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Microfinance and Financial Sector Development

This paper analyzes the relationship between performance of microfinance institutions (MFIs) and the development of the formal financial sector of the country in which the MFI is active. We find that MFIs reach more clients and are more profitable where access to the formal financial system is low. This finding is in line with the market-failure hypothesis: MFIs respond to a need that banks do not fulfill and flourish where the formal banking sector fails. However, we also find indications of interdependencies between MFI-performance and formal financial sector development. First, MFIs are less profitable where interest rates are higher reflecting the fact that MFIs depend upon the domestic banking system for additional funding. Secondly, MFIs are less profitable where inflation is high, suggesting that MFIs benefit from stability of the formal financial system. Overall, the results show that the macro-economic environment is crucial to fully understand MFI-performance and that outreach and accordingly impact of MFIs are contingent on financial sector development.

Development policy is increasingly concerned with expanding financial services to the poorer sections of the population. In a recent World Bank book, Demirgüç-Kunt et al. (2008) investigate what hinders and stimulates financial access and development. A policy for increasing access to financial services for the poor that receives a lot of attention is microfinance. Microfinance is the provision of small financial services to the poorer sections of the population. It is thought of as having a positive impact on the life of the poor by providing them access to something they previously did not have, namely access to financial services (Morduch, 1999). Consequently, through serving more people, the providers of microfinance services increase their societal impact.

The microfinance movement has known an important growth during the last couple of decades. However, growth seems unequally dispersed among countries and institutions. Microfinance institutions (MFIs) have known different levels of success: some have become very significant in size and serve a lot of clients, like the Grameen Bank in Bangladesh, or BRI in Indonesia, while other MFIs remain small or even cease to exist (Ahlin et al., 2008). The literature has mainly focused on MFI-specific characteristics such as governance and management-related issues in explaining these differences in success. For instance, Hartarska (2005) explores the relation between managers’ experience and compensation schemes on MFI-performance. Along the same lines, Mersland and Strøm (2009) analyze the relation between board-structures and MFI-performance. Recently, a number of studies have explicitly investigated the relationship between microfinance institutions’ performance and changes in the macro-environment of the country in which the institution operates. These studies recognize that the macro-economic environment in which the MFI is active is an important determinant for MFI-performance in addition to institution-specific characteristics. Or as However, the link between the performance of MFIs and the development of the formal financial sector remains unexplored. The market-failure solution theory of microfinance, which suggests that MFIs serve a different purpose than commercial banks, is commonly accepted, but has not yet been confirmed by empirical proof. Is microfinance indeed developing faster in countries where commercial banks fail to serve an important number of people? Or do MFIs rather benefit from existing banking facilities to develop faster? Are they that way having a bigger impact in countries that have less or more developed banking sectors? Similarly, are MFIs performing better in countries with well-developed banking sectors, or do banks hinder MFIs’ growth by means of increased competition?

Our paper sheds light on these issues by including the development of the formal banking sector as an explicit determinant for MFI performance, here measured in terms of outreach and profitability. In times where microfinance is increasingly commercializing, it is interesting to see how the two sectors interact. More specifically, we want to test whether the microfinance sector is in competition with the formal banking sector, whether they complement each other or whether they rather develop independently. In order to investigate these issues empirically we relate MFI performance measures to a number of variables that capture the development of the banking sector using a large unique panel dataset of 1,073 institutions over 10 years.

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Microfinance and Financial Sector Development