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Article Excerpt
MICROFINANCE INSTITUTIONS, OR MFIs, serve as important providers of credit to poorer borrowers and thus can play a significant role in programs to alleviate poverty and promote economic opportunity in nations around the world (Morduch 1999a, Zohir and Matin 2004). These institutions make loans to borrowers who seek relatively small amounts and who may be viewed as too risky by larger conventional lenders. Quite often, MFIs operate with subsidies from charitable or governmental agencies. There appears to be considerable heterogeneity in the microfinance industry in terms of institution size, sustainability, and clientele served. Worldwide, the leading 10% of MFIs (about 150 institutions) serve approximately 75% of all microfinance clients, with the remainder served by thousands of small and heterogeneous institutions with varying degrees of sustainability (www.themix.org). Given their important role in providing credit to underserved individuals and the use of subsidies from various sources to support them, MFI operations should be well understood. One important question is whether MFIs are becoming more cost effective over time, particularly if any improvements can reduce or eliminate the need for subsidies. We are particularly interested in whether all MFIs appear to improve at the same rate, and whether there are identifiable factors associated with any detected differences.
There are several novel features of our study to answer these key questions. First, we have access to a unique database on MFIs operating in the Eastern Europe and Central Asia (ECA) region for 2003 and 2004. Second, we are among the first to estimate a statistical cost function using data on MFIs, although the practice is commonly applied to banking institutions. Finally, we are among the first to provide an analysis of the operations of nongovernmental organizations (NGOs) in the ECA region.
In general, it would be expected that firm operating performance should improve with time, ceteris paribus. In the case of MFIs, this is both an understatement and an oversimplification. For MFIs, time is vitally important to offset the information asymmetries present. Both the lenders and the clientele learn over time.
To illustrate the importance of time in the microfinance production process and to highlight some of the time-related effects, we consider what might be the case of a typical microfinance lender. An MFI may begin lending operations as an NGO or some other form of nonprofit entity. They are in the business of making small loans to customers who are not generally serviceable by the commercial banking sector. The MFI clientele typically lacks either credit histories, or collateral, or both. Given time, successful borrowers, whether individuals or members of a borrowing group, will exhibit responsible behavior and generate credit histories, thus providing some of the information absent when the MFI began operations. If these borrowers are very successful they may also generate collateral.
While the situation is changing on the clientele side with the passage of time, improvements in the productivity of the MFI itself are also likely to occur. Navajas, Conning, and Gonzalez-Vega (2003) and Gonzalez-Vega et al. (1996), when discussing Bolivia, describe the evolution of an MFI from an NGO to a for-profit bank. In their studies, they detail several advantages in the form of various types of capital passed from the NGO to the bank. While they deal with individual cases, generalizing some or all of the detailed advantages to maturing MFIs is not far fetched, particularly as one considers how the passage of time should affect an MFI.
Several possible benefits of the passage of time on microfinance performance are pointed out by Gonzalez-Vega et al. (1996): (i) the lending technology is proven and improved through several years of experimentation, development, and adjustment; (ii) the MFI accumulates a stock of information capital about the clientele and the environment; (iii) the MFI develops client relationships and identifies well-performing clients; (iv) the MFI accumulates the human capital embodied in an experienced staff; (v) the MFI acquires a reputation as a serious organization capable of sustaining relationships with clients; and (vi) the MFI has likely established connections with international networks and enjoys the resulting technology transfers. All of the above represent benefits or sources of increased productivity over time for the MFI.
Thus, there are good reasons to expect MFIs that have been in operation longer to be able to reduce costs through learning by doing. However, there are also possible reasons why costs may be flat or even increasing with time, including the following factors: (i) screening and monitoring costs may rise as MFIs reach beyond their initial target group, (ii) operating costs may increase if MFIs move into more isolated and rural markets,(iii) operating costs could rise if MFIs begin competing in increasingly saturated markets, (iv) higher collection costs may be associated with a possible culture of nonrepayment and may be experienced if the MFI has to address increasing default rates, and (v) village banking methods may simply replicate costs as they are extended into new areas. Given the many potential differences in operating environments, degree of subsidization, organizational structure, and lending technology, it is not clear that any finding of increasing cost effectiveness would apply equally to all MFIs. It is for this reason that we estimate a mixture of cost functions along the lines of Beard, Caudill, and Gropper (1991, 1997).
Using the mixture estimation technique we find that there are, in fact, two distinct types of MFIs operating in this region during 2003 and 2004. About half of the MFIs are becoming more cost effective with time and about half are not. In order to determine which MFI characteristics are associated with decreasing costs and which are not, we estimate several auxiliary regressions. Cost reductions are found to be related to several factors. Importantly, lower total subsidies and a lower subsidy per loan are associated with greater cost reductions. MFIs offering deposits tended to improve over time, as did those located in Central Asia. Those MFIs not in networks also tended to achieve cost reductions.
Briefly, we find that the group of MFIs that is becoming more cost effective over time is relying less on subsidies and more heavily on deposits as a source of loanable funds. These MFIs are basically transforming themselves into institutions similar to small banks. A second group of MFIs is not showing increased cost effectiveness, and remains dependent on subsidies. To provide additional context for these findings, we turn next to prior research on MFIs, then present our model and data, and then discuss the results in detail.
1. PREVIOUS RESEARCH
Some of the research on microfinance has focused on the demand side of the market and specifically on the impact of microfinance on clients (see, e.g., Mckernan 2002, Armendariz de Aghion and Morduch 2005, chap. 8, Karlan and Zinman 2008, Hartarska and Nadolnyak 2008). Studies on the supply side of microfinance have progressed from a focus on financial policies to a focus on lending technologies and, more recently, to organizational form (Adams Graham and von Pischke 1984, Gonzalez-Vega 1998, Hartarska and Holtmann 2006). Much of this research focuses on innovations in lending technologies, such as joint-liability contracts and dynamic incentives, which alleviate information asymmetries and decrease screening, monitoring, and contract enforcement costs (Stiglitz 1999, Ghatak and Guinnane 1999, Conning 1999, Armendariz de Aghion and Morduch 2000, Paxton and Thraen 2003, Jain and Mansuri 2003).
Studies that explore the productivity and efficiency of organizations providing microfinance are predominantly case studies describing the experience and performance of a single MFI or a group of MFIs operating in one country or in similar markets (e.g., Navajas and Gonzalez-Vega 2003, Hernandez-Trillo, Pagan, and Paxton 2005). In some of these studies, the role of subsidies has been of special interest because questions such as how much and how long to subsidize an MFI have important policy implications (Morduch 1999b). While learning by doing can be important for any organization, it is particularly important for MFIs because microfinance, at its core, is about fundamental innovation in lending practices and the development of new lending innovations largely through trial and error. Understanding the risks involved in microfinance may also be best accomplished through experience, as managers and loan officers learn about their borrowers and the lending technologies most effective to serve them. Further, the changing institutional environments in transitional economies require adaptation and learning over time, with each situation likely to provide its own challenges and opportunities. While it is useful to conduct case studies to gain insight into particular situations, it is also important to look at many...
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