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Gravatar: Niels Hermes, Professor, University of Groningen, the Netherlands

Microfinance and the Incompatibility of Outreach and Cost Efficiency

07.09.2015Niels Hermes, Professor, University of Groningen, the Netherlands

Since the late 1970s, the poor in emerging economies have increasingly gained access to financial services offered by so-called microfinance institutions (MFIs). These MFIs have shown significant growth rates in terms of providing financial services to poor households, especially during the early 2000s until the breakout of the financial crisis. Next to the growing numbers of clients, the number of MFIs went up as well. Microfinance was perceived as a successful model, both from a developmental as well as from a business perspective. Thus, not only new NGO-type of institutions, also commercially oriented MFIs, entered the market. The strong growth of the number of MFIs led to increased competition for clients and markets. In addition, over time also the orientation of many MFIs changed. Whereas in the beginning of the microfinance movement, the focus was mainly on social objectives, this changed towards focusing more on financial performance, i.e. an orientation on profits and efficiency of operations.

These changes in the microfinance landscape do raise a number of questions. How did MFIs cope with the rapid increase of clients? What has been the impact of the change to being more profit-oriented for the social performance of MFIs? Is there a trade-off between these two orientations or can they be complementary? These are all important questions the microfinance sector, as well academics, have been struggling with during recent years.

In particular, there has been a lot of discussion on the existence of a trade-off between financial and social performance. On the one hand, improved financial performance may help MFIs in obtaining more funds, e.g. by making profits and/or by attracting the attention of external investors. This allows them to provide more services to the poor, thereby raising their social performance. At the same time, however, the focus on financial performance may go at the cost of servicing the poor as this is generally more costly, both in terms of delivering and monitoring services, i.e. financial and social performance could also be substitutes.

One could investigate the existence of a trade-off by looking at the association between measures of the financial and social performance of MFI operations. If this association is negative, this may indicate there indeed is a trade-off, i.e. financial performance goes at the cost of social performance. In contrast, a positive association would support the idea that both objectives are complementary. We studied this issue by measuring the cost efficiency, which is a proxy for financial performance, of 435 MFIs during the period 1997-2007. In particular, we compared cost levels of MFIs relative to the cost levels of the most efficient MFIs in our sample. The distance between the cost levels of these most efficient MFIs and the cost levels of an individual MFI is a proxy of the (in)efficiency of its operations: the smaller the distance the more cost efficient the organization.

We measured social performance (or outreach to the poor) of an MFI by taking the average loan size per borrower (in US dollars) and the percentage of female clients of its total loan portfolio. A higher average loan size may indicate that the MFI focuses on the less poor; a higher share of female borrowers suggests a stronger focus on the poor.

Next, we looked at the association between these measures of financial and social performance. In particular, we investigated whether the cost efficiency of an MFI is related to the extent to which the MFI focuses on reaching out to the poor, controlling for a number of MFI-specific variables, which may also influence its level of financial performance. We found strong evidence supporting the idea that financial and social performance are substitutes. On average, MFIs scoring high in terms of cost efficiency provided larger loans and had fewer female clients, i.e. they scored low on reaching out to the poor. These outcomes strongly suggest that a trade-off between financial and social performance exists. In other words, on average it will be difficult for MFIs to achieve both goals. We therefore conclude that the claim made by microfinance practitioners and researchers regarding the compatibility of efficiency and outreach, allowing MFIs to achieve a double bottom line, is a myth.

 

This blogpost is based on the study "Outreach and Efficiency of Microfinance Institutions", World Development, 39, 6, 2011, pp. 938-948, by Niels Hermes, Robert Lensink and Aljar Meesters. Corresponding author: Niels Hermes, Faculty of Economics and Business, University of Groningen, PO BOX 800 9700 AV Groningen, The Netherlands, telephone: +31-50-363 4863; email: c.l.m.hermes[at]rug.nl.

About the authors

Niels Hermes is professor of International Finance at the University of Groningen, the Netherlands, and visiting professor at Université Libre de Bruxelles, Belgium

Robert Lensink is professor of Finance and Financial Markets at the University of Groningen, the Netherlands, and professor of Finance and Developemntat Wageningen University, the Netherlands

Aljar Meesters is post-doc researcher at the University of Groningen, the Netherlands

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