An estimated US$4 billion is invested annually in microfinance around the world. But while microfinance institutions must have strong business models in order to survive, they face the challenge of making profits while creating lasting social change. A new study (Note 1) co-published by the ILO provides practitioners and policy makers with guidance on how to deal with the issue of balancing business and poverty reduction by defining criteria for supporting microfinance institutions. ILO Online spoke with Bernd Balkenhol, the editor of “Microfinance and Public Policy”.
ILO Online: Public institutions, commercial banks, NGOs…microfinance institutions are quite diverse and difficult to compare – what do they have in common?
Bernd Balkenhol: The first challenge was to make sense of the diversity of institutions with different kinds of customers, processes, and organizational cultures. But one strand cuts through all organizations: the importance of efficiency – the ability to use scarce resources to most effectively 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.
Our study found four different patterns of financial and social performance: the first group of MFIs is markedly inefficient – both in terms of social and financial performance – compared to what is being achieved by other institutions similar in location, legal form, delivery techniques, subsidies received and staff structure. The second category serves many poor households, but is weak on financial measures. The third category does well on profitability, but less well in terms of social impact. And the fourth category performs well in both respects. In the extremes, there are institutions that manage to reach very poor and remote households and still break even, while others cater to a better-off clientele, enjoy a relative monopoly and fail to do well financially.
ILO Online: How can the efficiency of microfinance institutions be measured?
Bernd Balkenhol: Efficiency in microfinance can be measured by different ratios: the most commonly used measure relates the operating expenses to the outstanding loan portfolio; others relate total operating cost to the number of borrowers, or the number of clients to the number of loan officers; less frequently used measures of efficiency are the share of loan officers to total staff, loan officer salaries compared to the minimum wage or the average processing time per loan.
In fact, institutions can operate with greatly varying degrees of efficiency. A 2005 survey of 365 leading institutions, for example, shows that on average lenders spent roughly 25 cents in operating expenses for every dollar of outstanding loans, but the measure ranged from under five cents for the most to over 40 cents for the less “efficient” lenders. Similarly, the average number of borrowers per staff member of the microfinance institution (another productivity measure) ranged from less than a hundred to more than 500 borrowers.
ILO Online: Is there a recipe for efficiency?
Bernd Balkenhol: There’s no magic recipe, one needs to bear in mind that 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 drivers of efficiency: average loan balances, salary costs and staff productivity. 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. The second driver of operating expenses is staff costs. These vary enormously between countries as a result of the scarcity of qualified loan officers. 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.
In part, managers of microfinance institutions must deal with the markets they are in, and have to take the nature of regulation and the structure of costs and wages as given constraints. Managers also have discretion; they can improve incentive contracts for loan officers, modify loan delivery techniques (e.g. choose between individual versus group transactions), adjust collateral requirements, choose combinations with non-financial services, and develop strategic partnerships with local groups and associations.
ILO Online: Is efficiency a guarantee for self-sustainability?
Bernd Balkenhol: What we learnt in analyzing the data was that efficiency does not necessarily translate into profitability, but moreover, that the successful outreach to the poor should not be used as an excuse for inefficiency. Inefficiency limits the scale of outreach and the quality of services, again leading to lost possibilities. Efficiency is a necessary but insufficient condition for full financial sustainability, there is space for public policy. Focusing on efficiency helps donors see that some institutions operate efficiently but fail to break even due to local market conditions (particularly high wage costs and low population density) or due to a strategic decision not to raise interest rates and other fees.
Patient public policy support can be justified, as long as institutions can demonstrate their cost-effective contributions to poverty reduction. Donors, though, still need to make sure that their support does not displace other service suppliers, private or public, or inhibit the microfinance institution from further innovation. We argue 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.
Note 1 - Microfinance and Public Policy - Outreach, performance and efficiency, edited by Bernd Bakenhol, International Labour Office, Geneva, 2007, ISBN 978-92-2-119347-0.
The study has been carried out by the ILO in partnership with the University of Geneva, Cambridge University and the Geneva Institute of Development Studies. It was funded by the EU, the Ford Foundation and the GIAN/RUIG (the Geneva International Academic Network).
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