reduce this credit constraint. One of them is
relationship lending. A large body of literature
proposed several variables to characterize
relationship lending. The relationship lending refers
to a process to build a strong and long term
relationship between the financier and the
entrepreneur or borrower. Relationship process
generate valuable soft information regarding the
business and the entrepreneurs in asymmetric
information environment. The relationship will then
increase trust in the financing evaluation. This effort
conducted with many ways such as making
communications to family members and other
people in community. This soft information is useful
to reduce information asymmetric regarding viability
of the business and the character/ trustworthiness of
the entrepreneur (Petersen and Rajan, 1994; Berger
and Udell, 1995; Boot, 2000; Elyasiani and Goldberg,
2004; Ogura, 2009).
Poverty alleviation is an important priority in
Islamic finance. In every wealth of the rich there is
the right of the poor to be expelled through zakat.
Syahid, W. and Dalimunthe, Z.
On the Existence of Relationship Lending in Islamic Microfinancing.
In Proceedings of the 1st International Conference on Islamic Economics, Business, and Philanthropy (ICIEBP 2017) - Transforming Islamic Economy and Societies, pages 751-755
ISBN: 978-989-758-315-5
Copyright © 2018 by SCITEPRESS – Science and Technology Publications, Lda. All rights reserved
751

There is also a recommendation to pay for waqaf,
infaq and sadaqah who get good rewards in the
afterlife. These funds are Islamic social funds that
should be used as source of microfinancing. Islamic
micro finance funds commonly channeled through
Islamic micro financial institutions (IMFs) known as
house of charity (baitul maal wattamwil, BMT) or
Islamic cooperatives. Today there are thousands of
BMTs and Islamic cooperatives in Indonesia. Besides
BMT and Islamic cooperatives, rural banks (bank
perkreditan rakyat syariah, BPRS) is other institution
that provide financing for micro and small firm.
This research aims to evaluate the existence of
relationship lending in financing process of Islamic
microfinancing institutions (IMFs). Specifically, the
research is to evaluate the strength of the relationship
between Islamic microfinance institutions (IMFs)
with entrepreneurs as their borrowers and how that
relationship effect to the access and terms of
financing. Relationship lending has become an
innovative way to provide micro financing and
become more reliable information along with the
strength of the relationship itself ( Petersen and
Rajan, 1994; Berger and Udell, 1995; Boot, 2000).
However, there is only few research regarding
relationship lending in Indonesia, while relationship
lending in Islamic microfinancing institutions (IMFs)
is even more rare. This research contributes to fill the
gap.
The paper is structured as follow. Section 2
describe literature review of relationship lending
topics and role of Islamic microfinance in Indonesia.
Section 3 describes methods employed to evaluate
hypothesis proposed here. Section 4 consist of
discussion and analysis section while section 5
provide conclusion of the research.
2 LITERATURE REVIEW
Berger and Udell (2006) highlight the importance of
micro, small and medium enterprises’ financing for
economic growth of a country, including the United
States. However, financing for this sector subject to
high asymmetric information involved. Micro and
small sectors commonly characterized by the lack of
reliable hard information. They rarely provide regular
financial report, even in unaudited form. Thus, there
are severe credit constraint in this sector.
Limited hard information in micro and small-scale
firm drive lending institutions to rely on much private
and soft information to make financing approval
decision. There are several ways to obtain this soft
information, but one method that is especially well
suited for opaque firms is to develop a long-term
relationship between lender and borrower. This
commonly known as relationship lending or
relationship financing (Peterson and Rajan, 1994;
Berger and Udell, 2002). Relationship lending based
on theory that a relational long term contract allows
the lender to implicitly apply incentive contracts
between the times. It means that the successful
repayment of a financing with higher interest rates
will be compensated by cheaper and easier financing
in the next period (Berger and Udell, 2002). This
argument means that long-term relationships between
lenders with borrowers will increase the chances of
credit availability for both new businesses and the
existing ones. Reduction in the financing cost is
driven by the reduction of information asymmetric
through acquisition of many relevant “soft”
information. Elyasiani and Goldberg (2004) stated
that the continuous contact between borrower and
lender in the provision of various financial services
can produce valuable input for the lender in making
decisions on whether to extend credit, how to price
loans, and whether to require collateral or attach other
conditions to the loan.
Relationship lending becomes an important
financing mechanism in SMEs financing to overcome
credit constraints in this sector. Petersen and Rajan
(1994) conducted an empirical study of 3,404 small
businesses in the US which are not evaluated by the
rating agencies, how the relationship between creditor
and entrepreneur would imply to the availability of
loan and the cost of the loans. It found that the strong
relationship has the positive effect on the availability
of financing although its impact on business capital
cost reduction was not significant. Ogura (2009) in
his study in Japan support the idea that the found the
higher loan cost available for younger firms
compared to older ones. Also, Lopez-Espinoza et al.
(2017) show that firms begin to capitalize the gains of
relationship lending when the relationship extends
beyond two years and that relationship lending
significantly mitigates the increased costs of re-
financing loans.
A study conducted by Behr et al. (2011) analyze
whether the closeness of the relationship between the
lender and the borrower would overcome asymmetric
information problem in SMEs sector. They examine
how this closeness imply to the availability of loan as
well as the term of the contract. This study took place
in Mozambique using data from 2000 to 2006.
Meanwhile, Behr et al. (2011) analyzed how the
impact of the intensity of the relationship between the
microlender and the borrower. It concluded that the
intensity of the lender-borrower relationship
ICIEBP 2017 - 1st International Conference on Islamic Economics, Business and Philanthropy
752

positively implies to: (a) the higher access to loan, (b)
the shorter of loan processing time, (c) the more
lenient terms of collateral. While from macro
perspectives, Egli et al. (2006) found that the
relationship lending is a mechanism which is superior
in an economy when the chances of default are quite
high due to the financial system which has not
developed as characterized by low transparency
and weak legal enforcement.
3 METHODOLOGY
Population in this research is Islamic micro finance
institutions (IMFs) consist of houses of charity
(known as baitul maal wattamwil or BMTs), Islamic
cooperatives, and Islamic rural banks (bank
perkreditan rakyat syariah or BPRS). We used
primary data generated from semi-close
questionnaire, mixing a close questionnaire with
direct interview to generate more understanding about
variable evaluated.
The measurement of relationship lending
variables here adjusted from Behr et al. (2011) and
Serrano-Cinca et al. (2016). The adjustment made to
get more appropriate measurement according to
Indonesians habit and culture. Relationship lending
here measured as (a) whether the credit officer knew
the prospective borrower previously or not, (b)
whether the credit officer knew the prospective
borrower’s relatives previously or not (c) whether the
prospective borrower had borrowing records before.
Meanwhile, financing terms as dependent variables in
this study are (a) the maximum financing the IMFs
ready to provide, (b) the length of processing time for
each loan application, and (c) the terms of collateral
required.
We divided maximum financing ready to provide
into five categories, length of processing time into
four categories and terms of collateral required into
three categories. Categories of maximum financing
ready to provide are (i) Rp 1.000.000, (ii) Rp
5.000.000, (iii) Rp 10.000.000, (iv) Rp 20.000.000
and (v) above Rp 20.000.000. Categories of
processing time are (i) one day, (ii) 2-5 days, (iii) 5-
14 days and (iv) more than 14 days. And categories
of terms of collateral are (i) loose terms when the
borrower only provide copy of motorcycle ownership
document, (ii) medium terms when the borrower
required to provide authentic motorcycle of car
ownership documents and (iii) tight terms when the
borrower required to provide authentic house
document ownership.
Furthermore, the categories of each independent
variable divided into three parts. In the first variable,
maximum financing IMFs ready to provide divided
into (a) higher, (b) indifferent and (c) lower. Higher
category defined as higher maximum financing the
IMFs ready to provide if any condition of relationship
lending applied, and vice versa. In the second
variable, the length of processing time divided into (a)
longer, (b) indifferent and (c) shorter. Shorten
category defined as when the IMFs process a loan
application in shorten time when relationship lending
applied, and vice versa. While in the third variable,
terms of collateral required, divided into three namely
(a) tighter, (b) indifferent and (c) looser. For analysis,
we used Wilcoxon sign rank test to examine whether
an IMF move from one into another category of each
variables (maximum loan ready to provide,
processing time and terms of collateral) when
relationship lending applied.
4 DISCUSSION AND ANALYSIS
The survey and interview conducted in 30 IMFs
located in several cities in Indonesia. The data consist
of 44% BMT, 33% Islamic cooperatives and 23%
Islamic rural banks. Summary of the Wilcoxon sign
rank test presented in table 1.
Table 1: Summary of Wilcoxon Sign Rank Test.
Maximum financing
Move to higher category
(p-value)
Knew borrower previously
0.0016
*)
Knew borrower’s relatives
0.0047
*)
Having track record in IMF
0.0048
*)
Processing time
Move to shorten time
category (p-value)
Knew borrower previously
0.0001
*)
Knew borrower’s relatives
0.0016
*)
Having track record in IMF
0.0001
*)
Terms of collateral
Move to looser category
(p-value)
Knew borrower previously
0.1573
Knew borrower’s relatives
0.0047
*)
Having track record in IMF
0.0047
*)
*) sig at 5%
4.1 Maximum Financing Ready to
Provide
The first variable evaluated in this study is the
maximum value of financing provided. In average,
financing provided are in the range of Rp 2 million -
Rap 10 million with repayment term of less than one
On the Existence of Relationship Lending in Islamic Microfinancing
753

year. Very little financing given in amounts above Rp
10 million. Perhaps, this term relates to the access for
financing provided by Indonesian commercial banks
commonly at the minimum amount of Rp 10 million.
Table 1 shows that most respondents
acknowledge that they are willing to provide higher
financing if the borrower has personally known in
advance or if the credit officer/significant person
knew the relatives of the borrower previously. From
the same data also found that IMFs are willing to
provide higher amount of financing if the borrower
had track record on the IMF. The Wilcoxon sign rank
test shows that relationship lending positively affects
access to higher financing.
4.2 Length of Processing Time Of Loan
Application
The following variable evaluated are the loan
application processing period. On average, the
average processing time is in the range of 5-14 days
in BMT and 2-5 days at BPRS and cooperative.
Among the three types of IMF in this study, the
cooperative has the shortest processing time
compared to BMT and BPRS, with the most
processing time on one day and 2-5 days. An
interesting finding is that only cooperatives under any
circumstances can process the financing application
within a day. Moreover, the processing was
sometimes only done through short messages or
phones communication while handing the
administrative requirements done in conjunction with
the financing signatories. Even for customers that had
a good track record, the cooperatives sometimes
‘picked up the ball’ by initiating to offer the new
financing or offered new financing before the
maturity of the last payment of the existing financing.
Thus, there is a sustainability for financing.
4.3 Terms of Collateral Required
The third financing variable, the collateral
requirement, appears different pattern. There is
insufficient evidence that the terms of collateral are
more lenient when the credit officer knows the
borrower previously. However, when a credit officer
knows the relative of the borrower or the borrower
has a track record on the BMT then the terms of the
collateral become more lenient significantly. Our
guess that the type of IMFs affects the type of
collateral requirement in which BPRS tends to require
strict collaterals while Islamic cooperatives and
BMTs require more loose collateral. The type of
engagement conducted on collaterals at BMT or
cooperatives put in the form of sealed agreement,
without notarial deed. By law, this agreement is very
difficult to execute transfer of ownership of the asset
in case of default.
5 CONCLUSIONS
This study shows that relationship lending exists in
the financing process at IMFs in Indonesia. The
officers acquainted to potential borrowers and their
families or relatives. Any information generated from
the relationship becomes an important factor for
making financing decisions. IMFs are significantly
willing to provide higher amount of financing when
the borrower has known by the officer previously or
when the officer knows the borrower's relatives as
well as that the borrower had previous records on the
IMFs. The closeness of this relationship also effects
to shorten length of approval processing time. It
means that IMFs will process financing faster when
the the IMFs officers knew the borrower or knew the
borrower's relative previously. However, the
closeness of this relationship results in an
inconclusive finding regarding the terms of collateral
requirement. There is no sufficient evidence to
conclude that the collateral requirement becomes
more lenient when the relationship become stronger.
The terms of the collateral requirement are
significantly looser when the officer knows the
entrepreneur's relatives, but not if the officer knows
the entrepreneur itself. This finding needs rational
explanation. Also, if the sample study is larger, this
conclusion might be different. Future research is
needed to answer this.
ACKNOWLEDGEMENTS
We are grateful to the University of Indonesia that has
funded this research through the PITTA grant in
2017. Also to all those who contribute so that this
research able to accomplish.
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