Microfinance in Developing Countries

Issues, Policies and Performance Evaluation

J. Gueyie, R. Manos, J. Yaron, J. Gueyie, R. Manos, J. Yaron

• Publisher: Palgrave Macmillan
• Year: 2013
• Print ISBN: 9780230348462
• eBook ISBN: 9781137301925
• Topic: Business
• Subtopic: Accounting
• Index: Business

Microfinance in developing countries is a collection of studies by leading researchers in the field of microfinance. It discusses key issues that the rapidly growing microfinance industry currently faces, and offers interesting views and analysis of topical matters concerning the microfinance realm.

1

Dilemmas and Directions in Microfinance Research

Ronny Manos, Jean-Pierre Gueyie and Jacob Yaron

1. Introduction

Associating microfinance with alleviation of poverty has become a truism. Subsequently, the microcredit movement has enjoyed wide support from governments, international development agencies, wealthy philanthropists, renowned financial institutions and even the Noble Peace Prize Committee. Indeed, in awarding the Nobel Peace Prize to Muhammad Yunus and Grameen Bank in 2006, the committee noted that ‘Yunus has, first and foremost through Grameen Bank, developed micro-credit into an ever more important instrument in the struggle against poverty’. Consistent with this trend, success stories abound on the internet and in countless reports of microentrepreneurs who set up successful businesses, lifting their families and neighbouring poor out of poverty.

Perhaps pouring a bit of cold water over this general optimism, however, criticism of microfinance operations has recently started to surface. This new trend may at least partly explain the fact that in recent years microfinance institutions (MFIs) and microfinance operations are being more intensively scrutinized than in the 1980s, when they were still a new phenomenon. The idea behind the increased scrutiny of MFIs is to expose inherent structural constraints and societal difficulties related to the provision of microfinance. It also involves re-evaluation of key factors associated with the mechanisms, dynamics, performance and impact of microfinance operations. The aim of this book is to add to this timely debate by highlighting and discussing issues, policies and performance-evaluation techniques that are currently on the agenda of microfinance research and practice.

This chapter is structured as follows. In Section 2 we define microfinance, outline its objectives and discuss the background to its development. Section 3 focuses on evaluation frameworks for assessing the social and financial performance of MFIs as well as the impact of microfinance. We highlight the difference between cost-effectiveness analysis, which focuses on MFI performance and cost–benefit analysis, which attempts to measure the impact of microfinance on its target clientele. In Section 4 we introduce key microfinance-related issues that are currently on the agenda of researchers and practitioners. The current microfinance agenda is the topic of this book and the introductory chapter concludes with Section 5, which presents the structure of the book and provides an overview of the rest of the chapters.

2. An overview of the development of the microfinance industry

Microfinance has been developed as a means of alleviating poverty through banking (Morduch, 1999). It first appeared in, and is most commonly associated with, developing countries, although it is also likely to be relevant for poverty pockets in developed countries. With respect to the US, for example, Blanchflower, Levine and Zimmerman (2003) find that access to credit varies across population groups, such that small businesses owned by African-American entrepreneurs are about twice as likely to be denied credit. In a similar vein, Pager and Shepherd (2008) provide an overview of findings from major studies of discrimination in employment, housing and credit while Glenn (2000) discusses insurance denial. Thus, although conceived in developing countries, the microfinance concept – namely to provide financial services to those excluded from mainstream finance as a way of fighting poverty and achieving other social goals – is a general model, widely applicable in both developing and developed countries.

Indeed, worldwide, it is estimated that 2.7 billion adults do not have access to formal financial services such as credit or saving facilities (Consultative Group to Assist the Poor (CGAP), 2011). Providing financial services through microfinance to these individuals, who are often poor, informally employed and dependent on irregular income, is believed to contribute to poverty alleviation for various reasons. For example, Carruthers and Kim (2011) argue that access to credit is critical for the success of a business and allows people to plan for the future and to smooth consumption over time. In addition, access to finance can help the poor to accumulate fixed assets, tools and equipment that can enhance income-generation ability and employability (CGAP, 2004). Access to credit and savings can cushion against external shocks, such as illness or drought, and can lead to better education, improved housing or better health care (Hermes and Lensink, 2011).

These anticipated benefits of microfinance have led to the channelling of funds from governments, development agencies, non-governmental organizations (NGOs) and other key donors to support the microfinance industry. In fact, since the establishment in 1976 of the first MFI, namely Grameen Bank in Bangladesh, huge amounts of funds have been directed towards microfinance.¹ The underlying rationale was that MFIs would be able to overcome obstacles which deterred mainstream financial institutions from providing financial services to some groups within society. For example, relatively high transaction costs per dollar of financial product and lack of effective collateral are serious obstacles for those who wish to provide financial services to low-income individuals or to those who are geographically or otherwise excluded from the mainstream financial system.

The high expectations from microfinance, and the accompanying funds that were channelled into the industry, coincided with widespread disappointment with state-owned development banks (SODBs) and their poor performance (Townsend, 2011).² The banks were established after the Second World War in almost all developing countries, and they were supported financially and otherwise for several decades by salient international development agencies and states. However, by the end of the 1980s it was generally accepted that most SODBs had failed to meet the objective for which they had been established – namely acceleration of economic growth and poverty alleviation (Yaron, 2006; Manos and Yaron, 2008).

The main reasons for the failure of most SODBs were lack of financial discipline and problematic quality of loan portfolios. In addition, SODBs were frequently saved by state bailouts, leading to sizable deficits in national budgets, which, in turn, accelerated the rate of inflation. In general, SODBs were established to implement a policy of directed credit whereby concessionary credit is channelled into predetermined sectors. In practice, however, concessionary credit was often obtained by those with political connections rather than by those for whom the credit was intended (Adams, Graham and von Pischke, 1984; Morduch, 1999). It was against this backdrop that the microfinance industry developed.

3. The development of frameworks to assess the performance and impact of microfinance operations

The motivation driving the enormous support and resources channelled towards microfinance, and in particular microcredit, is the ‘microfinance promise’ of alleviating poverty through banking (Morduch, 1999). The idea is that providing finance to microentrepreneurs and credit-constrained households should allow them to seize investment opportunities which would otherwise be foregone. Low-income entrepreneurs could benefit from the spread between the high returns obtained on their capital investments and the interest rates charged by the MFI. The crucial point is that this was expected to be the case even if interest rates charged on microloans were set sufficiently high to ensure the long-term sustainability of the MFI involved.³ It was further believed that relatively modest subsidies to MFIs may be required to initiate the microcredit operation, but that this would facilitate investment by microentrepreneurs, allowing them to grow their businesses and thus justifying the outlay of public funds. Hence, by relaxing credit constraints and allowing microentrepreneurs to borrow and invest small amounts of funds in good investment opportunities, millions of poor people could be pulled out of the poverty trap.

In line with this conceptual framework, microfinance has enjoyed tremendous growth since its inception in the late 1970s. Indeed, according to the State of the Microcredit Summit Campaign Report, by the end of 2009, more than 3500 MFIs reached about 190 million households and about 640 million poor individuals (Reed, 2011). These numbers point to a remarkable rate of growth, given the recent history of the industry. The tremendous growth of the relatively young microfinance industry was, no doubt, driven by donor agencies to whom microfinance became a top priority as more and more of them adopted the idea of financial inclusion. Supporting MFIs financially and otherwise became the tool by which donor agencies sought to increase financial inclusion and improve outreach to target clienteles of poor households and microentrepreneurs with financial services. In addition, SODBs were encouraged to enhance their microfinance operations while aspiring to pursue financial sustainability. Raising lending interest rates and pursuing efficiency were considered necessary to achieve these objectives.

The growing attention drawn to the microfinance sector has led to the development of standard modes of reporting on the performance of MFIs. Initially, two primary performance indicators were developed, namely the Outreach Index (OI) and the Subsidy Dependence Index (SDI). This two-prong performance framework was introduced by Yaron (1992) and used by the World Bank to evaluate the outreach and sustainability of publicly supported lending institutions. The first criterion, the OI, is a hybrid index that measures the degree to which an MFI had reached its target clientele. It involves defining the target clientele given the objectives of the MFI, and then assembling a weighted indicator that factors in outreach measures to reflect these objectives.

Common outreach measures include, among others, the number of borrowers; the number of depositors; the ratio of village posts to town units; and the quality and variety of products and services on offer.⁴ By assessing the degree to which the MFI has reached its target clientele, the OI provides an indication of the social performance of the MFI relative to its objectives. This social performance indicator is complemented by the second criterion, the SDI, a composite index which measures the financial performance of the MFI. In particular, the SDI reflects the financial sustainability of the MFI. It is computed as the annual public cost of allocating scarce resources to the MFI, measured against the annual income generated from interest and fees paid by microborrowers. The principle is that these public resources could have alternatively been used to improve the welfare of the target clientele by other means.

More generally, the outreach or sustainability criteria can be classed as a cost-effectiveness analysis to be distinguished from a cost–benefit analysis. The cost-effectiveness analysis facilitates evaluation of social and financial performance of an MFI or a group of MFIs vis-à-vis MFIs that are comparable in terms of products and target clientele. The evaluation is conducted with respect to the performance and outreach of the MFI, and does not attempt to measure the impact of microfinance activities on clients’ welfare. In contrast, cost–benefit analysis aims at evaluating the social desirability of the intervention in the financial market by measuring the cost to society against the impact of the intervention at the level of the ultimate client.

Indeed, significant progress has been made in recent years in evaluating and measuring MFI performance and microfinance impact. In particular, specialized agencies, such as the Consultative Group to Assist the Poor (CGAP) or the Microcredit Summit Campaign, as well as MFI rating agencies, including MicroRate and Planet Rating, have developed and promoted standardized reporting conventions. Moreover, microfinance information centres, such as MixMarket, gather a tremendous amount of data and information on the performance, activities and characteristics of MFIs, which are useful for both cost-effectiveness and cost–benefit analyses.

However, in spite of the progress that has been made in developing performance and impact indicators, a number of authors point to major problems with some of these practices. Yaron and Manos (2010), for example, consider one common indicator of performance – the Operational Self Sufficiency Index (OSS) – and highlight some of its embedded deficiencies. Inconsistency among various performance indicators is also a problem, and an eye-opening illustration of this point may be gleaned by comparing the results reported in two studies. In the first, Nawaz (2010) uses the SDI to assess the financial sustainability of 204 MFIs in 2005 and concludes that only 25 per cent were subsidy-independent. In contrast, the MicroBanking Bulletin⁵ uses an alternative and currently more popular measure of financial sustainability, the Financial Self Sufficiency Index (FSS). Using the FSS, it reports that in 2005, out of a total of 200 MFIs, as many as 71 per cent were self-sufficient. The indicator that best measures the sustainability and financial performance of MFIs is a topic currently being debated among microfinance practitioners and theorists, and it is also the subject of Beisland and Mersland in Chapter 5. Other questions relating to the balance between financial and social performance, the impact of microfinance or the phenomenon of over-indebtedness are also very much on the microfinance research agenda, which is discussed in the next section.

4. Current agenda

Microfinance research has gained momentum in recent years.⁶ It spans many sub-topics, which we have split into two topic areas in the discussion here. The first deals with performance and impact, including research related to measurement issues, objectives and evaluation. The second encompasses research related to internal structures, including strategy, governance, products and methods.

4.1. Performance and impact

A large fraction of microfinance research deals with questions of performance and impact. The focus on performance may be due to the fact that a large number of MFIs and microfinance programmes are still not financially sustainable (Hermes and Lensink, 2011). The focus on impact may be due to the fact that many MFIs are supported, at least in the beginning, by public funds which have opportunity costs in terms of how the funds could have been used alternatively to achieve the same goal of poverty alleviation. Indeed, The Economist reports that more than 50 per cent of the $11.7 billion invested in the microfinance industry in 2008 came in the form of subsidized funds from aid agencies, multilateral banks and other donors, and was priced at below-market rates.⁷ Performance-related research addresses issues including the technical question of what performance indicators should be used; the trade-off between multiple and single indicators of performance; the balance between social and financial performance; and the search for key determinants of MFI performance. Rosenberg (1...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Tables
• List of Figures
• Notes on Contributors
• 1. Dilemmas and Directions in Microfinance Research
• 2. Microfinance and Microenterprises’ Financing Constraints in Eastern Europe and Central Asia
• 3. Through the Thicket of Credit Impact Assessments
• 4. Assessing Microfinance: Striking the Balance Between Social Utility and Financial Performance
• 5. Earnings Quality in the Microfinance Industry
• 6. Culture and Governance in Microfinance: Desa Pakraman and Lembaga Perkreditan Desa in Bali
• 7. Crowd-Empowered Microfinance
• 8. From a Supply Gap to a Demand Gap? The Risk and Consequences of Over-indebting the Underbanked
• 9. Financing Businesses in Africa: The Role of Microfinance
• 10. Microcredit and Agriculture: Challenges, Successes and Prospects
• Author Index
• Subject Index