PAPER WRAP-UP: Microfinance Meets the Market, by Robert Cull, Asli Demirgüç-Kunt, and Jonathan Morduch

Written by Robert Cull, Asli Demirgüç-Kunt, and Jonathan Morduch, and based on data from the Microfinance Information Exchange (MIX Market), released May 2008 as Policy Research Working Paper Number 4630 by the World Bank Development Research Group, 40 pages, available at: http://www-wds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2008/05/27/000158349_20080527095250/Rendered/PDF/wps4630.pdf

“Microfinance Meets the Market” explores the tensions, opportunities, and overall dynamic of the microfinance industry as it shifts (or does not shift) towards commercialization. It outlines the evolution of microfinance (p3-7) from its beginnings as socially oriented non-profit microfinance institutions (MFIs) existing on subsidies to for-profit MFIs, and it explains the theory behind each model. It then presents a portrait of the current microfinance industry (p7-9), and lists a series of eight pertaining questions (p9), each of which it addresses as summarized below. The answers are used to consider overarching questions of subsidy, profit, and social impact in microfinance.

To answer the questions, the authors use data from the Microfinance Information Exchange (MIX Market), a not-for-profit online clearinghouse for information on the microfinance industry. The data set is large, covering 346 institutions that have a combined 18 million active borrowers and gross assets of USD 25.3 billion (all figures provided in the paper are in purchasing power parity-adjusted dollars) (p7).

Question1 : Who are the lenders? (p9-11)

The paper distinguishes between three distinct types of MFIs that make up the majority of the sample: nongovernmental organizations (NGOs), non-bank financial institutions (NBFIs), and microfinance banks. NGOs, all of which have non-profit status, make up 45 percent of the sample group. NBFIs, which make up 30 percent, include both for-profit and non-profit MFIs that have special concession from their respective governments to assume additional roles beyond credit, such as taking deposits. Microfinance banks make up just 10 percent (p9), and are for-profit. The fundamental difference between for-profit and non-profit MFIs is the ability of the former to distribute profits to shareholders. If non-profits do generate revenues greater than their costs, they reinvest them into their mission.

The data suggests that other differences exist between the groups in outreach and scale. Microfinance banks make up only 10 percent of the sample group, but account over half of the gross assets. NGOs account for 45 percent of the organizations, but have 21 percent (p10) of the assets. The loan portfolio for each group is the most important asset, implying that banks lend in much higher volume. Of the USD 2.6 billion (p11) in subsidized funds, NGOs take a disproportionate share. Banks also take subsidies, but in much smaller quantities. NGOs as a group reach a higher number of borrowers, claiming about 50 percent of data set. They also serve three-quarters of the female borrowers. Banks claim 25 percent of the total borrowers, but only six percent (p10) of the women borrowers.

The section concludes that although there has been a push towards commercialization, NGOs still maintain a niche, although it predicts that this trend in outreach will likely shift, as private sector banks increase in size.

Question 2: How widespread is profitability? (p11-13)

Earning profit is not restricted to for-profit organizations. Most organizations in the sample with revenues exceeding cost have non-profit status. However, they do not distribute them to investors. The paper stresses (p11) that this distinction is important: “It means that the microfinance industry’s drive towards profitability does not necessarily imply a drive toward ‘commercialization’, where the latter status reflects institutions that operate as legal for-profit entities with the possibility of profit-sharing by investors.”

Fifty-seven percent (p12) of the MFIs in the data set with relevant data are profitable. Profitable MFIs tend to be larger, serving 87 percent (p12) of the total customers. Seventy-three percent of banks are profitable, compared with 54 percent (p13) of NGOs. NGOs often prefer to keep non-profit status in order to reduce the burden of regulations and taxes. Profit-making NGOs look more like subsidy-dependent NGOs than they look like commercial banks in that they serve more borrowers overall, poorer households, and more women.

Non-profits have succeeded in becoming profitable largely from the support of social investors, which in 2007, invested USD 4 billion (p12) into microfinance (a number which is expanding). Social investors include international financial institutions and major mutual funds. Social investors do expect their money back, usually with a minimal return, but effectively provide a subsidy to the MFI equal to the difference in the cost of capital from that otherwise obtained from profit-maximizing sources. The MIX Market has adjusted its data to account for this implicit subsidy. For the industry to continue expanding on these terms, MFIs will need to maintain access to such subsidized funds, which is partly dependent on their ability to prove their social worth.

Question 3: Are loans in fact repaid at the high rates advertized? (p13-15)

The paper distinguishes between different MFI lending methods. Two-thirds of microfinance banks lend in the traditional manner to individual customers, whereas three-quarters (p13) of NGOs lend through group-based methods (solidarity groups and “village banking”) in which the group is responsible for loan payments. Group-based lending is generally used for the most costly-to-reach customers, and individual lending is more commonly used for more high-end microfinance customers seeking larger loans. The MFIs who use group based lending methods are on average less profitable.

However, the quality of loan portfolio does not seem to be affected by lending type. The portfolio at risk over 30 days remains strong at between two and four percent for each of the methods. The paper stresses (p14) that this information does not necessarily imply that the portfolios of MFIs employing group based lending methods would remain strong if they would switch to individual lending methods.

Question 4: Who are the customers? (p15-16)

As stated, banks lend in greater volume than NGOs. If loan size is taken as a proxy for poverty level of customers, microfinance banks serve customers who are better off than the customers of NGOs. Banks will thus have an easier time making profit assuming that the costs to extend loans (screening, monitoring, and processing) are fixed. According to the authors (p16), “Debate persists on the extent to which trade-off exist between pursuing profit and reaching the poorest customers. The data here suggests that this trade-off is very real.”

Question 5: Why are interest rates so high? (p16-18)

NGOs facing high costs often respond by raising interest rates. At the median, NGOs charge borrowers 25 percent interest per year, with the top quartile charging 37 percent (p16) or more. Microfinance banks, on the other hand, charge just over 13 percent interest at the median, and 19 percent (p17) or more for the top quartile. While scale does appear to be a route to cost reduction, it has been found that scale economies disappear after about 2000 customers (p17). Afterwards, cost reductions must be made by serving customers with larger loans and more services. The larger the loans, the less money spent by the institution per dollar. Whereas the median microfinance bank spends 12 cents on operating costs per dollar loaned, the median NGO spends 26 cents (p17). The diseconomies of transacting small loans cause MFIs in general to charge high interest rates, and NGOs to charge higher interest rates than microfinance banks.

Question 6: Are profits high enough to attract profit-maximizing investors? (p18-19)

The average return on equity for NGOs is 3 percent, and for microfinance banks is 10 percent (p19). The data at the top end show promise for microfinance to attract microfinance investors, however evidence suggests that investors seeking to maximize-profits would have little interest in most of the MFIs serving the poorer customers. As stated (p18), “It is one thing to earn profits, and quite another to earn profits that are high enough to attract investors who have no concern with social missions.” The hope for the majority of the microfinance sector is that returns remain large enough to continue to attract social investors.

Question 7: How important are subsidies? (p19-20)

Subsidy per borrower is USD 233 for the median NGO in the sample group, and reaches USD 659 (p19) for those at the seventy-fifth percentile (costs are in purchasing power parity dollars, and do not reflect the cost to the foreign donors). The median microfinance bank, on the other hand, receives no subsidy (p19). Whereas the median microfinance bank relies mainly on commercial funding and deposits to fund its activities, the median NGO relies on subsidies in the form of non-commercial borrowing and donations. At the bottom quartile, the financial self-sufficiency ratio for NGOs is 0.78 (p20).

Question 8: How robust are the financial data? (p20-21)

The MIX market data, as described earlier, has been adjusted to account for hidden subsidies, including those involved in socially motivated investments. This, of course, is a difficult adjustment to make, and the authors concede (p20) that it is open to error. They also stress (p21) that there is no way of adjusting for the fact that institutions would likely shift strategies to become more efficient if their access to subsidies were to dry up.

Conclusion

“Microfinance Meets the Market” (p23) shows that the profile of microfinance banks looks different from that of non-profit MFIs. It points out that NGOs tend to have higher operating costs than banks, and poses the question (p23) of whether this is due to smaller average loan sizes driving up costs, to working with particularly hard-to-reach households, or to subsidies breeding inefficiency. The paper does not address the question of how subsidies skew the market.

The authors state (p22) that without data on social and economic benefits, the paper cannot add to the debate on whether subsidies to microfinance enhance social impact. As social investors and donors begin to ask this question more seriously, non-profits seeking subsidized funds will need to start taking more rigorous evaluations.

The authors argue (p3), “Commercial investment is necessary to fund the continued expansion of microfinance, but institutions with strong social missions, many taking advantage of subsidies, remain best placed to reach and serve the poorest customers and some are doing so on a massive scale. The market is a powerful force, but it cannot fill all gaps.”

By Ryan Hogarth, Research Assistant

Additional Resources:

“Microfinance Meets the Market”, by Robert Cull, Asli Demirgüç-Kunt, and Jonathan Morduch, World Bank Development Research Group: May 2008

Microfinance Information Exchange (MIX Market): Home