Microfinance and Public Policy

An estimated US$4 billion is invested annually in microfinance around the world. But while microfinance institutions (MFIs) must have strong business models in order to survive, they face the challenge of making profits and at the same time creating lasting social change. The continued commitment to their original mission is not always easy for MFIs. It is particularly tricky in an increasingly competitive environment where competing MFIs set their priorities between financial performance and social impact differently.

For donors this raises the question of which criterion to use to judge “good” overall performance when some MFIs have an increasingly commercial and others a more social orientation. This opens a few fundamental issues:

• Why is it that some MFIs are profitable, but on closer scrutiny not very efficient?
• Of the various drivers of efficiency in microfinance, which can be acted on by MFI managers, and which are contextual? 
• What does it all mean for donor support, government interventions and public policy?
• Can subsidies in microfinance be justified for MFIs that fail to be financially self sufficient, as long as they are efficient? 

These and other questions are examined in Microfinance and Public Policy, a new book published by Palgrave McMillan and the International Labour Organization (ILO) and edited by Bernd Balkenhol. The publication is based on a survey of 45 well-established microfinance institutions in 24 countries, carried out by the ILO, the Universities of Geneva and Cambridge and the Institute of Development Studies in Geneva, with funding from the European Union and the Ford and GIAN Foundations.

The book explores the conditions that allow microfinance institutions to grow while remaining committed to their missions. It looks at mission drifts due to donor prodding, and presents evidence on the factors influencing the trade-off between profitability and poverty impact. The one criterion that gives an insight into MFI performance, regardless of mission, is efficiency. Efficiency is measured by the ratio of operating expenses to the loan portfolio. Operating expenses are in turn determined by three main drivers: average loan balances, salary costs and staff productivity.

Understanding the drivers of efficiency

Efficiency refers to the ability to use scarce resources most effectively to reach thousands of customers, deliver quality services, and close the biggest gaps between the supply and demand of basic financial products for the poor. In microfinance, efficiency means using the least amount of inputs - particularly staff time and capital - to produce the greatest number of loans, reach under-banked clients, and deliver a range of valued services.

Unfortunately, there’s no magic recipe for efficiency. Context matters critically for performance; it’s not just a question of good or bad management. However, a starting point is to better understand the three main drivers of efficiency:

1. Average loan balances: Given the cost functions in finance it always pays to go for larger loans; the downside is that one may lose the original clientele and move up-market into a less poor segment of the market.
   
   
2. Salary costs: The second driver of operating expenses is staff costs. These vary enormously between countries as a result of the scarcity of qualified loan officers.
   
   
3. Staff productivity: Even the third determinant of operating expenses is sometimes difficult to manage: in rural and peri-urban areas it is a challenge for a loan officer to cater to 250-400 clients.

MFIs operate with greatly varying degrees of efficiency, and four configurations emerge taking into account location, legal form, delivery techniques, subsidies received and staff structure. The first group of MFIs is markedly inefficient - both in terms of social and financial performance - relative to peer group institutions.  The second group serves many poor households but is weak on financial measures.  The third group does well on profitability, but less well in terms of social impact. And the fourth group performs well in both respects.

In order to improve efficiency, management must work on all three drivers. However, these drivers are themselves also subject to contextual constraints; a manager cannot change pay rates at will or hike up average loan balances. For donors this means that in order to be fair when rewarding progress towards greater efficiency, they should also differentiate between endogenous and exogenous factors.

Lessons for public policy: smart subsidies

All 45 MFIs reviewed in the research for Microfinance and Public Policy were being subsidized in one way or another. 34 were convinced that without subsidies, they would not be able to scale up by improving their use of human and financial resources. These results have implications for public policy, and especially subsidies:

1. Profitability does not necessarily mean efficiency. Several institutions operate as monopolists which allows them – for the time being – to charge high interest rates and earn tidy profits, but pass on the costs of their inefficiencies to their poor customers. Inversely, some MFIs operate efficiently but fail to break even due to local market conditions (particularly high labor costs and low population density) or because of a strategic decision not to raise interest rates and other fees.
   
   
2. Outreach to the poor can be used as an excuse for inefficiency which limits the scale of outreach and the quality of services. Both monopolies and strategic decisions can mask inefficiencies. Every single one of the 45 institutions received some form of subsidy, and current practices of subsidization continue to distort the market and undermine accountability: fifteen institutions even had two or three donors, and twenty had more than three sources of grant support. From 1999 to 2003 the use of subsidies decreased in 12 institutions, but in 14 MFIs the share of subsidies on total liabilities increased.
   
   
3. Subsidies can and should be tied to progress towards efficiency. Market distortions can be contained or avoided if subsidies are tied to progress towards efficiency. A better understanding of the drivers of efficiency will make donor support more stable, transparent, performance-based and - above all - “mission-neutral.” Instead of favoring one type of MFI over others, efficiency-based donor support accommodates different combinations of social and financial objectives. Subsidies should enhance and stimulate efficiency, rather than force an MFI to choose between its social objectives and financial performance.

The book argues for a fundamental reform of subsidies in microfinance, built on longer-term, stable “performance-based contracts” between governments/donors and microfinance institutions that are geared towards efficiency targets for which managers can be held accountable. Whether this will work or not hinges largely on efforts by donors and governments not to undermine each other: success depends on working together to promote principles of transparency and incentive-based support.