Kolar is a tranquil little town in the Indian state of Karnataka, not far away from the state capital of Bangalore. In microfinance circles, its name is only mentioned with apprehension since earlier this year, from one day to the next, around 15,000 MFI clients defaulted on their loans. Local Muslim organizations through their clerics had summoned all Muslim borrowers to stop repaying until further notice, claiming that paying interest contradicted the Koran. Just a few months later, similar instances were reported in three neighboring towns, following more or less the same pattern.

The defaults came as a surprise to the 8 MFIs operating in those areas which saw between 30 and 50% of their portfolio in these towns affected; right now, 53,000 loans amounting to 11.6m USD are in arrears. It has also been reported that MFI staff have been physically threatened when trying to enter Muslim districts for collection, Muslim borrowers were not allowed to get in touch with loan officers, and loan documentation had been destroyed.

Many blame the intervention of local clerics for this crisis. But in his article on a potential microfinance bubble in South India Daniel Rozas made an important point: it’s hard to inflame a happy crowd. Several loan officers we spoke to reported that MFIs had managed client relationships more and more passively over the past years by focusing solely on repayment. In some cases, loan officers were relying on center leaders for client acquisition and sometimes even repayments; staff gets transferred often, which can prevent an MFI from taking a responsible long-term perspective in these areas. We heard of instances in which center meetings went on for extended hours with group members being prohibited from leaving the site until the last borrower had paid her installment. This kind of zero tolerance approach can easily lead a client to become alienated from her MFI. Many also no longer seem to be comfortable with the concept of center-level joint liability, and prefer to be liable only at the group level.

It is hard to say how easily this crisis can spill over within the region or even beyond the borders of Karnataka. So far, defaults have been limited to Muslim borrowers in several urban centers (bar a few Hindu borrowers who have been free-riding on the default wave). MFIs have quickly mitigated their risk by lowering loan amounts, shortening loan durations, demanding higher security deposits, and restricting new loans to Muslim borrowers. But the real lesson should be that microfinance is a relationship business, more than anything else. Once you lose your clients’ loyalty, risk can quickly spin out of control. Kolar has been a vivid reminder of this, and a call for action to MFIs.