MICROFINANCE PAPER WRAP-UP: Microfinance and Financial Sector Development, by Annabel Vanroose and Bert D’Espallier

Written by Annabel Vanroose and Bert D’Espallier, published by the Emile Bernheim Center Research Institute in Management Sciences at the Solvay Brussels School of Economics and Management in September 2009, 41 pages, available at http://www.solvay.edu/EN/Research/Bernheim/documents/wp09040.pdf

This paper aims to determine the impact of formal banking sector development on several measures of performance of microfinance institutions (MFIs). The study is based on data from 1,073 microfinance institutions (MFIs) reporting to the MIX market, the microfinance information clearinghouse, from 1997 until 2006. The MFI data set includes cooperatives, non-bank financial institutions, banks, rural banks and non-profit organizations.

The main result is that, generally, lower formal financial sector development is associated with better performance for MFIs in terms of profitability and outreach. For MFIs, the number of active borrowers, total loan portfolio, ability to cover operational costs (OSS), return on assets (ROA), and return on equity (ROE) are all negatively correlated with the number of automated teller machines (ATMs), a measure of financial access. These same measures of MFI profitability and outreach are negatively correlated with domestic credit disbursed per capita, a measure of financial depth. The negative correlation between the profitability measures (OSS, ROA, ROE) and domestic credit disbursement is particularly strong. These results indicate that MFIs can achieve profitability and high outreach when there are a larger number of potential borrowers that are not served by the formal financial sector.

It is also important to note that financial access (number of ATMs) is significantly correlated with outreach (active borrowers and total loan portfolio), but financial depth (domestic credit disbursement) is not. This provides evidence that there is a distinction between financial access, a measure of the availability of financial services, and financial depth, a measure of the use of financial services.

Despite these results, there are also some indicators that a more developed formal financial system can be beneficial to MFI performance and outreach. For instance, lower interest rates, measured by both average annual deposit rate and average annual lending rate, are associated with greater profitability and outreach in terms of the variables mentioned earlier. As lower interest rates are generally associated with a more developed financial system due to greater bank competition, this result demonstrates how MFIs can benefit from financial system development. Simply put, domestic funding is generally more expensive when interest rates are high, which impacts MFIs negatively if they rely on domestic funding.

Inflation is also negatively correlated with all measures of MFI profitability and outreach. As banking activities are generally lower in places with high inflation (Boyd et al. 2001), this is an indication that a well-functioning financial system can provide a positive environment for MFI performance.

Lastly, in countries in the lowest quartile of financial system development in terms of number of ATMs as well as domestic credit disbursement, MFIs generally perform worse in terms of profitability and outreach. The average returns on assets and equity for MFIs in these countries is actually negative. This is in contrast to the general trend mentioned earlier, and indicates that a certain level of financial system development is beneficial for the performance of MFIs.

By Christopher Maggio, Research Assistant

References:
Boyd, J., Levine, R. and Smith, B. (2001) The Impact of Inflation on Financial Sector Development.
Journal of Monetary Economics, 47(2), pp. 221-248.

Similar Posts: