MICROCAPITAL PAPER WRAP-UP: Microfinance Institutions: Does Capital Structure Matter? by Vicki Bogan

Written by Vicki Bogan of the Department of Applied Economics and Management, Cornell University, published in May 2008, 42 pages, available for viewing here.

This paper examines existing sources of funding for microfinance institutions (MFIs) by geographic region, and explores how changes in capital structure could facilitate future growth and improve the efficiency and financial sustainability of MFIs. Ms. Bogan is Assistant Professor at the Dept. of Applied Economics and Management at Cornell University and holds a B.S, M.A and Ph.D. in Economics from Brown University and an M.B.A. from the Wharton Business School, University of Pennsylvania. The report establishes a relation between capital structure and key performance indicators of microfinance institutions (MFIs) by analyzing the performance of select MFIs over a period of three years between 2003 and 2006. What follows below is a summary of the report:

In recent years, there has been increased internal and external pressure for MFIs to decrease dependence on subsidized or grant funding. Reliance on donor funding limits the ability of MFIs to expand and meet the rising demand for services whereas commercially-funded MFIs tend to respond to profit incentives, working to increase revenues and decrease expenses so that they can have revenues sufficient to cover their overall operating expenses. A growing number of MFIs have formalized and sought to fund growth through public deposits accepting banking regulation and the set standards of transparency and management while others have transitioned to include commercial funding. Such changes are viewed as a general shift toward capital structures more typical of commercial financial institutions.

According to existing research on MFI funding, the sources of financing for MFIs is usually linked to the various stages of their development. In their formative stages of growth, MFIs typically rely on donor grants and soft loans (loans with subsidized interest rates) for funding. As MFIs mature, private debt capital becomes available as a source of funding and in their last stages of evolution, traditional equity financing becomes available. This paper, rather than accepting existing research on the link between success of an MFI and the life cycle pattern of funding, explores the role that different sources play in determining the success of MFIs.

To explore the role of capital structure for MFIs, key performance indicators of MFIs in Africa, East Asia, Eastern Europe, Latin America, the Middle East and South Asia were analyzed for the years 2003 to 2006. The MFI data was collected from individual institutions as reported to the MIX market, the microfinance information clearing house. All MFIs which satisfied the following criteria were selected for the study:

Total assets greater than USD 1.3 million

A minimum of level three diamond disclosure rating on the MIX market. (A level three rating by MIX market indicates that the MFI provides information on its outreach, impact and financial performance).

Audited financial statements that are in English, French or Spanish

No information on the total number of MFIs which qualified for the study is provided.

The key performance indicators analyzed for MFIs were outreach, efficiency and financial sustainability. These were compared against data for MFI capital structure variables (i.e. debt relative to assets, grants as a percent of assets and shareholder capital as a percent of assets) and data for MFI characteristic variables (i.e. the MFI age, log of assets, log of number of borrowers, log of number of savers, region, percent of the portfolio at risk and whether or not the MFI accepts deposits). Through a series of regression analysis, the study tries to establish a link between the performance indicators and characteristic/ capital structure variables, identifying the dependencies between them.

The results show that the asset size directly impacts the sustainability and outreach of MFIs. Grants as a percentage of assets and share capital as a percentage of assets were found to be significantly and negatively related to sustainability of MFIs. In this regard, MFIs in the Middle East and African regions which were found to have the largest share of grants as a percentage of assets (p 15) as compared to MFIs in other regions also had the highest percent of unsustainable MFIs (37.7 percent), the highest percent of portfolio at risk (7.02 percent) and the lowest average return on assets (0.43 percent). This indicates that the long term use of grants lead to inefficient operations due to lack of competitive pressures associated with attracting market funding.

The results also show that increase in grants does not necessarily lead to greater or more costly outreach. Thus, as per the results, MFIs in the Middle East and North African region which have the highest grants do not have the highest average cost per borrower. From an operational self-sufficiency perspective, the study indicates that subsidized funding and grants have a negative effect and drove down operational self-sufficiency. Please refer to the graphs on pages 14 and 15 of the document for a more detailed analysis. Thus, the results of the study indicate that grants could hinder the development of MFIs into competitive, efficient, sustainable operations.

The study concludes that only by weaning off donor dependency and adopting a commercial orientation can MFIs truly attract the capital and savings base they need to scale up their microloan portfolios, increase sustainability, lower lending rates, increase outreach and meet the demands. To address the capital constraint issues of most MFIs, the study calls for transparency, innovative instruments and financing as tools to decrease transaction costs and increase liquidity in the MFI funding market.

By Bharathi Ram, Research Assistant

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