The Commercialization of Microfinance in Latin America

Katherine Chasmar Queen’s University Economics Department Undergraduate Honors Thesis

April 1, 2009

Acknowledgments

First and foremost, I would like to thank my advisor, Sumon Majumdar, for his insightful comments and active encouragement. I am also grateful to Mike Abbott for generously giving his time to discuss my empirical work. Finally, I would like to recognize David Byrne, a current PhD student at Queen’s University, for his invaluable assistance with statistical programming.

Table of Contents

Section Page Reference

I. Introduction 3-6

II. Historical Overview of Microfinance 7-22

III. Microfinance in Latin America 23-37

IV. The Commercialization Debate 38-44

V. Empirical Analysis 45-91

VI. Looking Ahead 92-105

VII. Appendices 106-110

VIII. References 111-128

"A new mindset is taking hold. Where once the poor were commonly seen as passive victims, microfinance recognizes that poor people are remarkable reservoirs of energy and knowledge. And while the lack of financial services is a sign of poverty, today it is also understood as an untapped opportunity to create markets, bring people in from the margins and give them the tools with which to help themselves." – Kofi Annan, Former United Nations Secretary-General, 2005.

I. Introduction

In 2006, Muhammad Yunus was awarded the Nobel Peace Prize for a simple but revolutionary idea: tiny loans can transform destitute people into entrepreneurs. This concept has become the cornerstone of a powerful microfinance movement across the developing world. As of December 31, 2006, the 3,316 microcredit institutions reporting to the Microcredit Summit Campaign reached over 133 million clients (Daley-Harris, 2007). Microfinance refers to the provision of non-exploitative, small-scale financial services to low-income clients (Ledgerwood, 1999). According to the World Bank, approximately 80 percent of the world’s 4.5 billion people living in low- and middle-income economies lack access to formal sector financial services. Microfinance can thus be viewed as an attempt to overcome market failure in the mainstream economy by bridging the “absurd gap” between demand and institutional supply (Robinson, 2001). Although access to financial services does not, in itself, accelerate economic growth or eliminate poverty, such access can improve households’ ability to cope with emergencies, to manage cash flows and to make investments. Microfinance also has the potential to empower disadvantaged segments of the population; for example, even in countries where gender equality remains a distant goal, women represent the majority of microfinance clients (Cheston and Kuhn, 2002). Over the past several decades, the nature of microfinance has changed dramatically. Initially dominated by altruistic nonprofit and social service organizations, the microfinance landscape now includes an increasing number of sustainable microfinance institutions (MFIs) 1 and commercial banks. This trend toward commercialization – or, more specifically,

1 A microfinance institution (MFI) is any institution that provides microfinance services. The term encompasses both nonprofit organizations and for-profit entities, including commercial banks, state-run development banks, non-bank financial intermediaries, finance companies and credit unions. It is important to distinguish between sustainable (or commercial) MFIs, on the one hand, and informal commercial lenders, subsidized formal microcredit and unregulated institutions (namely NGOs), on the other. The former deliver

3 “the movement of microfinance out of the heavily donor-dependent arena of subsidized operations into one in which microfinance institutions ‘manage on a business basis’ as part of the regulated financial system” – has sparked a debate within the microfinance industry (Drake and Rhyne, 2002 (4)). In some regions, notably Latin America, industry pioneers have embraced the commercialization of microfinance as the only viable way to provide high-quality financial services to low-income populations. From this perspective, the vast amounts of funding required to reach the poor can only come from the banking sector itself. In other areas, such as Bangladesh, commercialization is viewed with skepticism, even hostility. According to Muhammad Yunus, for example, introducing the profit motive into microfinance undermines its fundamental objective. 2 The focus of this paper is the commercialization of microfinance in Latin America. For nearly two decades, Latin America has lead both the transformation of nonprofit organizations and foundations into regulated financial institutions and the penetration of commercial banks and finance companies into the microenterprise market niche (Poyo and Young, 1999). Today, microfinance represents an integral component of Latin American and Caribbean financial markets: in 2007, 193 institutions in 15 countries were managing US$12.8 billion in over 11.7 million loans to low-income clients (Gehrke, Martínez and Rondón, 2008). 3 An increasing number of unregulated microfinance NGOs in Latin America are considering transforming themselves into regulated financial institutions. Regulation enables MFIs to mobilize public deposits, access private capital sources, improve governance and transparency and, ultimately, achieve scale and financial sustainability (Campion and White, 1999). At the same time, leading practitioners are concerned about the impact of regulation on the poverty alleviation mission of MFIs (Dichter, 1997). Experiential evidence suggests that commercial institutions divert attention away from the poor and toward relatively

financial services to the economically active poor at interest rates that enable cost recovery and profit generation, while the latter rely on subsidies, government funds and/or local lending arrangements. 2 Yunus’ argument is largely philosophical. He believes that “poor people should not be considered an opportunity to make yourself rich” (Kinetz, 2008). Yunus also argues that profit-oriented microfinance necessarily leads to mission drift (by shifting the focus away from very poor borrowers and from poverty alleviation programs). A major critique of Yunus’ vision is its unrealistic expectations; Yunus speaks eloquently about eradicating poverty, but credit alone is not a panacea for poverty (Bruck, 2006). 3 In Bolivia alone, the share of microfinance in total banking assets increased from 5 percent in 1999 to 11 percent in 2006 (Berger, Goldmark and Miller Sanabria, 2006 (38)).

4 wealthier clients. 4 In this context, it is important to understand how regulation affects MFI financial performance and outreach and, in particular, to determine whether the benefits of regulation exceed the costs. 5 Although many studies highlight microfinance success stories, policy recommendations based on individual institutions may not be universally appropriate because they often depend on the environment in which the institution operates (Cuevas, 1996). In this paper, I study the impact of regulation on the performance of Latin American MFIs using a unique data set of 202 MFIs in 15 Latin American countries from 1997 to 2007. In order to assemble the data set, I leveraged the resources of the Microfinance Information Exchange (MIX), the largest global repository and platform for microfinance industry data. I also consulted the websites (if available) of individual MFIs for supplementary data on regulatory status, institution type and performance indicators. 6 The empirical analysis first evaluates the relative success of regulated and unregulated MFIs in terms of financial viability (self-sustainability and return on assets) and social impact ( breadth of outreach , or the number of borrowers, and depth of outreach, or the percentage of women borrowers and average loan size). The results indicate that regulatory status has no direct impact on MFI performance. Instead, institutional characteristics – age, size, capital-to-asset ratio, loan-to-asset ratio and write-off ratio, among others – are highly significant. This finding holds across all specifications, including a fixed effect specification that controls for unobserved heterogeneity across countries. Because the MFIs operate in different countries, it is also possible to analyze the environmental factors that contribute to financial performance and outreach. 7 To this end, I constructed a second data set with average (industry-wide) performance indicators for the 15

4 This shift in strategy – or “mission drift,” as it is known in the literature – may occur by necessity (in order to conform to stringent regulatory requirements such as capital adequacy ratios) or by deliberate choice (due to management’s decision to place greater emphasis on profitability). 5 The literature emphasizes the importance of an enabling regulatory framework for microfinance. However, the costs of designing and enforcing such a framework may be substantial. For example, a recent study by Steel and Andah (2003) suggests that the supervision of a large number of MFIs in Ghana was costly relative to the potential impact on the financial system. 6 Please refer to Section V for a more detailed discussion of the data assembly process. 7 The advantage of focusing on a single region with a common colonial background (Spanish and Portuguese) is that it is possible to control for the historical determinants of long-run economic development. Many economists recognize the formative role of history – or “path dependence,” as it is commonly referred to in the literature – in shaping institutions. For example, Acemoglu et al. (2001, 2002) discuss the enduring impact of colonial settlement patterns on institutional structures and, by extension, on economic development. In a related work, Sokoloff and Engerman (1997, 2000, 2006) argue that colonial development in Latin America left a historical legacy of inequality that still pervades the region. Despite considerable cross-country demographic and geographic diversity in contemporary Latin America, countries have similar political, economic, social and cultural institutions due to their shared historical experience.

5 countries represented in the sample over the period 1997-2007. I also collected country-level macroeconomic, demographic, social and institutional data from a variety of sources, including the World Bank, the United Nations, the International Monetary Fund, the Organization for Economic Cooperation and Development and the Heritage Foundation. The results from the multiple regression analysis indicate that country context is a key determinant of MFI performance. In particular, macroeconomic stability (proxied by the level of inflation), remittance flows and regulatory quality all contribute to MFI performance, while the impact of economic freedom, political stability and property rights is negligible.

The organization of the paper is as follows. Section II provides a brief overview of microfinance globally, from its roots in the 1960s to its current state. Section III examines the microfinance landscape in Latin America – its historical development, contemporary characteristics, institutional diversity and dominant players – as well as the economic, political and social context in which it developed. Section IV analyzes the debate surrounding the promise and peril of commercialization. Section V summarizes the findings of previous studies on commercial microfinance and then presents an empirical analysis of, first, the relative performance of regulated versus unregulated MFIs in Latin America and, second, cross-country differences in overall MFI performance. Section VI summarizes the main conclusions regarding the cross-country regressions from Section V, highlights the relevance of the empirical analysis for microfinance providers and practitioners and, finally, discusses the future of microfinance in Latin America.

II. Historical Overview of Microfinance

Microfinance is a relatively new phenomenon. Historically, poor people lacked access to financial services because banks assumed that the provision of small loans and deposit services would be unprofitable. The abysmal performance of state-run development banks reinforced this perception (Robinson, 2001). The legacy of financial repression also posed a fundamental challenge to the provision of microfinance services by sustainable microfinance institutions. Financial markets in developing countries operated under a series of restrictions, including interest rate ceilings, barriers to entry and credit rationing schemes, which gave traditional financial institutions little incentive to pursue unconventional lending practices (Barr 2005). Finally, the problem of restricted access was exacerbated by the limited influence of poor people: “those who hold the power do not understand the demand; those who understand the demand do not hold the power” (Robinson, 2001 (9)). In such an environment, low-income borrowers could only obtain credit from state-run development banks, informal moneylenders or donor-dependent NGOs. But this situation was about to change. In the disparate settings of Bangladesh, Indonesia and Bolivia, the founders of microfinance shared a vision: “to supply formal financial services to poor people shunned by banks because their savings were tiny, their loan demand was small, and they lacked loan collateral” (Zeller and Meyer, 2002 (1)). Microfinance pioneers created successful village banking networks and developed experimental lending programs that provided loans at subsidized interest rates to poor people living in sparsely populated areas. In the early 1980s, the pattern of subsidized microfinance shifted with the advent of the “microfinance revolution”: “the large-scale, profitable provision of microfinance services – small savings and loans – to economically active poor people by sustainable financial institutions” (Robinson, 2001 (10)). The following sections trace the growth of microfinance from a relatively obscure development experiment to a multibillion-dollar industry in a number of developing countries.

7 Precursors to Microfinance: Subsidized Credit and Informal Lending in the 1960s

During the post-colonial period, international donors and governments initiated credit programs to provide loans to farmers in developing countries. At this time, poor people were excluded from the formal financial sector; they could only obtain financial services from informal moneylenders. Both subsidized credit and informal lending were precursors to microfinance.

a) Subsidized Credit Delivery

Subsidized rural credit programs in developing countries date to the early 1900s. However, it was not until the aftermath of World War II that such efforts expanded dramatically (Adams and von Pischke, 1992). With the growth of modern foreign assistance, the governments of newly developed countries prioritized economic development and food cultivation (Robinson, 2001). During the four decades following the war, governments, foreign donors and international agencies injected tens of billions of dollars into low-income countries in Latin America, Asia and Africa. 8 The projects were introduced in the context of overall efforts to improve economic productivity through technical assistance and “green revolution” technologies (Tabella, 2002). In other words, rural development programs served a dual purpose: to improve agricultural productivity and to combat poverty (Braverman and Guasch, 1986). The goals of targeted credit – namely, improved economic efficiency and a more equitable income distribution – were well intentioned. But large-scale subsidized credit programs failed to consider both the social and political realities of rural life in developing countries, as well as the financial dynamics of local credit markets (Robinson, 2001).9 The programs were also unsustainable: high transaction and administrative costs, low repayment rates, lax lending standards and insufficient revenue led to continued donor dependence and, ultimately, inappropriate loan allocation. 10 Eventually, poor performance, coupled with the withdrawal of subsidies, left state-run banks either bankrupt or moribund (Robinson, 2001).

8 At their peak, agricultural projects absorbed over one quarter of the World Bank’s annual lending (Pischke, 1998). 9 The abject failure of subsidized credit programs is well documented (see, for example, Adams, Graham and von Pischke, 1984; Meyer and Larson, 1997; and FAO/GTZ, 1998). 10 Subsidized credit was often channeled to entrepreneurs with political connections rather than poor households, at high cost to both governments and intended beneficiaries (Morduch, 2000).

b) Informal Moneylenders

Private moneylenders – pawnbrokers, professional moneylenders, shopkeepers, traders and landlords, among others – have dominated local credit markets in developing countries for decades. They form part of a localized scale of financial intermediation with access to information on the activities and characteristics of low-income borrowers (Arun, 2005). Many scholars and government officials assume that “the informal sector is the natural environment for rural people” (Bouman, 1994 (166)) – it satisfies short-term financing needs at relatively low cost, responds to changes in economic conditions and manages risk and uncertainty. But this latter perspective overlooks the serious shortcomings of informal lending arrangements. First, informal moneylenders cannot satisfy the huge demand for credit and saving services among low-income households. 11 Second, they often charge higher interest rates than commercial MFIs.12 Last, informal providers fail to address issues of discrimination and systematic inequality; for example, marginalized or vulnerable groups are often unable to obtain credit, a situation that exacerbates existing disparities (Robinson, 2001). For these reasons, “the frontier of informal finance is shallow; its services are very valuable but do not go deep enough in scope (geographically, across products, and over long terms) and are vulnerable to the covariant risks of locally-based finance” (Gonzalez-Vega and Graham, 1995 (4)).

The abject failure of state-owned development banks, coupled with a recognition of the limitations of informal intermediation, led grassroots NGOs to extend outward the frontiers of semiformal and formal finance.

11 Gonzalez-Vega and Graham (1995) point out that “informal intermediaries typically do not provide… a sufficiently wide array of the services for which a (latent) demand exists, including safe deposit facilities, convenient mechanisms to transfer funds, and certain types of loans (especially large, long-term)” (4). 12 While there is considerable variation in informal lending arrangements, informal moneylenders tend to operate under conditions of monopolistic competition. As a result, “their low-income borrowers generally pay much higher interests rates for credit than would be necessary if commercial microfinance were widely available through financial institutions with broad outreach” (Robinson, 2001 (183)). An examination of Bank Rakyat Indonesia (BRI) microbanking clients reveals that borrowers previously involved in local moneylending relationships paid up to 653 times the BRI rate to informal moneylenders.

Microfinance in the 1970s: Pioneering NGOs and the “Demonstration Effect”

During the 1970s, subsidized credit was an integral part of the international development agenda. However, growth-oriented development efforts, misdirected international aid and “trickle down” economics failed to address the depth and complexity of poverty issues in developing countries (Dichter, 1999). In this context, new approaches to development began to emerge. One such approach was microfinance – the granting of small loans to people who farm or fish or herd; who operate microenterprises that produce or sell goods; who provide services; who work for wages or commissions; and who lease land or machinery for income. Grassroots NGOs were at the forefront of early microfinance experiments: they initiated operations in remote areas, designed appropriate loan products for low-income borrowers and pioneered group- and character-based lending methodologies. 13 From the perspective of foreign donors, NGOs have considerable appeal as microfinance delivery vehicles for several reasons (Bhatt and Tang, 2001). First, they establish close linkages with civil society, often in the poorest and most isolated communities. Unlike traditional bureaucratic approaches to development, NGOs tend to have participatory decision-making and governance structures that encourage direct community involvement. Second, NGOs provide nonfinancial services relating to literacy, health and enterprise management. These services address important social and political issues, such as women’s empowerment. Third, NGOs are generally believed to have altruistic motivations and to operate with integrity (Rose-Ackerman, 1996). Overall, NGOs are “favored both as vanguards of civil society and as more dependable partners in economic and social development” (Laird, 2007 (470)). At the end of the 1970s, the profits of a few flagship NGOs created a “demonstration effect,” 14 attracting other institutions to the microfinance arena. But high profits were the exception rather than the rule; the majority of institutions failed to recover their loans, and even successful programs remained severely capital-constrained. As sustainability and profitability became key issues, the limits of a philanthropic model became increasingly apparent.

13 For a comparison of group and individual loan methodologies, please refer to Ledgerwood (1999), Dellien et al. (2005), Morduch and Armendariz de Aghion (2005) and Lehner (2008), among others. 14 NGOs often act as “demonstrators” of the potential of microfinance; they develop new products and innovative delivery systems, provide technical assistance to financial institutions interested in developing microfinance services, tackle practical, political or regulatory issues and, more generally, work to create an enabling environment for microfinance.

Microfinance in the 1980s: A Decade of Change

The 1980s represented a turning point in microfinance: with changing attitudes, changing realities and changing approaches, it became clear for the first time that microfinance could achieve large-scale outreach on a sustainable basis.

a) Changing Attitudes: A New Policy Outlook for the Informal Economy

Households and enterprises operating in the informal sector of the economy generate most of the demand for microfinance services. 15 However, due to the specific nature of informal businesses – their non-legal status, lack of authorized business location, unconventional forms of collateral, preference for small loans and perceived riskiness, among other factors – regulated financial institutions are often reluctant to finance them. The political perception of the informal sector further isolates microenterprises from the mainstream economy. Historically, policymakers viewed the existence of informal microenterprises, from street vendors to home workshops, as a symptom of economic dysfunction. 16 As a result of this policy outlook, “the huge informal sector in many countries remained essentially invisible—in government plans and budgets, in economists’ models, in bankers’ portfolios, and in national policies” (Robinson, 2001 (12)). By ignoring and, in certain instances, actively repressing 17 small-scale entrepreneurship, policymakers undermined an economically important sector. The informal economy not only generates employment and income, but it also supplies inexpensive food, clothing and transportation. The sheer magnitude of the informal economy is astounding 18 :

15 In the labor markets of developing countries, there is not a clear-cut distinction between the “informal” and “formal” economy. Microenterprises often have both informal and formal characteristics, and some operate in both sectors. Still, it is possible to identify a number of features that distinguish informal enterprises, including family ownership, small-scale operations, non-legal status, lack of security, scarcity of capital, operation in unregulated markets, minimal barriers to entry, irregular work hours and labor-intensive production. 16 For policymakers, a growing informal sector exposed the limits of the formal economy, in particular its inability to absorb the national labor force. Only through improved macroeconomic performance could the “problem” of informal microenterprise be resolved (Robinson, 2001). 17 In some countries, officials went so far as to remove microenterprises from the streets or force urban migrants employed in informal activities to return to their home villages (Robinson, 2001). 18 By definition, the informal economy is difficult to observe, study, define and measure. Still, official estimates on the size of the informal economy provide a tentative picture of the sector’s relevance.

11 according to USAID, the sector absorbed between 30 and 70 percent of the labor force in many developing countries in the late 1970s (Snow and Buss, 2001 (297)). Beginning in the mid-1980s, the governments of many developing countries improved their macroeconomic management. 19 But while the formal economy matured, the informal economy continued to grow rapidly. From Nairobi to Lima, New Delhi to Sao Paulo, the same social and economic dynamic was taking place: people were moving in large numbers from rural to urban areas to create small businesses (Otero, 2005). Rising demand for low-cost goods and services produced by microenterprises, coupled with improved agricultural technologies and higher rural incomes, further contributed to the growth of the informal economy. Faced with an expanding informal sector, governments reexamined their approach to microenterprises. Microenterprises were no longer viewed as an obstacle to economic development; instead, they were seen as a viable solution to systemic problems ranging from urban poverty to migrant dislocation (Robinson, 2001). In this context, policymakers began to prioritize access to savings and credit for informal businesses.

Significantly, the scope of policy change extended beyond the informal sector to the economy as a whole. The governments of developing countries embarked on a series of neoliberal restructuring projects intended to spur growth, promote social development and increase transnational capital flows.

b) Changing Realities: the Transformation of the Financial Sector

When microfinance emerged in the 1970s, financial systems in most developing countries operated under restrictive policies. The transition from the old paradigm of subsidized credit to the new paradigm of sustainable microfinance coincided with financial sector liberalization in emerging economies. In the 1960s and 1970s, scholars such as Raymond Goldsmith, John Gurley, Edward Shaw and Robert McKinnon studied the financial sectors of developing economies and concluded that these sectors were proportionally smaller than those in developed countries. In so-called “repressed” financial sectors, low interest rate ceilings, barriers to entry, fragmented

19 For example, governments closed failing state enterprises and tightened fiscal spending, among other measures.

12 credit markets, prohibitive reserve requirements, insufficient risk awareness, directed credit programs and extensive subsidization, among other factors, result in high transaction costs, reduced competition, institutional inefficiencies, market asymmetries and sluggish innovation. Poor entrepreneurs – lacking collateral, a credit history and connections – are especially affected by capital market imperfections. 20 During the last quarter of a century, the technocrat mantra “stabilize, privatize and liberalize,” codified in John Williamson’s (1990) Washington Consensus, inspired a wave of reforms in Latin America, Africa and the transition economies of Eastern Europe (Rodrik, 2006). The movement toward a free market system fundamentally transformed the political and economic landscape in these regions. 21 In countries where liberalization proceeded the farthest, the financial sector was characterized by: i) the entry of foreign banks, leading to competition for high-end clients; ii) interest rate deregulation, allowing banks to enter new market niches profitably; iii) open exchange rate policies and other measures to reduce capital flight, encourage saving and increase liquidity; and iv) the development of capital markets and mortgage, insurance and pension plans (Rhyne and Christen, 1999). More significantly for purposes of this paper, financial sector reform created an environment conducive to the expansion of commercial microfinance. 22 For some microfinance practitioners, lending to the poor was like any other type of lending: “The principles behind the emerging techniques for offering financial services to the poor are the same as those found in any financial system.... These principles require the institution to break even or turn a profit in its financial operations and raise funds from non-subsidized sources” (Rhyne and Otero, 1994 (11)).

Significantly, it was this sort of thinking that served as the impetus behind the “big leap” to sustainable microfinance (Cull, Demirguc-Kunt and Morduch, 2008).

20 Information asymmetries and high transaction and contract enforcement costs hinder the allocation of capital to poor entrepreneurs with high-return projects. In general, market imperfections tend to exacerbate existing inequalities (Banerjee and Newman, 1994; Galor and Zeira, 1993). 21 This paper does not purport to argue that financial liberalization was the perfect remedy for improved economic fundamentals in developing countries. Indeed, the failure of Washington Consensus-style policies has been well documented (see, for example, Stiglitz (2003) in Globalization and its Discontents ). 22 Legal and regulatory reform is particularly important for NGOs seeking to become regulated financial institutions. Cuevas (1996) argues that the “successful graduation of MFIs requires financial sector deregulation and liberalization” (197).

c) Changing Approaches: the “Big Leap” to Sustainable Microfinance

By the mid-1980s, the microfinance community had demonstrated the financial viability of lending to the poor: with effective product and service delivery mechanisms, microfinance institutions obtained high repayment rates. 23 Still, only a few MFIs showed long-term growth potential 24 : a large percentage of programs eventually ceased operations due to inadequate funding. 25 At the end of the 1980s, microfinance pioneers took a “big leap” in arguing that MFIs should be financially sustainable. There was a three-part rationale for this shift (Cull, Demirguc-Kunt and Morduch, 2008): first, although small loans are costly to administer, the poor are capable of paying high interest rates 26 ; second, subsidies weaken incentives for innovation and undermine institutional efficiency 27 ; and last, subsidies are not available in the quantities necessary to fuel a growing sector. 28

23 Top microlenders boast repayment rates in excess of 98 percent, even in the absence of collateralized loans (Cull, Demirguc-Kunt and Morduch, 2008). 24 Robinson (2001) classifies microfinance lenders into three categories according to their level of sustainability. First, for the majority of lenders, revenues do not cover operating costs. Such programs are highly dependent on grants or low-interest loans from private donors, governments and international agencies. A second group of MFIs cover operating costs but are unable to finance the commercial cost of their loans. Programs at these institutions are dependent on subsidies to varying degrees and rarely include voluntary savings mobilization. Finally, a small number of MFIs cover all costs, make a profit and generate a return on equity comparable to that of private sector companies. 25 A 1995 worldwide survey of 206 microfinance institutions indicates that only 7 percent of institutions were created before 1960, while 48 percent were founded between 1980 and 1989. As Paxton (1996) writes, “most of the programs created in the 1960s and 1970s for microlending disappeared due to dismal repayment rates, corruption, and heavy subsidization, leading to a ‘grant mentality’ among clients” (9). 26 For Rhyne (1998), “the poverty/sustainability debate is ultimately about whether to subsidize interest rates. Those who let go of sustainability in the name of reaching the poor are saying, in effect, that the poor cannot fully pay for their borrowing. If the poverty/sustainability debate were discussed in this way, it would be much more transparent. It would move away from the question of being “for the poor“ or “against the poor“ to the question of whether or not the poor need subsidized interest rates. And this question is one with an important empirical component. It is possible to determine whether clients can afford to pay full cost interest rates by charging such rates and seeing whether client demand decreases. Little or no documentation of microfinance programs reports that increasing interest rates has significantly altered client demand for their loan products” (7). Rosenberg (1996) also finds “overwhelming empirical evidence that huge numbers of borrowers can indeed pay interest rates at a level high enough to support MFI sustainability.” 27 Yaron (1994) provides some examples of subsidies: i) differences between the market interest rate and interest rates paid on concessional borrowing from the state or donors; ii) state assumption of losses due to exchange rate fluctuations on loans denominated in foreign currencies; iii) compulsory deposits by financial or public institutions at below-market rates; iv) reimbursement by the state or donor of some or all operating costs; v) grants or gifts; and vi) exemption from reserve requirements (50). 28 To quote Rosenberg (1996): “Some people treat this question as if it comes down to a value judgment: which do you care more about – poor people or profits (...or financial systems...or neoliberal ideology). To avoid any such confusion, let’s assume that the only objective we care about is maximizing benefit to poor people. From this perspective, the argument for high interest rates is straightforward. In most countries, donor funding is a limited quantity that will never be capable of reaching more than a tiny fraction of those poor households who could benefit from quality financial services. We can hope to reach most of those households

14 In order to provide microfinance services without subsidy, MFIs developed new concepts, products and methods. They refined individual and group lending techniques, developed new credit and savings services, charged higher interest rates, incorporated innovative operating practices and information systems, improved management capabilities and sought to mobilize local savings and commercial investment. 29 Overall, the new “financial systems” approach to development “shifted the focus to finance itself, with market interest rates, a smaller role for the state, and an abandonment of the other elements of development to focus more narrowly and effectively on finance” (Moon, 2007).

While the advantages of institutional sustainability were generally accepted, the next logical step – from self-sufficiency to profit maximization – was more controversial. Through the following decade, tensions heightened between leading members of the microfinance community over how to reconcile for-profit, commercial banking with lending to the poor.

Microfinance in the 1990s: Developing an Industry

During the 1990s, the microfinance community expanded rapidly. In addition to this accelerated growth, microfinance pioneers placed increasing emphasis on scale, sustainability and profitability. The creation of new microlending NGOs, non-bank financial institutions, commercial banks and other specialized intermediaries resulted in heightened competition, product innovation and geographic expansion. With changes in the microfinance landscape, governments instigated regulatory reforms designed to create an appropriate supervisory framework for MFIs. Rating agencies began to operate in the microfinance sector. International agencies initiated teaching programs on commercial microfinance and built new channels for the dissemination of information on best practices. And expanding microfinance networks brought together practitioners from around the world. By the late 1990s, microfinance “was an industry – a fledgling industry, but a rapidly growing one” (Robinson, 2001 (54)).

only if MFIs can mobilize relatively large amounts of commercial finance at market rates. They cannot do this unless they charge interest rates that cover the [cost of funds].” 29 For example, Bank Rakyat Indonesia developed the first large-scale sustainable microbanking system operating without subsidy and Grameen Bank designed a successful group lending methodology that was later replicated by institutions around the world (Robinson, 2001).

15 a) A Theoretical Debate

Microfinance in the 1990s was marked by a major debate between two competing visions: the financial systems approach and the poverty lending approach (Rhyne, 1998; Gully, 1998; Robinson, 2001). For proponents of the financial systems approach, “there is in fact only one objective – outreach. [Institutional] sustainability is but the means to achieve it” (Rhyne, 1998 (7)). In other words, in order to achieve large-scale outreach without continued donor dependence, microfinance must become integrated into the formal financial sector. The poverty lending approach, by contrast, emphasizes poverty reduction through a combination of credit, skills training, education and health services. From this “welfarist” perspective, the overriding objective of microfinance is to serve the very poor through donor- and government-funded credit at below-market interest rates (Woller et al., 1999). Welfarists reject the institutionist argument that “ access to finance is more important than its price” (Cull, Demirguc-Kunt and Morduch, 2008 (4)). In the words of Muhammad Yunus (2007), “credit is more than business. Just like food, credit is a human right.” 30 Of course, there are important areas of shared vision. Both approaches agree that the demand for financial services is huge and growing and that access to reliable financial services can benefit hundreds of millions of people in developing countries. 31 But while institutionists emphasize financial self-sufficiency, welfarists emphasize poverty alleviation; while institutionists focus on breadth of outreach, welfarists focus on depth of outreach; and while institutionists see the future of microfinance dominated by large, for-profit institutions, welfarists embrace the work of NGOs and other philanthropic actors. 32 Robinson (2001) highlights the significance of this ideological schism: “Overall, the poverty lending approach poses a deep dilemma for governments, microfinance institutions, donors, and others. This is because microfinance has reached a fork in the road. The microfinance revolution, based largely on the financial systems approach, and the poverty lending agenda, based largely on eradicating poverty through credit, have begun to move in different directions. In one sense the roads heading out from the fork are complementary. Both lead to assistance for the poor, though in different ways. But donors and governments supporting microfinance have scarce resources, and they must choose how best to use them .”

30 Many microfinance practitioners reject this view of credit. According to Compartamos CEO Carlos Labarthe, “Opportunity is a human right…but credit is for [someone with the] opportunity to make something productive. [Microfinance is about] creating wealth…, not bringing up the destitute” (Bruck, 2006). 31 Rough estimates put the total demand for microcredit at $90 billion (or 30 percent of the world's low- income entrepreneurs) by 2025 (CGAP Focus Note 3, 1995). 32 Please refer to the table in Appendix 1 for a comparative overview of the financial systems and poverty alleviation paradigms.

16 b) Limits of the Poverty Lending Approach

Most of the published literature on microfinance espouses the view that, “as a global solution to meeting microfinance demand, the two views on microfinance – and the means they advocate – are not equal” (Robinson, 2001 (23)). 33 Under the poverty lending paradigm, financial institutions cannot provide microfinance services on a large enough scale to meet the excess demand. First, subsidized interest rates do not cover the high transaction costs of small loans or the intermediation risks associated with sustainable microfinance. Even the most effective institutions operating with subsidized loan portfolios experience difficulty achieving widespread outreach (Robinson, 2001). Second, an underlying principle of the poverty lending approach is that the poor need training in business, literacy, finance, health, agriculture and basic skill development in order to make effective use of their credit. But linking instruction to credit programs is problematic because costly training courses undermine the objective of institutional sustainability. Furthermore, many kinds of training, while integral for poverty alleviation, are irrelevant for purposes of loan repayment (Robinson, 2001). The economically active poor are often better able to assess their business and financial needs than institutional trainers, and general assistance programs fail to consider the disparate needs of a heterogeneous client base. 34 There are, of course, a few notable exceptions to this conclusion; the Bangladesh Rural Advancement Committee (BRAC) and Grameen Bank, for example, have strong records of financial management, outreach and poverty reduction through a combination of credit and training programs. But historical experience shows that most institutions providing both social services and microfinance fail, and that those that do survive can only meet a small fraction of the demand (Robinson, 2001).

In most of the developing world, the institutional infrastructure for microcredit services remains small, fragile and isolated from the mainstream financial sector. As a result, the demand for microfinance services continues to outstrip supply. 35 The poverty lending

33 See, for example, publications by the Ohio State University Rural Finance Program, USAID, the World Bank, CGAP, Maria Otero (of ACCION International) and Elisabeth Rhyne (formerly of USAID). 34 The experience of the Kenya Rural Enterprise Programme is revealing: “It…became obvious that the ‘integrated’ method of developing microenterprises, which combined traditional methods of making loans with intensive entrepreneur training and technical assistance, had limited impact on the beneficiaries, was costly, and could be sustained or expanded only through grant funding” (Mutua, 268). 35 According to BlueOrchard, a private Swiss company that monitors and reports on MFIs for current and potential investors, only five percent of the microcredit demand is currently being met (Nelson, 2007).

17 approach fails to meet this vast demand among the poor for microloans and voluntary savings services. Commercial microfinance, by contrast, can profitably reach large numbers of low- income clients.

a) Commercial Microfinance: The Single Way Forward?

Commercial microfinance has considerable promise. Yet the clash between a profit-driven model and socially oriented model offers a false choice. In the future, there is a role for both approaches: private investment is needed to finance the rapid expansion of commercial microfinance, while donor subsidies may be appropriately channeled to NGOs that reach underserved communities and experiment with innovative credit methodologies. Rhyne (1995) offers a compelling reminder that outreach and sustainability are complementary, not conflicting, goals: “Poverty and sustainability [are] the yin and yang of microfinance. They are two sides of a whole, each incomplete without the other…. Only by achieving a high degree of sustainability have microfinance programs gained access to the funding they need over time to serve significant numbers of their poverty-level clients. This image reveals that there is in fact only one objective—outreach. Sustainability is but the means to achieve it. Sustainability is in no way an end in itself; it is only valued for what it brings to the clients of microfinance” (7).

Furthermore, it is important to distinguish between the economically active poor and the extremely poor, between creditworthy and non-creditworthy borrowers. Credit is debt, and providing credit to the extremely poor is both ineffective and potentially harmful. Microfinance cannot solve chronic and severe poverty; instead, governments and donors must meet the demand for food, employment, healthcare and other basic services among the poorest of the poor. In short, “the market is a powerful force, but it cannot fill all gaps” (Cull, Demirguc-Kunt and Morduch, 2008 (3)).

Microfinance in the 21 st Century

“Today, the word microfinance doesn't even capture the scope and scale of what is happening in the world of finance for the poor. What was once a neat and tidy, well- delineated little sub-culture, now encompasses a dizzying range of delivery organizations and services, all increasingly interwoven with the rest of the financial sector. All around us, we are witnessing experimentation, and a surge of new entrants to the field. The result is an explosion of diversity: diversity of delivery channels, of services, of funding sources and, of course, clients.” – Elizabeth Littlefield, CGAP CEO and World Bank Director

Statistics on the Global Microfinance Industry

Blue Orchard and CGAP conservatively estimate the worldwide demand for microfinance at $100 billion from nearly 500 million households (Brugger, 2004). Today, microfinance serves only a fraction of these households (CGAP, 2001). According to the Microcredit Summit Campaign (2007), as of December 2006 there were over 3,300 MFIs 36 providing services to 133 million clients, of whom 93 million were among the “poorest” when they first obtained a loan. 37 Figure 1 highlights recent estimates for the number of microfinance borrowers according to various sources.

Figure 1: Estimated Number of Microfinance Borrowers

The Mix Market’s MicroBanking Bulletin (2008) tracks a smaller number of institutions 38 ; at the end of 2007, 900 reporting MFIs were serving 64 million borrowers through $32 billion

36 Of the 3,316 institutions, 873 submitted Institutional Action Plans to the Microcredit Summit Campaign in 2007. Data from 327 institutions was verified. The remaining 2,443 institutions sent their data in previous years, and the Campaign includes those numbers in the report. 37 The term “poorest” refers to those who live in the bottom half of their nation’s poverty line, or any of the nearly 1 billion people who live on less than US$1 per day, adjusted for purchasing power parity (PPP). Of the poorest clients counted in 2007, approximately 90.1 percent live in Asia – a continent home to nearly 64 percent of the world’s people living on less than US$1 per day – and 85.1 percent are women. 38 Although the Microbanking Bulletin has fewer participating MFIs than the Microcredit Summit Campaign, the former has accurate and complete data on all of the reporting institutions.

19 in loans, with deposit-taking institutions capturing nearly half of these figures, as highlighted in Table 1.

Table 1: Scale of Microfinance

Offices Employees Borrowers Deposit Loan Portfolio Deposits ('000) ('000) ('000) Accounts ('000) (USD '000 000) (USD '000 000) Africa 4 35 5,183 8,036 2,419 1,948 Asia 23 200 43,294 11,769 6,744 1,163 ECA 3 39 2,387 3,891 7,776 3,296 LAC 9 77 11,374 9,816 13,820 8,637 MENA 2 16 2,244 9 1,040 55 World 42 366 64,482 33,520 31,798 15,098 Note: BRI is not included in the survey. Source: MIX Market, MicroBanking Bulletin , Issue No. 17 (Autumn 2008): 26.

Although it is difficult to obtain accurate information on the number of microfinance providers and clients worldwide due to a lack of transparency, limited regulation and inconsistent reporting, leading practitioners estimate that there are 10,000 MFIs globally (Blue Orchard, 2007). Still, the majority of these institutions are small and financially unsustainable. 39 The microfinance industry remains highly concentrated, with nine percent of MFIs accounting for 75 percent of all borrowers. 40 A similar pattern of concentration is visible in national markets; the median share of the top ten MFIs in a given country is about 95 percent of the market (Gonzalez and Rosenberg, 2006). 41 Table 2 identifies flagship institutions from around the world.42

39 Christen (1997) discusses this interesting dynamic from an institutional perspective: “the microfinance industry embraces several thousand organizations offering microcredit and other financial services to poor clients. Almost all of these institutions are concerned with poverty alleviation, but relatively few of them are fundamentally committed to long-term financial sustainability and exponential growth. Most MFIs would like to be large and sustainable; but it is a much smaller group which understands the full price of such sustainability and is willing and able to pay it. MFIs without this profound commitment to sustainability may often be doing excellent work, but they do not represent the cutting edge of the microfinance industry” (9). 40 The industry giants – BRI, BRAC and ASA – account for more than 50 percent of the total number of borrowers at over 300 MFIs reporting to the MIX Market (Montgomery and Weiss, 2005). More generally, of approximately 10,000 MFIs in existence, between 150 and 200 serve the vast majority of clients. These leading MFIs share a number of characteristics: i) a range of products developed specifically for their clientele; ii) the ability to operate in a highly competitive environment; and iii) consistent maintenance of low portfolio risk (under five percent) and high repayment rates (in excess of 97 percent). Furthermore, a “commercial” approach to microfinance is embraced as the only way to make a real impact on poverty (Otero, October 2005). 41 For example, although there are more than 1,000 MFIs in Bangladesh, the four largest institutions – Grameen Bank, BRAC, ASA and Proshika – account for over 70 percent of clients. Similarly, the largest 10 MFIs in the Philippines (out of a total population of 400 MFIs) serve 60 percent of clients (Fernando, 2007). 42 These institutions were selected from multiple rankings: i) MIX Global 100 Composite Ranking (2008); ii) Championship League Latin America & Caribbean (2008); and iii) Forbes 50 Top Microfinance Institutions (2007). The rankings consider a number of factors, including efficiency (operating expense and cost per borrower), scale (size of gross loan portfolio), risk (portfolio quality), sustainability (operational self- sufficiency, return on equity and return on assets) and transparency.

Table 2: Global Leaders in Microfinance by Region

Region Leading MFIs Latin America CrediAmigo (Brazil); BancoSol (Bolivia); BancoEstado (Chile); WWB Cali (Colombia); Banco Solidario (Ecuador); Banco Compartamos (Mexico); MiBanco (Peru) Asia MBK Ventura (Indonesia); SKS (India); SDBL (Sri Lanka); JVS (Nepal); BRAC (Bangladesh); CARD Bank (Philippines); AMK (Cambodia) Eastern Europe ASC Union (Albania); FINCA (Armenia); ProCredit (Macedonia, Bulgaria, Kosovo, Bulgaria, Bosnia and Herzegovina); CREDO (Georgia) Middle East and Africa Tamweelcom (Jordan); Enda (Tunisia); Amhara Credit and Savings Institution (Ethiopia); Al Amana (Morocco); Al Tadamun (Egypt)

What are some of the key trends in commercial microfinance today? Rhyne and Busch (2006) examine the worldwide growth of the microfinance industry over the period 2004- 2006 using a representative sample of 222 regulated MFIs from across Africa, Asia, Eastern Europe and Latin America. The institutions reached 11 million clients in 2006, compared with only 3 million in 2004. Furthermore, the 71 MFIs from the 2004 study that were analyzed in 2006 experienced 82 percent portfolio growth, 70 percent asset growth, 49 percent equity growth and 31 percent growth in the number of clients served on an annual basis. Other financial trends include increasing financial leverage and rising average loan sizes. Commercial MFIs in the study had an average asset-to-equity ratio of 8.6 in 2006, up from 6.6 in 2004. Aggregate average loan sizes also increased, from US$623 in 2004 to US$1,193 in 2006. In terms of divergent regional development, Asian MFIs experienced remarkably high portfolio and asset growth. 43 In Latin America, by contrast, new institution formation was relatively slow; instead, established MFIs continued to grow at an impressive pace. The overall picture is of a rapidly expanding microfinance industry in Asia; a developing industry in Africa and Eastern Europe; and a healthy, maturing industry in Latin America.

43 Asian portfolios increased by 249 percent and assets by 281 percent. A few institutions – SHARE in India, for example – grew their portfolios by nearly 600 percent and expanded their client base by 300 percent.

From relatively modest and improbable beginnings, the microfinance industry has reached an impressive scale. Yet the face of microfinance is constantly changing 44 : there are new institutions and clients, new donors and investors, new skills and comparative advantages, new technologies and delivery mechanisms (Rhyne and Christen, 1999). 45 Perhaps most importantly: “Microfinance today stands at the threshold of its next major stage, the connection with the capital markets…. This is nothing short of changing the very nature of banking, from servicing the top 25 or 30 percent (at the most) of the population of the developing world to meeting the demand of the rest. It is reclaiming of finance for society at large – the true democratization of capital” (Chu, 1998 (2)).

This situation is most evident in Latin America, where industry pioneers recognized early on that the funds necessary for growth would come from the formal financial sector. The remainder of this paper focuses on the microfinance landscape in Latin America.

44 While the institutions listed in Table 2 are among today’s top performers – in fact, they are often more profitable than mainstream commercial banks in their respective countries – the microfinance landscape is far from stagnant. According to Otero (October 2005), “the dominance of today’s microfinance leaders will last only if the leadership of these institutions develops a set of skills that they largely do not possess today. They need excellent governance and management with strategic planning skills to avoid the complacency of success.” 45 Existing MFIs are building new capacity and newly formed MFIs are forging into different markets. New-generation MFIs, in particular, are leveraging best practices and proven models in order to “start with a for- profit mindset and aggressive break-even and growth targets from the outset” (Ehrbeck, 2006 (6)).

22 III. Microfinance in Latin America

Nowhere has commercial microfinance developed more rapidly or completely than in Latin America (Christen, 2001). According to an Inter-American Development Bank study, commercial (regulated) banking institutions in the region serve 64 percent of all clients and provide 81 percent of microcredit funds (Navajas and Tejerina, 2006). The relative dominance of formal financial intermediaries today can be contrasted with the situation over a decade ago, when microcredit was the sole domain of microfinance NGOs. This section traces the historical evolution of microfinance in the region, with particular emphasis on the defining features of the Latin American microfinance landscape.

The Latin American Model in Historical Perspective

In its early stages, microfinance in Latin America evolved in much the same way as it did in other regions of the world. During the 1960s, international donor agencies established lending programs that channeled funds to credit unions and state-owned development banks targeting the rural poor (Adams, 1971). Consistent with the experience of other developing nations, the paradigm of supply-driven, top-down, targeted rural credit failed: ineffectual loan collection 46 , coupled with rampant inflation and general macroeconomic instability, eroded the real equity value of government-owned rural financial institutions. The economic cost of this dismal performance was enormous. 47 Programs not only accumulated hefty losses (and thus required frequent recapitalization to sustain their operations), but they also failed to reach their intended recipients (Schreiner, 2001). Argentine provincial banks, for instance, repeatedly lost capital by extending loans to rural elites without expectation of repayment (Robinson, 2001 (145)). The eventual withdrawal of international donors resulted in the collapse of many state-owned institutions and specialized financial intermediaries. With the end of targeted rural credit, academics, policymakers and nongovernmental organizations shifted their focus to the growing shantytown populations surrounding Latin

46 For example, Mexico’s BANRURAL had a loan repayment rate of a mere 25 percent in the late 1980s, excluding recoveries from the unprofitable national agricultural insurance company (Yaron, Benjamin and Piprek, 1997). 47 According to Yaron, Benjamin and Piprek (1997), agricultural subsidies totaled 2.2 percent of Brazil’s GDP in 1980 and 1.7 percent of Mexico’s GDP in 1986.

23 American cities. Previously, governments and international development agencies had neglected these low-income communities because their activities were concentrated in so- called “unproductive” sectors of the economy, namely informal trading and services. In reality, however, the informal sector was not only highly productive; it was also integral to the household economy of the poor. 48 Figure 2 graphs the estimated size of the informal sector in 17 Latin American countries in the early 2000s.

Figure 2: The Informal Economy in Latin America

Recognizing the potential income- and employment-generating capabilities of small- scale entrepreneurs, NGOs established microenterprise credit programs outside major urban centers. These programs used innovative lending technologies, such as solidarity groups and character-based assessments, to accommodate borrowers that lacked traditional forms of collateral. Many provision models also included training and technical assistance designed to improve the financial and managerial skills of poor entrepreneurs.

48 There are more than 50 million microenterprises in Latin America and the Caribbean. According to the International Labor Office, these businesses accounted for roughly half of the region’s employment during the mid-1990s. Moreover, this share has been growing steadily since the 1970s (Berger, 2000).

24 During the late 1980s and early 1990s, a number of NGOs substantially expanded their operations. These organizations were successful in minimizing loan delinquency and expanding outreach. Nevertheless, donor dependency and organizational restrictions placed limits on growth (Poyo and Young, 1999).49 In this context, NGOs began to explore alternate legal vehicles and institutional forms for the provision and delivery of microfinancial services. The creation of BancoSol in Bolivia in 1992 marked the birth of a new trend in institutional development within the microfinance industry: the transformation of NGOs into formal financial institutions with access to domestic and international financial markets. As regulated entities, NGOs can mobilize savings from the public and stabilize their governance processes. Thus, for a large number of NGOs, “institutional transformation [is] the strategic end-objective…” (Campion and White, 2001). The success of grassroots organizations, including transformed NGOs, resulted in two coincident developments: first, interest by commercial banks in microfinance and, second, the emergence of a number of professional financial institutions specializing in microfinance services. With the entry of new players, competition became a hallmark of the business environment. Although increased competition led to improved product design, pricing, delivery and management practices, it also had adverse consequences. In a few countries, namely Bolivia, competition became so fierce that the predatory lending practices of some MFIs, coupled with client over-indebtedness, undermined the performance of all players in the market (Rhyne, 2001). By the late 1990s, the microfinance panorama in Latin America featured a diversity of providers, customer strategies and products. As leading institutions sought to leverage the competitive advantages offered by scale, the industry underwent a process of expansion, formalization and consolidation (Marulanda and Otero, 2005). Today, a number of Latin American countries – namely, Peru, Bolivia and Ecuador – have microfinance markets that are among the most active and mature in the world (KMPG, 2008). Before providing an overview of the contemporary microfinance landscape – its institutional topography, defining features and regional disparities – it is constructive to examine the environment in which microfinance emerged and developed.

49 From an institutional perspective, NGOs rely on external funds to support subsidized interest rates and significant operational cost structures. High dependency on grants and concessional funding may undermine operations if donor money dries up. Furthermore, NGOs have two organizational flaws that limit their ability to serve the microfinance market: i) they are unable to hold deposits and ii) they lack a defined ownership structure.

25 Macroeconomic and Social Context

Microfinance in Latin America must be viewed within its larger economic and social context: relatively high per capita incomes, elevated inflation rates, high real interest rates (both deposit and lending rates), minimal financial deepening, severe inequality and rampant poverty (Sawers, Schydlowsky and Nickerson, 2000 (73-74)). These characteristics give a “distinct cast” to microfinance in the region, as compared with the Asian, African or Eastern European experience (Berger, 2000 (74)).50

a) Neoliberal Restructuring

From 1950 to 1980, Latin America grew at an average rate of six percent; however, this rapid growth was accompanied by excessive protectionism, persistent fiscal deficits, rigid economic structures, sluggish export growth, inefficient tax systems and rising inequality. In order to finance widening current account deficits, Latin American countries borrowed extensively from the rest of the world. 51 However, a combination of factors – a rise in international interest rates, eventual recession in the developed world and the second oil shock – caused major strains in international lending to the region (Frieden, 1992). With Mexico’s announcement in 1982 that it was unable to service its external debt obligations, the supply of funds to Latin America was effectively cut off. 52 The aftermath of the 1982 debt crisis (and, in particular, the failure of early policies implemented to resolve it) played a pivotal role in reshaping views in Latin America. It became increasingly apparent that state involvement in the economy, far from cushioning the impact of major external shocks, significantly undermined the ability of the domestic economy to deal with foreign disturbances. In this context, a number of political leaders sought to address the precarious economic situation by adopting a new vision of economic

50 The economic policies followed by Latin America in the post-World War II period differ sharply from those adopted by a number of East Asian countries, among them Hong Kong, Singapore and South Korea. In particular, while most Latin American governments encouraged inward-looking growth and underestimated the value of macroeconomic stability, East Asian economies initiated policies that fostered export growth and preserved macroeconomic equilibria (Edwards, 1995 (4)). 51 Access to cheap foreign capital facilitated the accumulation of record amounts of foreign liabilities. With a dramatic increase in oil prices (400 percent from 1973 to 1974 and 200 percent from 1978 to 1979), international banks began to recycle petro dollars and the global credit supply ballooned. 52 Not only did capital inflows cease, but capital outflows accelerated. From 1973 to 1987, capital flight from Latin America exceeded $150 billion, equivalent to approximately 43 percent of the total external debt acquired during that same period (Pastor, 1989).

26 policy based on the free market, international competition and a limited role for the state in the economy (Edwards, 1995).53 In the financial sector, market-oriented reforms in the late 1980s and early 1990s led to the removal of interest rate ceilings, the reduction or elimination of barriers to entry (including the preferred status of government-owned banks) and the development of regulatory frameworks (Berger, 2000). A number of reforms had direct implications for the microfinance industry; in Bolivia and Peru, for example, changes in banking regulations made it possible for nonprofit foundations to transform into formal financial intermediaries (Edwards, 1995). More broadly, the adoption of universal banking and the elimination of direct credit controls opened microfinance to a spectrum of financial institutions (Loubiere, Devaney and Rhyne, 2004). By 1992, most Latin American countries had recovered from the economic chaos of the 1980s: growth rates were increasing, exports were expanding, foreign investment was rising and productivity was improving. Unfortunately, this “spectacular progress” on the economic front was not accompanied by infrastructure improvements or political modernization (Edwards, 2005). Furthermore, “the free market model [prescribed to address the economic situation] did not address growing problems of poverty and exclusion” (Thorp, 1998 (264)).

b) Poverty, Inequality and Social Exclusion

Inequality, poverty and social exclusion in Latin America are embedded in the historical and demographic legacy of Spanish and Portuguese colonization (Acemoglu, Johnson and Robinson, 2001; 2002).54 Colonial rule established gross material and political inequalities and provided the basis for social exclusion by race ethnicity and gender, among other characteristics (Karl, 2000). During the early twentieth century, high fertility rates among low-income women served to perpetuate the intergenerational transmission of poverty and disadvantage. Centralized government policies, geographic isolation and uneven regional

53 Beginning in the late 1980s, most countries in Latin America opened their economies to international competition, implemented major stabilization programs and embarked on ambitious privatization programs of state-owned firms. The intensity and scope of free-market reforms varied across countries. In general, though, liberalization policies led to higher rates of growth, productivity and foreign capital inflows (Edwards, 1995). 54 During the fifteenth century, colonizers imposed on indigenous societies an economic system based on large landholdings, forced labor and natural resource extraction. The elites that controlled this exploitative arrangement restricted democracy and opposed investment in human capital (Engerman and Sokoloff, 1997; 2000).

27 development further contributed to rising inequality between prosperous and marginalized regions within national borders (Inter-American Development Bank, 2003). By the late 1980s, Latin America had the most unequal distribution of income in the world (Lustig, 1995). According to a study by Psacharopolous (1997), the average Gini coefficient for Latin America at this time was 0.50, compared with 0.39 for non-Latin American countries. 55 The wealthiest 20 percent of the population in Latin America had an income 10 times greater than that of the poorest 20 percent; the comparable figure for a sample of low- and middle-income countries across other regions was only 6.7 times (Lustig, 2005 (2)). During the 1990s, governments in Latin America introduced programs designed to reduce both poverty and inequality. 56 Unfortunately, increased social spending and investment in human capital failed to produce a significant reduction in poverty or income inequality (Dion, 2007). According to World Bank (2005) estimates, 9.7 percent of Latin Americans were living on less than one dollar a day and 26.9 percent were living on less than two dollars a day in 1981. As of 2001, these figures were still 9.5 percent and 24.5 percent, respectively. The problem of persistent inequality is compounded by social exclusion. 57 While today the social cost of exclusion is singled out as a crucial policy issue, “only two generations ago exclusion was so thoroughly woven into the fabric of Latin America that it was simply accepted” (Thorp, 1998 (xi)).

Today, the socioeconomic situation in Latin America remains precarious. Furthermore, after less than a decade of renewed growth, Latin American countries are experiencing greater instability in most macroeconomic indicators than in the years prior to the restructuring. 58

55 The figure for non-Latin American countries is based on a joint World Bank/International Labor Office study of income distributions in 23 industrialized and developing countries during the 1960s and 1970s. Although the Gini coefficient estimate for Latin America reflects a more recent period, Psacharopolous (1997) argues that “the disparity…between LAC countries and non-LAC countries is still quite relevant, and could possibly have increased over time” (19). 56 International financial institutions promoted targeted social spending as a means to cushion the impact of the economic crisis (World Bank 1990; Inter-American Development Bank 1998). 57 Social exclusion is both a cause and consequence of inequality; it extends the concept of inequality to groups who share a common identity (such as gender, age, race, ethnicity disability, HIV/AIDS, migration status or other excluding features). Excluded populations typically suffer multiple and cumulative disadvantages, prejudice and discrimination; for instance, primary school enrollment rates are lower and child mortality is higher for children of indigenous families (Inter-American Development Bank, 2003). 58 Potter (2001) captures the near-universality of this situation: “Per-capita growth, enhanced flows of foreign investment, and increases in labor productivity slowed and eventually ended in a debt default, currency

28 The Contemporary Microfinance Landscape

Today, the microfinance landscape in Latin America is dynamic and diverse, competitive and transformative. According to 2007 estimates, there are over 600 institutions serving more than 8 million clients and providing US$8.6 billion in credit in 25 countries. 59 In 2001, by contrast, institutions reached only 1.8 million clients and had a total portfolio of approximately US$1 billion. Figure 3 shows the growth in microfinance portfolio size and client outreach in Latin America and the Caribbean over the period 2000-2007.

Figure 3: Growth Figures for the Latin American Microfinance Industry 2000-2007

devaluation, and political disaster in Argentina in late 2001. Once hailed by neoliberals as a model of economic reform, Mexico is struggling to reach its modest growth targets, and the legislative impasse under President Fox stymied the enactment of important fiscal reforms. Mass protest in Bolivia toppled President Sánchez de Losada and his market-based policies in 2003 and led to a landslide victory for the anti-neoliberal Evo Morales in 2006. Ecuador’s bond default and banking collapse contributed to the abandonment of the sucre for the dollar in 2000, as well as a new tradition of premature executive departure. For Colombia and Peru, the dramatic improvements in fiscal performance and high economic growth of the 1990s have slipped into budget deficits and a precarious reliance on traditional primary exports or U.S. security funds to sustain financial solvency. Brazil is highly indebted and is growing at a relatively slow rate compared with its historical average. For all countries in the region except Chile, projected increases in gross domestic product (GDP) barely match or fall below expected increases in population. The neoliberal triumphalism of the early 1990s has receded, leaving a dark cloud over the rationale and promise of free-market economic reforms” (4). 59 The 25 countries in the Inter-American Development Bank survey include Argentina, Barbados, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Guyana, Haiti, Honduras, Jamaica, Mexico, Nicaragua, Paraguay, Panama, Peru, Saint Lucia, Suriname, Trinidad and Tobago, Uruguay, and Venezuela.

The microfinance industry is also highly commercial; regulated financial institutions provide almost 70 percent of the total loan volume and serve over half of all borrowers (Inter- American Development Bank, 2008). Tables 3 and 4 list the leading Latin American MFIs by microenterprise loans outstanding and market penetration.

Table 3: Top MFIs by Number of Loans Outstanding

MFI Country Microenterprise Loans Outstanding 1 CompartamosBanco Mexico 837,743 2 CrediAmigo Brazil 329,071 3 MiBanco Peru 245,028 4 WWB Cali Colombia 209,693 5 FMM Popayán Colombia 196,519 Source: MIX Market, “Championship League: Latin America and the Caribbean 100,” Microenterprise Americas , Fall 2008.

Table 4: Top MFIs by Market Penetration

MFI Country Microenterprise Loans/ Poor Population 1 BancoEstado Chile 5.6% 2 CompartamosBanco Mexico 4.6% 3 Fondo de Desarrollo Local Nicaragua 2.4% 4 Visión de Finanzas Paraguay 2.3% 5 FIELCO Paraguay 1.8% Source: MIX Market, “Championship League: Latin America and the Caribbean 100,” Microenterprise Americas , Fall 2008.

While the MFIs listed above are among today’s top performers – in fact, they are often more profitable than mainstream commercial banks in their respective countries – the microfinance landscape features a diversity of institutional structures and legal forms. In the next section, I provide an overview of the different types of microfinance providers in Latin America.

a) Typology of Commercial Microfinance

Microfinance institutions can be broadly classified into two categories: regulated and unregulated institutions. In order to obtain a license, MFIs must be sustainable; thus, all licensed, regulated institutions operate on a commercial basis (Christen, 2000). Unregulated microfinance institutions, namely NGOs and credit unions, are typically not sustainable.

30 i) Regulated Microfinance Institutions

Regulated microfinance institutions include transformed microcredit NGOs, specially licensed microfinance institutions, commercial banks and finance companies. First, a significant number of nonprofit institutions and foundations transform into regulated financial institutions under the same legal structure as traditional banks. After Bolivian NGO Prodem (later BancoSol) was granted a full banking license in 1992, other institutions – Corposol (later Finansol) in Colombia, AMPES (later Financiera Calpia) in El Salvador and Accion Communitario del Peru (later MiBanco) in Peru, among others – followed the Bolivian model. Another group of regulated MFIs includes NGOs that transform into specially licensed MFIs and municipally owned local non-bank intermediaries. This second group of NGOs is distinct from the first group in that the former become licensed under a special microfinance law, whereas the latter transform under the general banking law. In Peru, for example, local financial intermediaries known as cajas municipales were set up to capture deposits. 60 Finally, a number of traditional banks and finance companies now target the same clientele as microfinance institutions (Rhyne and Christen, 1999).61 After an initial “demonstration effect” by NGOs, “downscaling” commercial banks entered the microfinance sector as a new niche market, integrating microfinance-specific lending methodologies into their core business strategy. 62 This approach is most widespread in Chile, where the government directly subsidizes the entry of commercial banks into the market for microfinance (Valenzuela, 2002). Examples of conventional financial institutions that target microfinance clients include Banco del Pacifico in Ecuador, Banco Empresarial in

60 Peru is an interesting case study due to the coercive nature of its commercialization process relative to other Latin American countries. MFIs were brought into the non-bank financial sector from the beginning and were subject to regulation and supervision. The Peruvian government has since adopted new legislation to force NGOs into a regulatory regime. 61 Because conventional financial institutions do not concentrate primarily on microfinance, their portfolios in this sector do not normally exceed 10 percent of total assets (Almagro and Fiestas, 2003). 62 In a recent survey of 220 banks in 60 countries, 48 percent of the 148 banks listed “profitability” as the primary reason for making micro and small enterprise loans. The second most common response (44 percent of banks) was changing market conditions and increased competition in traditional market segments (such as lending to medium-size enterprises and large corporations). Fewer banks were motivated by non-commercial factors: 20 percent stated poverty alleviation or social mission and 17 percent gave government regulation as the reason for entry into the microfinance sector (Jenkins, 2000).

31 Guatemala, Banco del Comercio in Costa Rica, FASSIL in Bolivia and Cooperation Liberacion in Chile (Almagro and Fiestas, 2003). Consumer finance companies also attract microfinance clients with a wider product range than traditional MFIs. 63 In Argentina, Brazil, Colombia and Mexico, for example, consumer finance to salaried employees represents one of the fastest growing segments of the financial sector. During the ten years it took Chilean microfinance institutions to build a portfolio of 83,000 clients, seven consumer finance companies collectively reached 2.8 million consumer loan clients, or approximately half of the country’s workforce. In Paraguay, small finance companies receive a significant portion of their net income from microcredit (Christen, 2001).

ii) Unregulated Microfinance Institutions

Although regulated institutions are driving the commercialization of microfinance, as of 2007 NGOs supplied approximately 31 percent of funds to microenterprises in Latin America (Inter-American Development Bank, 2008). The dominance of unregulated NGOs is particularly pronounced in countries like Nicaragua, where commercialization is still nascent and commercial banks have not yet entered the microfinance market. Credit unions 64 also provide microfinance services and, like NGOs, are not subject to regulation by the state banking supervisory agency. However, they may come under the supervision of a regional or national cooperative council (MIX Market, 2008).

b) Defining Characteristics of Latin American Microfinance

Latin American microfinance has certain features that distinguish it from microfinance experiments in Asia, Africa, Eastern Europe and elsewhere.

63 It is important to consider the implications of a growing consumer finance sector for microfinance institutions, as anecdotal evidence suggests that the overlap between consumer finance and microcredit is threatening the competitive position of MFIs. In Chile, for example, Banco del Estado reported that 30 percent of loan applicants had received personal credit from banks and finance companies. 64 Credit unions were established in the 1950s, 1960s and 1970s with the goal of helping the poor. Early credit unions lacked professional management (many were organized by Catholic priests or U.S. Peace Corps volunteers) and, despite charging low interest rates, were generally ineffectual at loan recovery and portfolio expansion. More recently, credit unions have improved financial sustainability. According to a recent IDB/CGAP survey, at the end of 2001 credit unions in 17 Latin American countries provided loans to about 1.5 million microentrepreneurs. In the same year, MFIs served an estimated 1.8 million borrowers (Ramirez, 2004).

32 First, microfinance institutions in Latin America stand out for their integration into the formal financial system and for their impressive scale, growth, operational self- sufficiency, profitability and financing capabilities (Miller, 2003). Regulated MFIs in the region are not only more profitable than comparable institutions in other developing countries; in many instances, they outperform traditional banks and finance companies (Christen, 2001). Table 5 compares the portfolio risk and profitability of upgraded MFIs with corresponding performance figures for the national banking sector.

Table 5: Performance of Upgraded MFIs Relative to Country Averages

Country Institution or Sector PAR>30 ROA ROE Operating Expense/ (%) (%) (%) Avg Portfolio (%) Bolivia BancoSol 5.40 1.30 11.0 12.6 Financial Sector Average 13.7 0.42 4.21 6.85 Colombia Finamerica 4.20 1.90 11.3 16.3 Financial Sector Average 3.15 2.66 24.5 9.35 El Salvador Banco ProCredit 2.17 1.30 10.0 12.5 Financial Sector Average 2.16 1.05 9.64 4.62 Mexico Compartamos 0.60 20.0 54.0 35.6 Financial Sector Average 1.99 1.91 15.7 5.08 Nicaragua Banco ProCredit 1.89 4.00 25.1 15.9 Financial Sector Average 2.38 2.17 26.8 9.55 Peru MiBanco 2.90 5.80 33.9 18.8 Financial Sector Average 2.68 1.53 21.3 6.81 Note: PAR>30 is the portfolio at risk for more than 30 days. This ratio is calculated as the sum of the past due loan portfolio and loans in legal recovery as a percentage of the total portfolio. Source: Berger, Goldmark and Miller Sanabria, 2006 (57)

Second, unlike their counterparts in rural Asia, most Latin American microfinance pioneers began as private, nonprofit organizations working in urban markets. 65 Although they targeted the poor (and low-income borrowers still comprise the majority of their client base), these institutions were concerned more about outreach to the unbanked in general than to the poor in particular. The majority of Asian and African institutions, by contrast, focused exclusively on the poor (Berger, Goldmark and Miller Sanabria, 2006). These historical differences in mission and target group persist today.

65 For example, BancoSol was created following the collapse of Bolivia’s populist regime in order to address the problem of widespread urban unemployment and to provide credit to the cash-strapped informal sector. The institution targeted the “economically active poor” – low-income people with established businesses in need of capital. From the start, then, “Bolivian microcredit certainly saw itself as ‘pro-poor’ but also saw itself as a business, potentially as a branch of commercial banking” (Rutherford, 2003).

33 Third, while the microfinance industry has grown at an estimated annual rate of 30 to 40 percent over the past three to five years, Latin American MFIs have not achieved the same massive scale found in some Asian institutions. The average number of borrowers per MFI is 130,000 in Asia, compared with only 31,000 in Latin America (Berger, Goldmark and Miller Sanabria, 2006 (5)). On the other hand, the average gross loan portfolio for Latin America is almost 75 percent larger than that for Asia (Miller, 2003 (3)).66 Fourth, it is important to highlight the uneven development of microfinance across regions. Market penetration rates range from 55.7 percent in Bolivia to 0.8 percent in Venezuela (Marulanda and Otero, 2005).67 In general, the small and medium-sized countries of Central America and the Andean region – Bolivia, Ecuador, Peru and El Salvador – are the leaders in microfinance (Economist Intelligence Unit, 2007). By contrast, the microfinance sector is virtually undeveloped in large countries such as Argentina, Venezuela, Uruguay and, to a lesser extent, Mexico and Brazil.68 This seemingly paradoxical situation can be explained by the relative scarcity and limited success of NGOs in large Latin American markets, as well as the strong presence of state development banks and disinterest on the part of commercial banks in microfinance (Ramirez, 2004). Furthermore, there is a crucial link between microfinance penetration and demand, on the one hand, and regulatory, investment and institutional climates, on the other (Economist Intelligence Unit, 2007; 2008). Figure 4 depicts graphically the regional disparity in access to microfinance services. Figure 5 ranks Latin American countries according to the quality of their microfinance business environments. 69 In addition to the cross-regional skew in microfinance outreach, wide disparities exist in terms of institutional viability within countries. Large, established MFIs consistently outperform, while smaller providers tend to operate at a substantial financial loss (Montgomery and Weiss, 2005).

66 These discrepancies can be explained in part by differences in population and in wealth. First, the population in Latin America is 14 percent of the population in Asia, while the number of microfinance borrowers in the former region is only six percent of that in the latter. Second, many Latin American countries have a higher GNP per capita than African or Asian countries, leading to larger average loan sizes. 67 Penetration rates are based on Westley’s (2001) study of the size of the microenterprise sector in various countries. Marulanda and Otero (2005) conservatively estimate the potential demand for microfinance services at 50 percent of the microbusinesses in Westley’s survey. They then compare the estimated size of the market with current market coverage to calculate microfinance penetration rates for each country. 68 Given that more than 50 percent of Latin America’s microentrepreneurs live in these countries, a critical challenge for microfinance practitioners going forward will be to expand the microfinance revolution to underserved areas. 69 The ratings are based on 13 indicators – regulation and supervision of microcredit operations, governance and accounting standards, capital market and judicial system development, political stability, credit bureaus and MFI development – and provide an indication of the business climate for regulated and non- regulated MFIs.

Figure 4: Share of Microenterprises with Credit

Figure 5: Favorability of the Microfinance Business Environment

Fifth, Latin American institutions tend to be highly responsive to customer demand. Microfinance as a business model includes not only loans but also other financial services, such as short-term working capital loans, savings facilities, currency exchange, local tax collections, public utility payment services and microinsurance (Berger, Goldmark and Miller Sanabria, 2006). An area that is receiving particular attention is remittance services; according to the Inter-American Development Bank (2006), migrant remittances to Latin America and the Caribbean exceeded US$53.6 billion in 2005, making the region the largest remittance market in the world. Last, the microfinance industry attracts individual and commercial investors who, through their involvement in professionally managed microfinance funds, channel money to commercial MFIs. 70 While institutions in Asia and Africa typically rely on savings deposits and equity, institutions in Latin America tend to borrow from private sources to fuel growth. In fact, a growing portion of borrowing in Latin America is obtained from institutional investors, including pension funds, investment banks and international investment and capital development funds, at market rates (Miller Sanabria and Narita, 2008). This trend toward greater reliance on commercial sources of capital reduces donor dependence and facilitates outreach.

Conclusion

“Twenty years ago, the main challenge in microfinance was methodological: finding techniques to deliver and collect uncollateralized loans to “microentrepreneurs and poor households. After notable successes on that front, the challenge today is a more systemic one: finding ways to better integrate a full range of microfinance services with mainstream financial systems and markets.” – Littlefield and Rosenberg, 2004

With growing awareness that building financial systems for the poor necessitates sound domestic financial intermediaries that can mobilize deposits and recycle domestic savings, an increasing number of unregulated MFIs are obtaining licenses to operate as banks or specialized finance companies. Given that the failure of commercial financial institutions to reach the poor provided the initial impetus for microfinance experiments, “this new trend is

70 As of mid-2004, investors had placed nearly US$1.2 billion in debt, equity and guarantees in approximately 500 MFIs and cooperatives (Ivatury and Abrams, 2005). Over 40 percent of this amount was directed toward Latin America and a further 46 percent went to Eastern Europe and Central Asia. These regions have a large number of regulated MFIs, which explains the high concentration of investment by geography.

36 paradoxical and raises the question of whether the initial poverty reduction objectives of the transformed NGOs will be subjugated to commercial criteria (so-called “mission drift”)” (Montgomery and Weiss, 2005 (3)). There is also a recent trend in the opposite direction – traditional banks penetrating into the microfinance market niche in order to expand their client base. While in theory regulated MFIs embody the “ultimate promise of microfinance” (Morduch, 2004) – the realization of institutional sustainability and strong social performance – in practice commercial microfinance entails a complex set of tradeoffs and challenges. The next section evaluates the implications of the rapid commercialization of the microfinance industry.

IV. Commercialization: Promise or Peril?

Commercial microfinance is predicated on a commitment to financial sustainability and profitability. While commercialization often leads to improvements in client service, diversification in lending products, lower interest rates on loans and a wider target group, it may also have adverse consequences, such as client over-indebtedness and systemic risk for MFIs. For this reason, academics, policymakers and practitioners must consider both the benefits of commercialization in terms of wider outreach and increased efficiency, as well as the potentially detrimental effect of the profit motive on the social mission of MFIs. This section provides the theoretical foundation for the empirical work in Section V. It identifies the key issues in the commercialization debate and presents the underlying questions that motivated the regression analysis in this paper.

4.1 The Promise of Commercial Microfinance

In theory, commercialization promises access to cheaper sources of funds, broader outreach, lower prices, a wider range of financial products and services and improved performance standards. First, commercialization enhances the financing capabilities of MFIs by removing barriers to deposit mobilization. 71 According to Frank (2001), regulatory policies in most countries prohibit nonprofit, unregulated institutions from collecting savings. By registering as formal financial entities, MFIs can gain access to local savings deposits. 72 Today, the demand for savings is immense: while billions of poor people do not operate microenterprises, they do save, albeit in small amounts and often at inconsistent intervals. 73

71 See Otero (1989), Jackelen and Rhyne (1991) and Fiebig, Hannig and Wisniwski (1999) for a detailed discussion of the advantages and disadvantages of savings mobilization as a funding source for MFIs. 72 In practice, regulated MFIs continue to have difficulty capturing savings. Furthermore, institutions must weigh the benefits of savings mobilization against the costs, including the expense and difficulty of developing savings products. Despite these challenges, however, the positive impact of savings mobilization from the client’s perspective is clear: it opens access to larger loan sizes and makes it possible to earn a return on deposits or leverage credit with savings (Robinson, 2001). 73 De Soto (2000) emphasizes the magnitude of this neglected savings capacity: “The value of savings among the poor is, in fact, immense—forty times all the foreign aid received throughout the world since 1945. In Egypt, for instance, the wealth that the poor have accumulated is worth fifty-five times as much as the sum of all direct foreign investment ever recorded there, including the Suez Canal and the Aswan Dam. In Haiti, the poorest nation in Latin America, the total assets of the poor are more than one hundred fifty times greater than all the foreign investment received since Haiti’s independence from France in 1804” (5-6).

38 MFIs that are able to attract voluntary savings can increase loan capital and “expand dramatically the reach of financial services down the socio-economic ladder” (Woller, 2002 (14)). 74 From the perspective of potential clients, savings accounts in regulated MFIs represent a compelling solution to the problem of “dead capital” 75 because they constitute legally recognized assets that can be used as collateral for loans and mortgages (Robinson, 2001 (234)).76 A related gain from commercialization as it pertains to upscaling NGOs is the possibility of leveraging equity from commercial banks. Banks are often reluctant to lend to unregulated MFIs without some form of guarantee facility. Commercial MFIs can also raise capital on world bond and equity markets. With the ability to access funds from diversified sources, MFIs can reduce the risk of liquidity shortfall (especially in times of economic crisis), expand their portfolios (while simultaneously decreasing donor dependence 77 ), and increase market penetration (Ledgerwood and White, 2006). Third, commercial microfinance is associated with increased competition and product diversification. As the number of microfinance providers increases and a dynamic market develops, institutions will expand their geographic coverage and lower interest rates (Steger, Schwandt and Perisse, 2007 (56)). They will also have an incentive to design new loan products that reflect the needs of a heterogeneous client base. For example, Banco Solidario de Ecuador 78 significantly expanded its product range post-transformation in order to improve its competitive position. 79

74 In fact, empirical evidence shows that some credit unions and MFIs are able to fund their entire loan portfolios from small-scale savings. 75 De Soto argues that the property of the poor is “dead capital”: “it exists in a universe where there is too much room for misunderstanding, confusion, reversal of agreements, and faulty recollection.” This situation is problematic because assets cannot be used in efficient and legally enforceable market transactions if ownership is not readily validated and exchanges are not governed by a defined set of rules (De Soto 2001, 13-14). 76 Although poor people have assets – houses, farms and small businesses – the ownership rights to these properties are generally not adequately recorded or legally enforceable. In other words, they “cannot readily be turned into capital, cannot be traded outside of narrow local circles where people know and trust each other, cannot be used as collateral for a loan, and cannot be used as a share against an investment” (de Soto, 2000 (6)). 77 Bogan, Johnson and Mhlanga (2007) uncover a negative relationship between MFI sustainability and the use of grants. This finding reinforces the view that donor dependence hinders the development of competitive and sustainable MFIs and, instead, leads to costly outreach and inefficient operations. 78 Banco Solidario de Ecuador was created in 1995 when two entities – a for-profit finance company and an NGO – merged to form a hybrid institution with a double bottom line strategy. 79 According to Brand (1999), the new offerings “represent a shift [away] from the supply-driven products typically offered by most microfinance institutions” (1) and toward the product range of classic retail banking.

39 Last, commercialization promises to provide a framework for enhanced performance standards. According to a Sustainable Banking with the Poor survey (1996), numerous MFIs do not have accurate accounting systems; “[and] if some managers of microﬁnance institutions are unable to answer questions about their own costs and arrears without the help of outside experts, how can they be expected to run sustainable financial institutions?” (World Bank, 1996 (4)) Effective accounting standards and prudential regulations can improve MFI planning, product pricing and resource allocation. They can also attract private and institutional investors, many of whom require transparent and accurate financial statements in order to make investment decisions (Woller, 2002).

Upscaling and downscaling represent, respectively, the extension of nonprofit microfinance into the formal financial sector and the penetration of for-profit commercial banking into the market for microfinancial services. But commercialization goes deeper than the simple integration of formerly separate sectors; it entails a connection with the capital markets. Such a connection “is a watershed in the fact that, if accomplished, it will make the outreach of microfinance to date…a mere prologue for what will come. The millions reached today will increase a hundredfold” (Robinson, 2001 (25)). Perhaps the most compelling illustration of the promise of commercial microfinance is the case of Banco Compartamos, a leading microfinance institution in Mexico (CGAP, 2007). 80 In April 2007, Compartamos completed a landmark public offering (IPO) of its stock in which insiders sold 30 percent of their holdings to new investors. 81 The sale was oversubscribed by 13 times – a remarkable success by any market standard – and resulted in a market valuation of the company at over $1.5 billion. For supporters of Compartamos, the IPO represents the future promise of private sector investment in microfinance. It also underscores the advantages of commercialization in terms of outreach; by the end of 2006, Compartamos was serving 616,000 borrowers, compared with only 60,000 prior to its transformation from NGO into regulated finance company in 2000.

80 From 1990 to 2000, Compartamos operated as an NGO. During this time, it received US$4.3 million in grants and soft loans from international development agencies and from private Mexican investors. In order to gain access to commercial funds, Compartamos transformed into a regulated, for-profit finance company in 2000. Public development agencies and socially oriented investors contributed $45 million toward a successful transformation. In 2002, Compartamos issued US$20 million in bonds on the Mexican stock market. Finally, in 2006, Compartamos received a full banking license from the Mexican government. 81 Initial investors in Compartamos injected $6 million into the bank between 1998 and 2000; with the sale of their 30 percent stake in 2007, they received an astounding $450 million.

40 But not all members of the microfinance community rejoiced at the news of the successful IPO. Muhammad Yunus, for example, raised concerns about the exorbitant interest rates – in excess of 100 percent – on Compartamos loans. The Compartamos IPO thus highlights the tension in commercial microfinance between public and private benefit (Epstein and Smith, 2007). In the next section, I consider the limitations of a commercial microfinance model.

4.2 The Peril of Commercial Microfinance

A central theme in the literature on commercialization is “mission drift” 82 – the tradeoff between financial and social objectives as MFIs place increasing emphasis on sustainability and profitability. This academic discussion is an extension of the contemporary public policy debate between welfarists, who stress outreach to the poor (Woller, 2002; Montgomery and Weiss, 2005; Hashemi and Rosenberg, 2006), and institutionists, who emphasize sustainability and efficiency (Rhyne, 1998; Christen, 2001; Isern and Porteous, 2006). Mission drift is arguably the greatest “peril” of commercialization, as it constitutes a marked deviation from the raison d’être of microfinance – namely, poverty reduction. 83 To what extent do transformed NGOs and other regulated MFIs abandon their initial social mission in pursuit of higher financial returns? It is difficult to quantify the magnitude of this tendency to drift up-market, but the forces behind it are clear: “the unsatisfied credit demand among the disadvantaged nonpoor, the not-so-poor, and the poor, together with the high costs of targeting and reaching the very poor, creates an almost irresistible pull for [MFIs] to move upscale to wealthier and more profitable market segments” (Woller and Woodworth, 2001 (274)).

82 Mission drift has a number of different interpretations; however, it is most often associated with institutions moving up-market from where they would naturally situate themselves in order to generate higher returns. Hishigsuren (2007) provides a broader definition, arguing that mission drift encompasses depth of outreach, quality of outreach and scope of outreach. Depth of outreach is reflected in demographic statistics, such as client income levels, interest rates and average loan sizes. Quality of outreach captures client satisfaction and is often evaluated through client-employee ratios. Scope of outreach refers to the various types of services offered, including both financial and nonfinancial services. While Hishigsuren’s broad conceptual framework captures the multidimensional nature of outreach, it is difficult to apply to cross-country empirical analyses of mission drift due to the absence of complete and publicly available data on microfinance institutions and clients. 83 The initial objective of microfinance was poverty alleviation. However, the microfinance industry today consists of a spectrum of MFIs serving diverse market niches. These institutions have different missions and many do not see poverty reduction as their main objective (Gulli, 1998).

41 Furthermore, when NGOs transform from unregulated, non-profit and usually donor- dependent entities to regulated, for-profit and financially sustainable non-bank financial institutions or commercial banks, they adopt a new institutional governance structure. Whereas before management was responsive to social investors seeking to maximize social impact, under a commercial model the fiduciary duty of the board is to serve the interests of profit-maximizing investors. True, shareholders may sanction behaviors that emphasize social over financial return; however, such actions effectively constitute a subsidy to the MFI, a practice that, as previously discussed, is counter to the rhetoric of sustainable microfinance (Woller, 2002). Another peril of transformation relates to innovation. According to Dichter (1996), “the NGO contribution has been, as it should be, to take a chance, to innovate and experiment and to show the way to others” (268). 84 Nonprofit institutions are often in a better position to experiment with new products, methodologies and technologies and thereby extend the provision of sustainable financial services even further down the socioeconomic ladder. 85 Third, commercialization can lead to client over-indebtedness and systemic risk for MFIs. While in some countries MFIs have a near-monopoly position, in other countries they face intense competition. 86 Competition may create problems if lenders overextend themselves or borrowers obtain credit from multiple institutions. The Bolivian microfinance industry took on these dimensions in the late 1990s when competitive pressures, aggressive lending tactics, overindebtedness and economic recession contributed to high delinquency and falling profits at leading MFIs (Rhyne, 2001). Finally, both upscaling and downscaling entail a set of organizational challenges. Transformed NGOs must adopt incentive systems geared toward profit maximization while preserving the integrity of their social missions. Commercial banks, on the other hand, must

84 Dichter further argues that “NGOs who shift into sustainable credit programs may be losing their real competitive advantage in the world of development – their capacity to reach the very poorest and engage in a variety of activities that help people change, but which cannot necessarily be financially supported by the recipient of the assistance.” 85 A notable exception to this general conclusion is the collaboration between commercial banks and self-help groups (SHGs) in India (Harper, 2002). SHGs are indigenous groups of approximately 20 members that band together for purposes of training, education, political activism or accessing financial services (they resemble in many ways the village banks in traditional microfinance). In India, 41 commercial banks, 166 regional banks and 111 co-operative banks have extended loans to approximately 235,000 SHGs representing four million people. The SHG model is low-cost, highly flexible and integrated into the formal financial system; for these reasons, the Indian government is aggressively promoting it as an alternative to traditional microfinance and a viable solution to the persistent dilemma of how to achieve the twin goals of outreach and institutional sustainability. 86 In regions of Bolivia and Bangladesh, for instance, the market for microfinance services is saturated (Duquet, 2006).

42 overcome “an entrenched corporate culture that is usually antithetical to microfinance” (Rhyne and Christen, 1999). In some instances, institutions are unable to surmount these difficulties and transformation results in portfolio deterioration, among other problems. 87

4.3 Conclusion

The Latin American microfinance industry is becoming increasingly integrated into the formal financial system: NGOs are upscaling, commercial banks are downscaling and socially oriented MFIs are forging partnerships with banks to leverage comparative advantages (Uy, 2005). 88 Leading microfinance practitioners support the formalization of microfinance operations, arguing that the future of microfinance lies in a licensed setting (Christen and Rosenberg, 2000).89 But the current push for commercialization and regulation is not justified by robust cross-country empirical analyses; instead, it is based on the success of a number of transformed incumbents. Unfortunately, the experiences of individual institutions may not have universal applicability, as institution- and country-specific factors can influence outcomes. Furthermore, while some organizations have achieved impressive results both prior to and after becoming regulated, recent theoretical work suggests that heightened competition has changed the microfinance landscape in such a way that donor support for regulated MFIs alone may be misguided (McIntosh and Widyck, 2005). Finally, it is important to consider the possibility of self-dealing and “regulatory capture”; established

87 Finansol, a regulated financial intermediary in Colombia that grew out of NGO Corposol, experienced major difficulties with transformation. It inherited a sound loan portfolio, a proven lending methodology and a track record of operational profitability. However, a number of factors – product over- diversification, organizational flaws and misguided management decisions – culminated in the rapid deterioration of Finansol’s financial position. While Finansol has since recovered from the crisis, the experience highlights the potential pitfalls of institutional transformation. For more information on the Finansol crisis, please refer to Patricia Lee (2001). 88 In countries as diverse as Haiti, George and Mexico, partnerships between commercial banks and MFIs represent a compelling alternative to MFIs seeking their own financial licenses. Partnerships vary in their degree of engagement and risk sharing, ranging from common office space to direct equity investment (Littlefield and Rosenberg, 2004). 89 Much of the policy debate focuses on NGOs. Without legal charters to govern their financial operations, these institutions cannot mobilize savings, obtain public funds or engage in financial intermediation. By obtaining special licenses or transforming into full-fledged banks, NGOs can access savings deposits, leverage debt and equity from the capital markets, improve operations and broaden outreach.

43 MFI networks may promote regulation to prevent entry by future competitors or limit access to donor funds and equity investments. 90 The contribution of this paper is to move beyond a theoretical discussion of the promise and peril of commercial microfinance and to evaluate empirically the tradeoffs and synergies between financial sustainability and outreach for regulated and unregulated MFIs in Latin America. Furthermore, while a significant amount of research on microfinance relates to “best practices” – the institution-specific strategies and techniques, including product and contract innovations, management processes and organizational structures, which promote strong performance – the literature has largely ignored the crucial relationship between microfinance and the macroeconomy. The empirical analysis in the subsequent section examines this crucial policy issue.

90 Regulatory policy tends to reflect the underlying balance of power among economic, political and public interests. Many instances of regulation do not proceed from a desire to correct market failure but, instead, to serve the interests of a particular group (Posner, 1974; Majone, 1996).

V. Empirical Analysis

Despite increasing pressure on MFIs in developing countries to transform into regulated financial intermediaries, few studies compare the financial and outreach success of regulated and unregulated institutions. This section explores the impact of regulation on MFI sustainability and outreach in Latin America using an empirical model that specifies performance as a function of MFI-specific, regulatory, macroeconomic and institutional variables. Conducting cross-country comparisons of MFIs is a delicate task, as no two institutions are identical in their characteristics and circumstances. MFIs operating in different markets will be affected by different external factors, among them monetary policies, regulatory requirements and macroeconomic conditions. Internal strategic decisions regarding loan size and maturity, urban versus rural focus, and centrality of the poverty alleviation mission also affect MFI efficiency and profitability. Overall, then, “it is a highly subjective exercise to compare and judge microfinance institutions based on financial and operational indicators, because in certain cases their performance and characteristics may be the result of deliberate choices regarding social and financial objectives” (Jansson and Taborga, 2000 (8)). Still, econometric analyses that evaluate MFI performance while controlling for institutional and country-level characteristics produce valuable results for policymakers and academics, business leaders and industry experts, donors and investors. The analysis in this paper seeks to answer the following questions regarding the microfinance landscape in Latin America from 1997 through 2007:

1. Do regulated institutions achieve better financial results, as measured by operational self-sustainability and return on assets, than unregulated institutions? What MFI- and country-specific factors contribute to the varying success of the two groups? 2. How do regulated and unregulated institutions compare in terms of breadth of outreach (number of borrowers) and depth of outreach (percentage of female borrowers and average loan size)? In other words, is there evidence of mission drift? 3. Which macroeconomic, demographic and institutional variables help to explain cross- country differences in overall financial performance and outreach?

45 To address these questions, I assembled a unique data set of 202 MFIs from 15 countries in Latin America over the period 1997-2007. I also collected macroeconomic, demographic, social and institutional data on the countries represented in the sample. The empirical results provide insight into a fundamental issue in commercial microfinance – namely, the existence and magnitude of a tradeoff between institutional sustainability and social impact – and promote a deeper understanding of the degree to which an MFI’s performance depends on its own institutional characteristics, the country-specific environment in which it operates, or other variables. The organization of this section is as follows. Section 5.A describes the data set. Section 5.B addresses the impact of regulation on financial performance; it summarizes the findings of previous empirical studies, presents a conceptual framework to evaluate the sustainability and profitability of regulated and unregulated MFIs in Latin America, and discusses the results of the regression analysis. Section 5.C follows a similar approach in its evaluation of outreach and mission drift. Finally, Section 5.D examines the relationship between average MFI performance and country-level variables.

5.A Data

5.1 MFI Data

a) Data Sources

Historically, MFIs have been reluctant to reveal performance information; however, increased competition for donor funds has led to greater reporting and accounting transparency. The empirical analysis uses data from the MIX Market. 91 The MIX Market platform (www.mixmarket.org ) provides information on MFIs, public and private investors, microfinance networks, rating agencies, advisory firms and governmental and regulatory bodies. The MIX Market also ranks MFIs based on the quantity and quality of their financial

91 The MIX Market began as a United Nations Conference on Trade and Development project under the guidance of a microfinance advisory board and with the support of the government of Luxembourg. In 2001, the Consultative Group to Assist the Poorest (CGAP) expanded the scope of the MIX Market. Formally launched in September 2002, the MIX Market is now part of the MIX (Microfinance Information eXchange), a nonprofit private organization supported by CGAP, the Citigroup Foundation, the Open Society Institute, the Rockdale Foundation and other private foundations. As of December 2008, the site provides information on 1347 MFIs, 103 investment funds and 180 market facilitators.

46 and outreach data using a 5-star system (with 5 being the most complete data available and 1 being the least complete data available). To date, the MIX Market information exchange contains the best publicly available cross-country data on individual MFIs.92 Nevertheless, the data has certain limitations. First, the MIX Market does not adjust MFI reports to compensate for subsidies or to standardize loan loss accounting (Gonzalez and Rosenberg, 2006).93 Second, because the data is self- reported and many MFIs do not provide complete information, there may be selection bias in the sample. For example, MFIs may only begin reporting to the MIX Market after having achieved a particular level of sustainability. In general, it is reasonable to assume that the MIX Market’s coverage of MFIs is skewed toward relatively successful industry performers.

b) Summary Statistics

At the time of data collection, the MIX Market had 338 listed MFIs representing 19 Latin American countries. The panel used for this study utilizes only 4- and 5-star ranked data (i.e. only data from audited financial statements) 94 and excludes institutions for which microfinance represents less than 91 percent of operations. 95 Credit unions are also omitted from the sample, as their governance mechanism and regulatory status differ from those of MFIs (Hartarska and Nadolnyak, 2007). Finally, approximately 25 MFIs were excluded from the analysis due to a lack of financial data or the absence of a sufficiently large MFI sample size for a given country. The final data set consists of 202 MFIs from 15 Latin American countries. 96 Table 6 provides information on the number of observations for each country. Countries with mature microfinance sectors – namely, Bolivia and Peru – are overrepresented in the sample, while countries such as Argentina and Paraguay have a smaller number of observations.

92 Of the reporting institutions, about 81 percent are externally audited and 28 percent independently rated, usually by a firm that specializes in microfinance. 93 A detailed description of the MIX methodology used in data collection can be found at www.mixmarket.org . 94 The only qualitative difference between 4- and 5-star ranked MFIs is that those with a rank of 5 have at least 3 years of financial statements, while those with a rank of 4 have less than 3 years of data. 95 In order to verify and supplement the MIX data, I consulted MFI websites, press releases and annual reports, corresponded with leading microfinance networks, and read case studies, reports and journal articles. In many cases, I was able to obtain more accurate and/or complete information on regulatory status, institution type and financial and social indicators for the MFIs included in the data set. 96 Please refer to Appendix 2 for a complete list of the institutions used in the analysis.

47 Table 6: Number and Share of Observations by Country

Country Name Unregulated Regulated Total Share in Over/Under (REG=0) (REG=1) Sample Representation 97 Argentina 66 11 77 3.47% -3.20% Bolivia 137 94 231 10.40% 3.73% Brazil 0 77 77 3.47% -3.20% Colombia 77 55 132 5.94% -0.73% Costa Rica 110 0 110 4.95% -1.72% Dominican Republic 31 24 55 2.48% -4.19% Ecuador 117 37 154 6.93% 0.26% El Salvador 66 44 110 4.95% -1.72% Guatemala 165 0 165 7.43% 0.76% Haiti 51 15 66 2.97% -3.70% Honduras 57 86 143 6.44% -0.23% Mexico 136 51 187 8.42% 1.75% Nicaragua 170 39 209 9.41% 2.74% Paraguay 11 33 44 1.98% -4.69% Peru 194 268 462 20.79% 14.13% Total 1,388 834 2,222 100.00%

Table 7 summarizes the number of observations by regulatory status and institution type. Of the 2,222 observations in the sample (representing 202 MFIs over the period 1997-2007), 1,388 are unregulated MFIs (mostly NGOs) and 834 are regulated MFIs (banks and non-bank financial institutions).

Table 7: Number of Observations by Regulatory Status and Institution Type

Regulatory Status/ Bank Non-Bank Non-Profit Total Institution Type Financial Institution Organization Unregulated (REG=0) 0 154 1,234 1,388 Regulated (REG=1) 151 507 176 834 Total 151 661 1,410 2,222

Table 8 presents summary statistics for the sample. A number of salient observations emerge. First, regulated MFIs achieve (marginally) better financial results than unregulated MFIs. The mean OSS is 120.2 percent for regulated MFIs and 118.2 percent for unregulated MFIs. The corresponding ROA values are 3.5 percent and 2.5 percent, respectively. Second, the

97 This column calculates a country’s over/underrepresentation in the sample (i.e. the deviation from 6.67%, which represents a perfectly weighted sample in which each country has the same number of MFI observations).

48 average capital ratio for regulated MFIs is 0.25, compared with 0.47 for unregulated MFIs. 98 In general, MFIs are much less leveraged than banks due to the increased risk associated with microfinance loan portfolios.99 Third, while a small number of unregulated MFIs in the sample mobilize saving, most unregulated institutions do not have the legal authority to capture public deposits. 100 Thus, the savings (deposits) to total assets ratio is considerably higher for regulated institutions. 101 Fourth, regulated and unregulated MFIs have identical mean write-off ratios; in other words, it appears that asset quality and delinquency rates are relatively constant across institutions. 102 Finally, in terms of outreach indicators, regulated MFIs in the sample reach more borrowers than unregulated MFIs, although the former have proportionally fewer female clients than the latter. Regulated institutions also extend larger loans than unregulated institutions. Overall, the descriptive statistics are consistent with the discussion in Section IV regarding the possible tradeoff in commercial finance between profitability and breadth of outreach, on the one hand, and social mission and depth of outreach, on the other.

98 According to Conning (1999), reaching the poorest of the poor is more costly than reaching other segments of the population; for this reason, unregulated institutions that target the lower end of the market may find it difficult to achieve leverage. 99 Barth et al. (2003) report an average capital ratio of 0.13 for a sample of banks from 47 countries. According to the Basel rules on capital adequacy standards, banks can have as little as US$8 of equity for every US$100 of risk-weighted assets. As of January 2008, commercial banks in the US had leverage ratios of approximately 10-12 times and investment banks of 20-25 times (Prasad, 2009). 100 Approximately two percent of unregulated MFIs in the sample have savings, possibly because savings mobilization is part of a group lending technology (Hartarska and Nadolnyak, 2007). 101 Not all regulated MFIs mobilize savings and many institutions (both regulated and unregulated) do not provide data on savings mobilization. Of the 827 regulated MFIs in the sample, approximately 30 percent have savings, 23 percent do not have savings and a further 47 percent do not provide such information. Unfortunately, the data does not distinguish between voluntary and compulsory savings. 102 Jansson and Taborga (2000) find similar patterns in institutional form, size and maturity for Latin American MFIs. NGOs tend to have lower debt-to-equity ratios and relatively higher measures of solvency and liquidity. Regulated MFIs, on the other hand, more closely resemble commercial banks in terms of leverage, solvency and efficiency. In some respects, though, there is little or no distinction between different institutional forms: NGOs and regulated MFIs perform similarly in terms of asset quality.

Table 8: Summary Statistics for Regulated and Unregulated Institutions

Unregulated (REG=0) Regulated (REG=1) Mean Std. Dev Min Max Mean Std. Dev Min Max OSS 1.18 0.433 0.00240 5.93 1.20 0.278 0.225 3.38 ROA 0.0248 0.176 -1.82 0.519 0.0353 0.0645 -0.680 0.294 ROE 0.0369 0.496 -4.73 1.32 0.0435 2.28 -3.77 1.31 AGE 13.9 6.54 1 34 14.5 6.97 2 34 SIZE 15.0 1.49 9.21 19.7 16.7 1.73 10.3 21.9 CAPITAL 0.473 0.238 0.00175 1 0.250 0.193 0.00931 0.948 LOANS 0.768 0.158 0.0624 1.33 0.777 0.123 0.140 1.10 SAVING 0.00917 0.0616 0 0.699 0.266 0.284 0 0.860 WRITEOFF 0.0196 0.0329 0 0.383 0.00196 0.0291 0 0.302 WOMEN 0.691 0.225 0 1 0.566 0.175 0 1 NB 8.58 1.54 0.693 13.6 9.80 1.39 6.52 13.8 AVGLOAN 6.08 0.903 1.95 8.98 6.72 0.797 3.55 9.04

5.2 Country Data

a) Data Sources

In addition to information on individual microfinance institutions, I collected data on country-specific demographic characteristics, macroeconomic variables and institutional frameworks. Demographic indicators – namely, population and population density – were retrieved from the World Bank (World Development Indicators Database). 103 Macroeconomic data on gross domestic product, gross national income, inflation, remittances, foreign direct investment and official development assistance, among other indicators, was obtained from the following sources: the International Monetary Fund (International Financial Statistics Division), the World Bank (World Development Indicators Database, National Accounts Database and Doing Business Database) and the United Nations (Organization for Economic Co-operation and Statistics Division). Finally, the econometric analysis employs two indices – the Heritage Foundation Index of Economic Freedom 104 and

103 Data on poverty, inequality, unemployment and literacy was also obtained (from the World Bank and the United Nations), but these variables were later excluded from the analysis due to the unavailability of complete, continuous data over the period under consideration. 104 Each year, the Heritage Foundation publishes an Index of Economic Freedom that provides a systematic, empirical evaluation of economic freedom in countries throughout the world. 104 A country’s overall level of economic freedom is calculated based on a weighted average of ten different freedom measures: business freedom, trade freedom, fiscal freedom, government size, monetary freedom, investment freedom, financial

50 the Kaufmann et al. Governance Matters Index 105 – to capture the effect of country-specific institutional and sociopolitical environments.

b) Summary Statistics

Table 9 presents country-level data on key macroeconomic, demographic and institutional indicators. GDP per capita is highest in Mexico and Argentina and lowest in Haiti. In terms of macroeconomic stability, it is interesting to note that Bolivia and Peru, the leaders in microfinance according to the Economist Intelligence Unit’s Microscope on the Microfinance Business Environment in Latin America and the Caribbean , have among the lowest average inflation rates over the period under study. Population density is low across the region (in fact, it is roughly one third that of the rest of the developing world (Almagro and Fiestas, 2003). While countries have similar property rights scores (ranging from 30 to 50), there is more variation in the political stability and regulatory quality measures. Table 10 summarizes average MFI financial performance and outreach by country over the period 1997 through 2007. The top performers in terms of OSS and ROA are Colombia, Brazil, Mexico, Nicaragua and Paraguay. Countries with more developed microfinance sectors – Bolivia, Ecuador and Peru, for example – also have strong financial results, although margins are lower due to more mature and competitive microfinance industries. MFIs in Argentina, Haiti and Honduras have the lowest average OSS and ROA. In terms of social outreach, MFIs in Bolivia, Colombia, Mexico, Paraguay and Peru reach the most borrowers, while Mexico and the Dominican Republic have the highest percentage of female borrowers. Average loan sizes are variable but tend to be higher in countries with more developed microfinance industries, such as Bolivia and Peru.

freedom, property rights, freedom from corruption and labor freedom. Higher scores (approaching a maximum of 100) indicate a higher level of freedom and a lower level of government interference in the economy. The notion that free institutions that protect the liberty of individuals to pursue their own economic interest result in greater prosperity for society can be traced to Adam Smith’s The Wealth of Nations (1776). For the Heritage Foundation, the highest form of economic freedom signifies “an absolute right of property ownership, fully realized freedoms of movement for labor, capital and goods, and an absolute absence of coercion or constraint of economic liberty beyond the extent necessary for citizens to protect and maintain liberty itself” (Heritage Foundation, 2009 (11)). 105 The Kaufmann et al. Governance Matters Index defines governance as the “set of traditions and institutions by which authority in a country is exercised.” The index measures six dimensions of governance: i) voice and accountability; ii) political stability and absence of violence; iii) government effectiveness; iv) regulatory quality; v) rule of law; and vi) control of corruption. Aggregate indicators for each country are based on several hundred variables measuring perceptions of governance by enterprise, citizen and expert survey respondents. Please refer to the World Bank Governance Matters database for a detailed description of methodology.

51 Table 9: Average Macroeconomic, Demographic and Institutional Statistics by Country 1997-2007 106

Country GDPCAP POPDENS INFL ODA REMITT FINDEPTH BFREEDOM POLSTAB PRIGHTS REGQUAL Argentina 8.52 2.62 0.0764 0.894 1.72 0.302 75.6 40.5 48.2 33.2 Bolivia 6.91 2.09 0.0334 4.32 3.05 0.532 56.0 27.4 40.9 41.0 Brazil 8.21 3.06 0.0744 -0.0645 2.67 0.497 67.1 41.4 50.0 58.1 Colombia 7.69 3.67 0.0710 2.39 4.04 0.335 70.4 4.87 39.1 54.9 Costa Rica 8.37 4.39 0.110 1.03 4.13 0.419 68.0 78.0 50.0 69.1 Dominican 7.76 5.24 0.149 2.28 5.51 0.376 55.3 46.3 30.0 Republic Ecuador 7.61 3.83 0.268 2.63 4.88 0.215 55.6 21.7 37.3 47.2 El Salvador 7.72 5.76 0.0296 3.41 5.80 0.421 76.2 44.5 53.6 26.9 Guatemala 7.64 4.69 0.0678 3.13 4.79 0.311 54.2 22.2 39.1 47.5 Haiti 6.16 5.70 0.172 3.47 4.49 0.388 39.5 11.2 10.0 15.6 Honduras 6.92 4.11 0.0878 4.44 4.80 0.515 55.1 32.1 40.9 40.0 Mexico 8.77 3.96 0.0679 0.0804 4.87 0.282 63.9 37.0 50.0 64.2 Nicaragua 6.75 3.73 0.0738 5.00 4.44 0.399 55.3 37.3 30.0 41.5 Paraguay 7.06 2.65 0.0856 2.26 3.85 0.266 56.8 23.8 31.8 24.5 Peru 7.77 3.05 0.0237 2.84 3.56 0.305 61.0 20.0 41.8 60.0

Table 10: Average MFI Financial and Outreach Statistics by Country 1997-2007

Country OSS ROA NB WOMEN AVGLOAN Argentina 0.835 -0.197 5.86 0.628 5.42 Bolivia 1.17 0.027 9.63 0.573 6.77 Brazil 1.20 0.075 9.01 0.551 6.18 Colombia 1.26 0.052 9.65 0.627 6.24 Costa Rica 1.24 0.041 6.38 0.537 7.33 Dominican Republic 1.24 0.024 9.73 0.844 6.41 Ecuador 1.04 0.028 8.45 0.603 6.23 El Salvador 1.08 0.008 8.63 0.737 5.79 Guatemala 1.18 0.035 9.41 0.687 6.20 Haiti 0.886 -0.033 8.77 0.729 5.76 Honduras 1.05 -0.123 9.04 0.757 5.84 Mexico 1.21 0.100 9.65 0.857 5.62 Nicaragua 1.23 0.064 8.92 0.655 6.20 Paraguay 1.34 0.060 9.91 0.503 6.09 Peru 1.22 0.040 9.29 0.638 6.42

106 Please refer to Sections 5B and 5D for variable definitions.

52 5.B Financial Performance: Does Regulation Enhance Sustainability and Profitability?

In general, MFIs operate as either regulated or unregulated entities. Regulated institutions are subject to entry regulation, prudential regulation or tiered regulation (a particular combination of entry regulation and consequent monitoring), while unregulated institutions are not exposed to such restrictions. MFIs can be further categorized by institution type – nonprofit organization, non-bank financial institution, bank or credit union. Until recently, “regulated microfinance was so new that microfinance institutions and banking authorities barely shared a common vocabulary” (Rhyne, 2002). The rise of a global microfinance industry has led to a growing recognition that regulation in such areas as capital adequacy, risk weighting of assets, bad debt provisions and reporting requirements is integral to the profitable and sound operation of microfinance providers. A number of papers have advanced the thinking on microfinance regulation and supervision; however, most of these writings address the topic from a purely theoretical perspective. The stylized consensus of normative research and of microfinance practitioners is that deposit-taking institutions should be regulated, while institutions that do not mobilize deposits should not be subject to such restrictions (Christen and Rosenberg, 2000; Vogel, Gomez and Fitzgerald, 2000; Valenzuela and Young, 1999). The importance of regulation stems from the asymmetrical distribution of information between financial institutions, clients and investors (Chaves & Gonzalez-Vega, 1994; Stiglitz, 1994; Staschen, 1999; Hardy et al., 2003; Marulanda and Otero, 2005). 107 Effective financial regulation promotes efficient capital accumulation and resource allocation while ensuring the integrity and sustainability of financial institutions that mobilize deposits from the public (Jansson and Wenner, 1997). Van Greuning, Gallardo and Randhawa (1998) emphasize the importance of an enabling regulatory for microfinance; such an environment involves a tiered approach to external regulation that takes into account the continuum of institutions providing microfinance. In this context, regulation of MFIs may differ from that of other financial institutions: “there are many instances in which generally applied financial regulation is not entirely appropriate for institutions lending to small and microentrepreneurs ” (Jansson and Wenner, 1997 (43)).

107 The case of Bangladesh suggests that a lack of regulation of deposit-taking MFIs is both hazardous and costly. In an environment where hundreds of unsupervised NGOs offer savings services with impunity, many people have lost money due to incompetence and fraud. According to Wright (2000), it is time to “learn from the anarchy of benign neglect in Bangladesh” and institute deposit guarantee schemes to protect microfinance clients.

5.1 Review of the Literature on Commercialization and Financial Performance

The promise of commercial microfinance is considerable: upscaling MFIs can access new forms of credit, expand their portfolios, strengthen management and enhance efficiency, while downscaling commercial banks can profit from an emerging industry. But are these competitive advantages realized in practice? A number of studies evaluate the experience of transformed microfinance NGOs and traditional banks.

a) Case Studies from Latin America

i) Upscaling NGOs

As discussed in Section II, NGOs initiated microcredit operations at a time when poor and low-income households were precluded from involvement in the formal financial system. Today, however, an increasing number of NGOs are themselves transforming into regulated financial institutions. These transformed entities have achieved positive results in four main areas: i) an ownership structure consistent with a double bottom line strategy; ii) increased access to commercial funds; iii) a broader range of services, including voluntary deposit mobilization; and iv) greater breadth and depth of outreach (Fernando, 2004). Bolivia was the first country to witness the integration of a traditionally non-profit microfinance sector into the formal financial sector. 108 Rhyne (2001) studies the institutional transformation of Bolivian NGO PRODEM into BancoSol and emphasizes the benefits of transformation in terms of breadth of outreach, efficiency and independence from donor funds.109 Fernando (2003) presents the case of MiBanco, a leading microfinance commercial bank in Peru that grew out of NGO Peruvian Acción Comunitaria del Perú (ACP). He finds that upscaling was costly in the short term but ultimately provided access to additional

108 The commercialization process in Bolivia occurred against the backdrop of the debt crises of the 1980s. During this period of economic instability, the microfinance industry boomed. However, increased competition, coupled with a desire for greater financial independence, led NGOs to consider institutional transformation. 109 While Rhyne clearly supports the commercialization proposition, she presents a balanced discussion. For example, she points to higher average loan sizes (from US$326 at the time of the transition in 1992 to US$904 in 1999) as a possible sign of mission drift. Furthermore, while PRODEM offered nonfinancial services such as health education in addition to its loans, BancoSol’s activities are restricted to financial services.

54 sources of capital in order to fuel growth. MiBanco is now able to capture savings deposits and access the capital markets. 110 Furthermore, the bank has enhanced its value to clients by, for example, increasing the depth and breadth of its outreach (expanding from urban to rural areas) and widening the scope of its operations (incorporating passbook savings, time deposits, money transfers and checking accounts, among other services). Rhyne (2002) compares the upscaling experience of six MFIs in Latin America. 111 According to Rhyne, regulation was overwhelmingly advantageous for the institutions surveyed: it increased access to sources of funds for both equity and debt, facilitated client outreach, improved professional operations and expanded product selection. Furthermore, although the costs of supervision were non-negligible – 5 percent of total costs to meet supervisory requirements during the initial year and 1 percent thereafter, according to CGAP estimates – many of these expenses led to internal improvements that contributed to overall operational sustainability (Christen, Lyman and Rosenberg, 2003). Perhaps the greatest negative associated with supervision was the loss of the ability to experiment with unconventional ideas. This adverse effect does not negate the benefits of regulation but, instead, highlights the continued value of NGOs as seedbeds for innovation.

ii) Downscaling Banks

Other case studies examine privately owned financial institutions that expand their services into the microenterprise sector. Chowdri (2004) draws on interviews from leading microfinance institutions and commercial banks to synthesize the experiences of downscaling institutions in Latin America. A growing number of banks are entering the market for microfinance in Peru, Ecuador, Venezuela, Haiti, Columbia and Paraguay. Chowdri provides in-depth case studies of various institutions in those countries and finds that microfinance portfolios uniformly

110 In December 2002, MiBanco issued bonds for $6 million with a 50 percent guarantee from USAID. In the future, it is likely that MiBanco will be able to access the capital markets without guarantees from external parties. 111 The institutions in the ACCION International study include: BancoSol (Bolivia), Banco Solidario (Ecuador), Caja Los Andes (Bolivia), Calpia (El Salvador), Compartamos (Mexico), Finsol (Honduras) and Mibanco (Peru).

55 contribute to institutional bottom lines. 112 Downscaling also benefits clients through improved access to services and through efficiencies driven by market competition. Poyo and Young (1999) study two downscaling institutions in Bolivia: Banco Economico and Fondo Financiero Privado FA$$IL. Initially focused on small and medium- sized enterprises, Banco Economico extended its institutional mission by targeting microenterprises. This strategy, consistent with the bank’s culture and competencies, was successful from the point of view of return on shareholder investment (due to expanded market share and cost synergies) and client service (namely, product diversification). FA$$IL, the only microfinance institution in Bolivia established entirely with private risk capital, had a more difficult experience with microfinance due to the ineffectiveness of its highly compartmentalized production line credit methodology in an environment characterized by significant information asymmetries.

In general, articles and reports that focus on the transformation of a particular NGO into a regulated non-bank financial institution or the penetration of a commercial bank into the microfinance market evaluate the successes and failures of commercialization with a view toward developing best practices (see, for example, Yaron (1994), Chaves and Gonzalez- Vega (1996), Lee (2001), Kaboski and Townsend (2005), de Aghion and Morduch (2005) and Cull et al. (2006)). While such studies are informative, they generally focus on a small number of institutions. In this paper, I adopt a more rigorous approach to the commercialization debate and evaluate empirically the profitability of regulated and unregulated MFIs.

b) Empirical Evidence

Hartarska and Nadolnyak (2007) investigate the impact of regulation on MFI performance for 114 institutions in 62 countries. Controlling for macroeconomic and institutional frameworks as well as bank-specific characteristics, they do not find evidence that regulated MFIs are more sustainable than unregulated MFIs.

112 It is perhaps interesting to note that while some banks are attracted to microfinance as a means to exploit value opportunities, not all institutions enter the field for commercial reasons. For some providers – Banco del Pichincha in Ecuador, Visión in Paraguay and Banco del Caribe in Venezuela, for example – the idea of microfinance as a source of profit has only recently captured the attention of management and shareholders. Political pressure or public incentives also play a role in the decision to downscale.

56 Bogan (2009) studies the relationship between capital structure and sustainability for the top 300 MFIs in Africa, East Asia, Eastern Europe, Latin America, the Middle East and South Asia. In the cross-sectional regression analysis, regulation is not a statistically significant determinant of operational self-sufficiency. However, the use of grants is negatively related to sustainability; this latter finding reinforces the view that long-term reliance on donor funds may hinder the development of MFIs into competitive, efficient and profitable institutions. 113

Aside from a few key articles and books, robust empirical evidence on the relative financial performance of regulated versus unregulated microfinance providers is scarce. Furthermore, although rudimentary quantitative observations of microfinance suggest that regulated institutions outperform their unregulated counterparts, this result has not been tested empirically. In the next section, I present an empirical model to evaluate the impact of regulation on MFI sustainability and profitability in Latin America.

5.2 Theoretical and Empirical Specifications

a) Empirical Model

In empirical analyses of banks and other financial institutions, financial performance is usually expressed as a function of bank-specific variables, macroeconomic indicators, institutional factors and regulatory frameworks (Barth et al., 2003; Demirguc-Kunt et al., 2004). Thus, a general empirical model is as follows:

Yit = constant + αRit + βIit + δCit + u it + εit where Yit is the performance measure Rit is a dummy variable that captures the impact of regulatory status Iit is a vector of institution-specific variables Cit is a vector of country-specific variables ui is the institution’s individual unobserved effect εit is an error term

113 Wisniwski (1999) points out that subsidized funding, coupled with a lack of clear ownership structure, can distort incentive structures and undermine sustainability during the early stages of an MFI’s development. This “moral hazard” problem is pervasive in the finance literature; please refer to Jenson and Meckling’s (1976) seminal paper for a detailed discussion of the agent/principal issue.

57 The above framework can be adapted in order to evaluate the financial performance of MFIs. More specifically, I estimate the following relationship:

Yit = constant + α1REG i + α2NGO i + β1AGE i + β2AGE2 i + β3SIZE i + β4CAPITAL i + B5SAVINGS i + β6LOANS i + β7WRITEOFF i + δ1BOLIVIA + δ2ECUADOR + δ3PERU + εit

Table 11 defines the dependent and independent variables in the regressions. The rationale for and significance of these variables are discussed in more detail below.

Table 11: Variable Definitions

Variable Definition Dependent Variables OSS Ratio of total financial revenue to sum of total financial expense plus loan loss provision expense plus operating expense ROA Ratio of net operating income less taxes to period average assets Independent Variables A. Institutional Variables REG A dummy variable that takes the value of 1 if the institution is regulated, 0 if otherwise. NGO A dummy variable that takes the value of 1 if the institution is an NGO, 0 if otherwise. AGE, AGE2 Age and age squared of the MFI SIZE Logarithm of the total assets of the MFI CAPITAL Ratio of total equity to total assets SAVING Ratio of savings to total assets LOANS Ratio of gross loan portfolio to total assets WRITEOFF Ratio of write-offs for a 12-month period to period average gross loan portfolio B. Country Variables BOLIVIA A dummy variable that takes the value of 1 if the institution is located in Bolivia, 0 if otherwise. ECUADOR A dummy variable that takes the value of 1 if the institution is located in Ecuador, 0 if otherwise. PERU A dummy variable that takes the value of 1 if the institution is located in Peru, 0 if otherwise.

b) Conceptual Framework

Dependent Variables: OSS and ROA

MFIs have a dual objective: to cover costs and to expand their client base. These criteria of institutional sustainability and outreach were first used by Yaron (1992) and later developed

58 by Christen, Rhyne, and Vogel (1995) in establishing a framework for the comparative analysis of microfinance programs (Robinson, 2001). Sustainability measures the extent to which revenues cover all nonfinancial and financial costs without subsidy or risk and yield a profit. The majority of microfinance institutions globally are not self-sufficient; however, institutions that drive the microfinance revolution achieve this level of operational success, as large-scale outreach depends on institutional sustainability. For this study, it was not possible to find data on institutional sufficiency that excluded explicit or implicit subsidies. 114 Thus, the analysis employs a measure of operational self-sustainability (OSS) that is unadjusted. 115 OSS may be a more appropriate measure of financial performance than return on assets (ROA) or return on equity (ROE) due to the diversity of microfinance institutions and the extent of accounting irregularities (Hartarska and Nadolnyak, 2007). However, I perform a second set of regressions using return on assets (ROA) as the dependent variable in order to confirm the robustness of the results. 116

Independent Variables: MFI-Specific

Dummy variables for regulatory status (REG) and institution type (NGO) are included in the regression to capture the partial effect of regulation and nonprofit status on the financial performance measure. For the majority of institutions in the sample, these variables are time invariant. However, if an NGO transforms into a regulated MFI during the period under investigation (1997-2007), this change is reflected in the data. For example, ADOPEM, a microfinance organization that operates in the Dominican Republic, was an NGO prior to its transformation into a savings and loan bank in 2005. The data set characterizes ADOPEM as an unregulated NGO until 2004 and a regulated bank beginning in 2005.

114 Yaron (1994) points out that rural financial institutions are often sustained by both implicit and explicit subsidies, and financial self-sufficiency requires that the return of equity equal or exceed the opportunity cost of funds net of all subsidies. 115 Although the OSS measure is not perfect, Hartarska and Nadolnyak (2007), among others, argue that it is a reasonable approximation of financial performance. 116 The analysis was conducted for both ROA and ROE. However, the ROA specification is preferable, as ROE may be distorted by leverage or differences in financing structures between NGOs, non-bank financial institutions and banks (Olivares-Polanco, 2005). The results from both the OSS and ROA regressions are presented in this paper.

59 In order to measure accurately the impact of REG on OSS, it is necessary to control for institutional variables that affect financial performance. 117 I include the following independent variables in the regression: AGE and AGE2 (age and age-squared of the MFI), SIZE (logarithm of total assets), CAPITAL (ratio of total equity to total assets), SAVING (ratio of savings to total assets), LOANS (ratio of gross loan portfolio to total assets) and WRITEOFF (ratio of write-offs for a 12-month period to period average gross loan portfolio). The capital ratio measures leverage, the loans-to-assets ratio controls for focus on lending and the write-off ratio captures risk exposure. 118 From the existing body of empirical literature, we would expect REG, AGE, SIZE, CAPITAL, SAVING and LOANS to have a positive impact on financial viability. On the other hand, nonprofit status (NGO) and WRITEOFF may undermine sustainability.

Independent Variables: Country Dummies

Finally, country dummies and country-regulation interaction dummies for three Andean countries – Bolivia, Ecuador and Peru – are included in the regression. These countries were selected on the basis of their strong regulatory, investment and institutional frameworks for microfinance. 119

5.3 Results

117 The life cycle theory of MFI development posits a relationship between funding and institutional development (Fehr and Hishigsuren, 2005). Empirical studies confirm that age, size and capital structure affect sustainability (Bogan, 2009). 118 Empirical models of bank performance usually include loans as a measure of bank exposure. Unlike banks, most MFIs do not engage in income-generating activities other than lending. Thus, LOANS controls for both risk exposure and focus on lending because using funds for other purposes – building maintenance, for example – affects income generation in the current period (Hartarska and Nadolnyak, 2007). I also include a more direct measure of risk exposure, the write-off ratio. Other measures of risk (such as portfolio-at-risk > 30 days) were also considered and tested, with similar results. 119 As outlined in Section III, Bolivia, Peru and Ecuador occupied the top three spots in the Economist Intelligence Unit’s ranking of microfinance business environments in Latin America for 2007 and 2008.

60 Table 12: Estimates for Performance Measured by OSS and ROA

Dependent Variable: OSS Dependent Variable: ROA I. II. III. IV. I. II. III. IV. REG -0.00230 -0.0173 -0.0213 -0.0226 0.0193 0.00831 0.00751 0.00821 (0.0512) (0.0275) (0.0340) (0.0280) (0.0134) (0.0118) (0.018) (0.0121) NGO -0.0272 -0.0117 -0.00680 0.00655 0.0110 0.0162 0.00838 0.0210 (0.0532) (0.0344) (0.0450) (0.0377) (0.0134) (0.0156) (0.021) (0.0163) AGE 0.0118* 0.00851 0.00679 0.0104*** 0.0116*** 0.0109*** (0.00664) (0.00714) (0.00673) (0.00387) (0.004) (0.00407) AGE2 -0.000247 -0.000157 -0.000103 -0.000261** -0.000285*** -0.000277** (0.000212) (0.000231) (0.000223) (0.000104) (0.000) (0.000109) SIZE 0.0357** 0.0298 0.0392** 0.0223*** 0.0151*** 0.0231*** (0.0182) (0.0219) (0.0189) (0.00552) (0.004) (0.00567) CAPITAL 0.243*** 0.250*** 0.252*** 0.0359 0.0123 0.0328 (0.0589) (0.0638) (0.0574) (0.0351) (0.038) (0.0356) LOANS 0.704*** 0.756*** 0.700*** 0.248*** 0.270*** 0.251*** (0.108) (0.108) (0.103) (0.0453) (0.049) (0.0444) SAVING 0.0334 0.0187 0.0218 -0.0789*** -0.0872*** -0.0770** (0.0598) (0.0556) (0.0520) (0.0258) (0.030) (0.0269) WRITE-OFF -2.05*** -1.98*** -2.05*** -0.695** -0.615** -0.674** (0.321) (0.345) (0.327) (0.338) (0.301) (0.340) BOLIVIA -0.00160 -0.0206*** (0.0614) (0.00748) ECUADOR -0.0328 0.0198 (0.0275) (0.0139) PERU 0.0731*** 0.0125* (0.0204) (0.00742) R-squared 0.0011 0.193 0.189 0.203 0.0019 0.185 0.179 0.190 No. obs 1038 831 831 831 909 831 831 831 Prob>F 0.533 0.000 0.000 0.000 0.317 0.000 0.000 0.000 Note: standard errors in parentheses. *Significant at 10%; **Significant at 5%; ***Significant at 1%. I: regulatory and nonprofit status; II: all institutional variables; III: institutional variables under fixed effect model; IV: institutional variables with country dummies

Column I regresses the performance indicator (OSS or ROA) on regulatory and nonprofit status. Column II presents the results for an extended model that includes institutional characteristics; by controlling for MFI-specific factors, it is possible to determine whether regulation has an independent and statistically significant effect on sustainability and profitability. Column III represents the fixed effect specification, which controls for unobserved heterogeneity across countries. Finally, Column IV is a partial fixed effect model with country dummy variables for Bolivia, Ecuador and Peru.

The results show that AGE, SIZE, CAPITAL, LOANS, SAVING and WRITEOFF are statistically significant determinants of MFI financial success. Across all specifications (II- IV), MFIs with a larger asset base, a higher loan-to-asset ratio (and hence a greater focus on lending) and a lower write-off ratio tend to outperform.120 OSS is affected by the capital ratio (CAPITAL), which measures the impact of donor equity; in particular, less leveraged MFIs are more sustainable. One possible explanation for this result is that donors provide equity to MFIs that do well and extend loans to MFIs that underperform (Hartarska and Nadolnyak, 2007). In addition, high leverage may undermine MFI performance in the context of an economic recession or currency crisis. 121 After controlling for entry regulation (REG), MFIs that collect savings (and are thus subject to prudential regulation) do no better (or worse) in terms of OSS than those that do not collect savings. 122 On the other hand, SAVING has a negative effect on ROA. While mobilized savings typically represent a cheaper source of financing than external commercial sources, the added administrative costs associated with providing and servicing deposits may undermine profitability (Ledgerwood, 1999). 123 Lastly, AGE is insignificant in the OSS

120 The finding that size is positively associated with financial viability is consistent with the results of Honohan’s (2004) cross-country study of more than 70 MFIs. Honohan finds that doubling MFI scale is associated with an increase in the self-sufficiency index (operating income as a percentage of expenses) of between 6 and 10 percentage points. Larger firms, whether measured in terms of total assets or number of clients, tend to be more profitable. 121 Leverage represents a threat to institutional sustainability in the event of a major economic downturn or devaluation because highly leveraged MFIs have smaller capital bases to cover losses (Robledo, 2008). 122 SAVING measures savings mobilization; however, it also serves (implicitly) as a proxy for the impact of regulation because MFIs that collect savings are generally subject to some degree of prudential regulation. 123 For regulated institutions that mobilize saving, the latter enhances both OSS and ROA. In other words, the negative effect of saving in Table 12 appears to be driven by higher sustainability and profitability among MFIs that do not capture deposits. When the regression is performed using a smaller sample size that includes MFIs with positive savings only, the coefficient on SAVING is positive and statistically significant in

62 model but significant in the ROA model; more specifically, the ROA regressions feature an increasing and then decreasing effect of MFI age. AGE2 allows for a possible nonlinear effect of age, but there is limited evidence of a significant departure from non-linearity. The country fixed effect specification (III), which controls for regional disparities in cultural, political and institutional environments, yields similar results. When dummy variables for BOLIVIA, ECUADOR and PERU are included (IV), PERU is positive and statistically significant for both OSS and ROA. This finding is consistent with the Economist Intelligence Unit’s Microscope on the Business Environment in Latin America , which places Peru at the top of the 2008 ranking. BOLIVIA, on the other hand, has a negative coefficient. This outcome may seem surprising given that Bolivia is often cited as the model for commercial microfinance; however, the Bolivian microfinance industry entered a state of crisis in the late 1990s when commercial entry and competition, coupled with a severe economic downturn, led to high delinquency, client over-indebtedness and falling profits (Rhyne, 2001). Furthermore, because the Bolivian microfinance industry is relatively mature, profit margins may be lower than in other Latin American countries (where microfinance is still in its nascent stages and a few providers have near-monopoly positions). 124 Finally, the simplified regression model (I) in which REG and NGO are the only independent variables fits the data poorly. A formal test of the joint significance of REG and NGO could not reject the null hypothesis that the two coefficients are zero. Furthermore, controlling for institutional features, REG does not have a separate effect on MFI performance. The variable NGO is also insignificant; this latter finding undermines Besley and Ghatack’s (2004) argument that nonprofit status alone has a positive effect on performance because it reassures donors of the permanency of the microfinance mission. Overall, the empirical results do not support the hypothesis of a positive link between regulation and MFI financial performance: “high growth, positive returns, increased

the OSS specification. This result is consistent with the theoretical argument that savings contributes to operational performance by insulating MFIs from negative market conditions (whereby the cost of external funding increases or liquidity dries up). 124 Because of the maturity of the Bolivian microfinance market, MFIs have thin margins; interest rates charged to clients are comparatively low and conditioned by high competition on the supply side. The MIX Market MicroBanking Bulletin (Issue No. 17, Autumn 2008) reports that the average return on assets for market leaders in Bolivia is situated between 1.5 percent and 2.5 percent. In Mexico, by contrast, the existence of a “quasi-monopolistic market” allows for high interest rates charged to clients and extremely high returns (Robledo, 2008).

63 commercial funding, and increasing efficiency are not the reserve of for-profit MFIs” (MIX Market, 2006 (31)).

5.C Outreach: Is there Evidence of Mission Drift?

In the context of an increasingly commercial microfinance industry, there is concern that MFIs may abandon or dilute their poverty alleviation missions in pursuit of higher financial returns. In this section, I assess the risks and realities of mission drift in Latin America. I first survey the existing body of literature and then present my own empirical findings based on the data set described in Section 5A.

5.1 Review of the Literature on Commercialization and Mission Drift

Does the empirical literature support the premise that commercialization leads to mission drift? Examining the impact of commercialization on the strategy and performance of MFIs in Latin America, Christen (2001) makes an early contribution to the literature. In particular, he studies average loan balances at regulated and unregulated MFIs in order to determine whether the former are neglecting their traditional target group (namely, the poorest of the working poor) in order to achieve higher returns. 125 Christen finds that regulated institutions extend larger loans 126 but argues that this situation is not necessarily an indication mission drift; instead, larger average loan sizes may simply reflect the natural evolution of the target group or the period of entry into the market, among other factors. 127 Olivares-Polanco (2004) tests Christen’s conclusions using a data set with 28 Latin American MFIs over the period 1999-2001. Although the analysis includes only one observation for each MFI, a simple OLS regression confirms the existence of a tradeoff

125 Average loan size is often used as a proxy for the poverty level of microfinance clients. Larger loan sizes, presumably to better-off clients, are associated with lower average costs and, by extension, greater financial viability. 126 The average loan balance for unregulated NGOs ($322) is roughly a third that for regulated MFIs ($803). This unequal relationship also holds for a more comparative measure, average outstanding loan balance as a percentage of GNP per capita, with regulated MFIs offering double the average loan size of unregulated NGOs (Christen, 2001). 127 For example, Accion International and Internationale Projekt Consult, two of the most prominent microfinance pioneers in Latin America, engage in incremental lending. Initially, loan balances are well below the client’s ability to pay; the installments are subsequently increased through a series of shot-term loans. Today, the programs of these and other institutions not only have more mature portfolios, but the microenterprises they finance are also more developed. Thus, higher average loan balances are hardly unexpected.

64 between profitability and depth of outreach: the more profitable the institution, the larger the average loan size. Olivares-Polanco also finds that institution type and regulatory status – whether bank or NGO, regulated or unregulated – have no effect on loan size. Instead, age is a statistically significant determinant of loan size: the older the institution, the smaller the average loan size. 128 Makame and Murinde (2006) perform a similar analysis using a balanced panel data set consisting of 33 MFIs in five East African countries over the period 2000-2005. Analyzing depth and breadth of outreach (as approximated by average loan size and number of borrowers, respectively), Makame and Murinde find that unregulated MFIs with higher operating expenses (and hence lower profitability) tend to have deeper outreach. One possible explanation for the negative relationship between regulation and outreach is that excessively burdensome regulatory rules (capital adequacy ratios, financial sustainability requirements, etcetera) impose additional costs and divert attention away from growth. The findings also support Olivares-Polanco’s claim that MFI age and average loan size are inversely related. Cull, Demirgüç-Kunt and Morduch (2006) further investigate issues of efficiency and outreach. Their comprehensive survey of 125 microfinance providers in 49 countries finds that the simple relationship between profitability and average loan size is statistically insignificant. Instead, institutional design (individual versus group borrowing) and orientation (business practices and objectives) are key variables. More recently, Hermes, Lensink and Meesters (2008) use the technique of stochastic frontier analysis to evaluate the relationship between MFI financial performance and social impact. Using data on 435 MFIs over the period 1997 to 2007, they find evidence of a negative correlation between outreach and efficiency: MFIs that have lower average loan balances (and hence deeper outreach) tend to be less efficient. Interestingly, MFIs with a greater percentage of female borrowers – another indication of outreach – also underperform. These results hold even after controlling for a number of variables that may influence the performance of individual institutions in different regions. Ghosh and Tassel (2008) develop a theoretical model of commercial microfinance in which equilibrium behavior closely approximates empirical observations of mission drift. In response to the entry of profit-oriented donors, the most effective microfinance institutions

128 These results undermine Christen’s argument that first-generation, transformed NGOs have higher loan sizes due to the maturation of the initial client base.

65 optimally reallocate their lending portfolios away from the poorest clients and toward less poor clients. This shift in lending strategy decreases the relative effectiveness of donor funds in poverty reduction, as measured by the reduction in poverty per dollar invested in the institution. At the same time, a larger budget allows MFIs to achieve a greater reduction in poverty overall. 129 According to the authors, this latter result is in perfect consonance with the fundamental objective of poverty minimization. Frank (2008) analyzes financial and outreach data for 27 transformed MFIs over the period 2002 through 2006. She compares these institutions against a control group of 25 non- transformed MFIs and concludes that transformation results in broader client outreach, accelerated loan portfolio growth, significant product diversification and increased savings mobilization. 130 At the same time, transformed institutions have larger average loan sizes and serve proportionally fewer female clients. 131 Finally, although Navajas, Conning and Gonzalez-Vega (2003) do not directly analyze the outreach-sustainability tradeoff, their study of the Bolivian microfinance market during the 1990s suggests that heightened competition may reduce access to credit for the poorest borrowers. 132 In a related study, McIntosh and Wydick (2005) find that competition exacerbates asymmetric information problems over borrower indebtedness, creating a

129 There is a crucial distinction between relative and absolute poverty reduction. The reduction in poverty per dollar spent falls (due to the portfolio shift toward larger loans), while the overall impact on poverty reduction increases (due to a larger budget). One could argue that the poor would be better off if MFIs used their larger budgets to issue small loans exclusively to the poorest of the poor; however, such behavior cannot be sustained in equilibrium if profit-oriented donors skew their investments toward MFIs with the highest returns. 130 The transformed MFIs achieved a compound annual growth rate (CAGR) in total gross portfolio outstanding of 29.9 percent over the period under study, compared with a 16.3 percent CAGR for the non- transformed group over the same period. Furthermore, while the combined average number of active borrowers grew at a CAGR of 30.4 percent for the transformed group, the corresponding CAGR for the non-transformed group was only 14.9 percent. 131 Between 2002 and 2006, transformed MFIs consistently provided loans that were two to three times greater than those provided by non-transformed MFIs. However, the difference in average loan size between the two groups converges in 2006, suggesting that as NGOs mature there is a tendency for average loan size to increase. An analysis of the percentage of female borrowers at transformed MFIs shows a significant decline in the percentage of women clients served in the years following transformation. Furthermore, a comparison of the transformed group and non-transformed group reveals that the latter serve a higher percentage of female clients than the former. 132 In their article “Lending Technologies, Competition and Consolidation in the Market for Microfinance in Bolivia,” Navajas, Conning and Gonzalez-Vega present a theoretical model of credit market competition between two regulated microfinance institutions, BancoSol and Caja Los Andes. They argue that competition changes the type of loan contracts supplied to different segments of the market, thereby limiting access to credit for some borrowers. Thus, the overall effect of competition on the poorest is ambiguous: although heightened competition spurs product innovation and improves general access to credit via a decrease of monopoly rents, it also limits the extent to which socially oriented lenders can cross-subsidize poorer borrowers.

66 negative externality that leads to less favorable equilibrium loan contracts. 133 Last, McIntosh, Alain and Sadoulet (2005) use data from Uganda’s largest incumbent microfinance institution to show that rising competition induces a deterioration in repayment performance and a reduction in savings deposits among borrowers of the incumbent lender. 134

Overall, the literature seems to suggest that a stronger emphasis on profitability induces MFIs to focus less on the poor. But the results of empirical studies do not necessarily imply that greater efficiency is bad for poverty reduction. As Zeller and Johanssen (2006) argue, sustainable MFIs that target microenterpreneurs above the poverty line may engender higher poverty reduction at the macro level than subsidized MFIs that effectively reach the poor due to positive spillover effects. Under such a scenario, the contribution of efficient MFIs to improved economic conditions at the local, regional and national levels exceeds the contribution to poverty alleviation made by donor-dependent MFIs focused on depth of outreach.

5.2 Theoretical and Empirical Specifications

a) Empirical Model

In order to evaluate the impact of regulation on the social mission of MFIs, one would ideally compare the financial and outreach characteristics of formalized institutions both prior to and after institutional transformation. Unfortunately, this type of analysis is not possible due to the relatively small number of transformed institutions (and, in particular, limited data on recently transformed incumbents). Thus, the empirical analysis in this paper compares the breadth and depth of outreach of regulated and unregulated MFIs using the following empirical specification:

133 It may seem counterintuitive that increased competition results in less favorable credit contracts for the entrepreneurial poor in developing countries – after all, economists since Adam Smith have almost universally favored competition as a way to decrease equilibrium prices for consumers. However, McIntosh and Wydick (2005) identify a number of potentially adverse effects of the entry of new MFIs into an existing pool of borrowers: first, competition reduces the ability of socially-motivated lenders to generate rents that support lending to the poorest (and potentially least-profitable) borrowers (also known as cross-subsidization); second, as the number of lenders increases, information sharing becomes more difficult; third, asymmetric information permits borrowers to take multiple loans, leading to client over-indebtedness and portfolio deterioration. 134 According to the authors, “these phenomena are consistent with a model of competition whereby clients do not abandon the incumbent lender but rather take multiple loans, thus damaging their repayments to the incumbent. Because mandatory savings and minimum savings balances are standard among MFIs, double- dipping clients are forced to share their scarce savings amongst the institutions from whom they borrow, reducing their level of savings with the incumbent” (1002).

67 Yit = constant + α1REG i + α2NGO i + β1AGE i + β2AGE2 i + β3SIZE i + β4CAPITAL i + B5SAVINGS i + β6LOANS i + β7WRITEOFF i + δ1BOLIVIA + δ2ECUADOR + δ3PERU + εit

Dependent Variables: NB, WOMEN and AVGLOAN

Breadth of outreach is measured by the log of the number of active borrowers (NB) – the number of individuals with an outstanding loan balance. Outreach is relevant to the commercialization debate, as proponents of transformation argue that regulated MFIs are able to reach more borrowers than unregulated MFIs.135 Depth of outreach is evaluated using two indicators: percentage of women borrowers (WOMEN) and the log of average loan size (AVGLOAN). One of the purported perils of commercialization is that transformed MFIs target a smaller percentage of women and of very poor borrowers than NGOs. 136 In general, larger average loan sizes are associated with relatively wealthier clients (and often fewer women), lower transaction costs and higher profits. Schreiner (2001) summarizes this tradeoff: “greater loan size usually means more profitability for the lender but less depth of outreach for the borrower” (21).

Independent Variables

To study the effect of regulation on outreach, I include in the regression dummy variables for regulatory status (REG) and institution type (NGO). As in the financial regressions from Section 5B, I also control for a number of institutional characteristics: AGE, AGE2, SIZE, CAPITAL, SAVING, LOANS and WRITEOFF.137 Finally, country dummy variables for BOLIVIA, ECUADOR and PERU are incorporated into the model.

135 Regulated MFIs can achieve economies of scale, attract commercial funds and develop financial leverage. For this reason, many argue that regulated institutions perform better in terms of client outreach (Krahnen and Schmidt, 1994; Otero and Rhyne, 1994) and are better able to deal with risk and with problems of moral hazard and adverse selection (Kyereboah-Coleman, 2007). On the other hand, the formative variable may be sustainability rather than regulation; in other words, if unregulated institutions can achieve sustainability, they may be able to achieve considerable financial and outreach success. Data from the MIX Market supports this latter proposition; of the 146 reporting NGOs reporting to the MIX database in 2003, only half (53 percent) were sustainable but those sustainable institutions reached over 90 percent of the total number of clients at NGOs (Helms, 2006 (45)). 136 According to Mary Ellen Iskenderian, CEO of Women’s World Banking, MFIs that move toward a for-profit model often end up serving proportionally fewer women. This is a “particularly disturbing trend…since you can’t talk about poverty alleviation without talking about women’s economic empowerment” (Caplan, 2008). 137 Please refer to section 5B for variable definitions.

68 The literature on commercialization and mission drift predicts a positive REG coefficient (or negative NGO coefficient) in the NB and AVGLOAN regressions and a negative REG coefficient (or positive NGO coefficient) in the WOMEN regression. In other words, we would expect regulated institutions to have more borrowers, larger average loan sizes and proportionally fewer female clients.

5.3 Results

Table 13: Empirical Results for Breadth of Outreach

Dependent Variable: NB I. II. III. IV. REG 0.446*** 0.0597 0.134 0.0639 (0.140) (0.0899) (0.100) (0.0936) NGO -1.02*** 0.174* 0.394 0.222** (0.144) (0.0943) (0.113) (0.0979) AGE 0.00368 0.0448*** 0.000542 (0.0165) (0.0160) (0.0174) AGE2 -0.000393 -0.00148*** -0.000287 (0.000477) (0.000475) (0.000494) SIZE 0.854*** 0.822*** 0.860*** (0.0225) (0.0220) (0.0221) CAPITAL 0.685*** 0.579*** 0.686*** (0.144) (0.135) (0.146) LOANS 0.660*** 1.16*** 0.729*** (0.241) (0.231) (0.236) SAVING -0.438*** -0.236* -0.345** (0.132) (0.127) (0.136) WRITE-OFF 1.61** 0.758 1.36* (0.742) (0.686) (0.741) BOLIVIA -0.347*** (0.0983) ECUADOR -0.159** (0.0699) PERU 0.0313 (0.0612) R-squared 0.182 0.793 0.782 0.798 No. obs 1133 825 825 825 Prob>F 0.000 0.000 0.000 0.000 Note: standard errors in parentheses. *Significant at 10%; **Significant at 5%; ***Significant at 1%. I: regulatory and nonprofit status; II: all institutional variables; III: institutional variables under fixed effect model; IV: institutional variables with country dummies

The results indicate that breadth of outreach, as measured by the number of borrowers, is affected by AGE, SIZE, CAPITAL, LOANS, SAVING and WRITEOFF. MFIs with larger asset bases, higher capital and loan ratios, lower savings ratios and higher write-off ratios tend to reach more borrowers. The gains from size are particularly significant; a ten percent increase in an MFI’s asset base is associated with more than an eight percent increase in the number of borrowers. Proponents of commercialization argue that MFIs need to become regulated in order to access the commercial funding required for large-scale outreach (Robinson, 2001). However, the empirical results indicate that NB and CAPITAL are positively related; in other words, highly capitalized (less leveraged) MFIs reach more borrowers. The finding that SAVING negatively affects NB is also surprising 138 , as the benefits of savings mobilization are well documented in the literature. 139 When country dummy variables are included (IV), BOLIVIA and ECUADOR are negative and statistically significant. In other words, MFIs in Bolivia and Ecuador tend to reach fewer borrowers than MFIs in other Latin American countries. This result may be due to greater competition for clients (among a larger number of institutions) in mature microfinance markets. The Peru dummy is statistically indistinguishable from the adjusted mean of the other countries in the sample. Without controlling for any institutional characteristics (I), regulated institutions reach more borrowers than NGOs. However, when MFI-specific explanatory variables are included in the regression, regulatory status has an insignificant effect on outreach. This result holds across all specifications, including a fixed effect model (III) that controls for idiosyncratic country effects. In fact, for two identical MFIs that differ only in regulatory status, the regulated MFI tends to reach fewer borrowers than the NGO (II, IV). Overall, then, the results do not support the claim that regulated institutions achieve broader outreach than unregulated institutions.

138 Because a majority of MFIs in the sample do not mobilize deposits, a separate regression analysis was performed for institutions with positive savings. For this specification (which includes 217 observations), SAVING remains negative but loses its significance. 139 A number of scholars and practitioners argue that introducing savings facilities can improve client outreach, increase demand and improve operational cost control (see, for example, CGAP, 1998; Fiebig, Hannig and Wisniwski, 1999; Bass and Henderson, 2000; Robinson, 2001; Dauner, 2004; Ledgerwood, White and Brand, 2006).

70 Table 14: Empirical Results for Depth of Outreach

Dependent Variable: WOMEN Dependent Variable: AVGLOAN I. II. III. IV. I. II. III. IV. REG -0.0517*** -0.0233 0.029 -0.0191 0.222** -0.0559 -0.125 -0.0606 (0.0196) (0.0211) (0.024) (0.0215) (0.0939) (0.0904) (0.101) (0.0940) NGO 0.0985*** 0.0263 0.117*** 0.0299 -0.549*** -0.173* -0.381*** -0.219** (0.0202) (0.0245) (0.027) (0.0250) (0.0944) (0.0947) (0.114) (0.0981) AGE -0.000474 0.008 0.000211 -0.00429 -0.0461*** -0.00275 (0.00561) (0.006) (0.00586) (0.0164) (0.0159) (0.0173) AGE2 0.0000249 -0.000 0.0000109 0.000434 0.00154*** 0.000376 (0.000162) (0.000) (0.000168) (0.000475) (0.000470) (0.000490) SIZE -0.00754 -0.014** -0.00749 0.144*** 0.177*** 0.139*** (0.00655) (0.007) (0.00635) (0.0226) (0.0222) (0.0222) CAPITAL 0.180*** 0.154*** 0.179*** -0.721*** -0.614*** -0.717*** (0.0413) (0.040) (0.0416) (0.143) (0.135) (0.146) LOANS -0.0903 0.078 -0.0708 0.872*** 0.390* 0.806*** (0.0669) (0.063) (0.0637) (0.230) (0.228) (0.229) SAVING -0.146*** -0.036 -0.117*** 0.449*** 0.250* 0.359*** (0.0364) (0.036) (0.0362) (0.134) (0.130) (0.138) WRITE-OFF -0.393** -0.445** -0.486*** -1.48** -0.651 -1.26* (0.182) (0.198) (0.184) (0.737) (0.688) (0.738) BOLIVIA -0.0803*** 0.342*** (0.0236) (0.0991) ECUADOR -0.0516* 0.126* (0.0306) (0.0682) PERU -0.0329* -0.0279 (0.0181) (0.0613) R-squared 0.102 0.194 0.162 0.209 0.153 0.368 0.350 0.384 No. obs 944 764 764 764 1106 825 825 825 Prob>F 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 Note: standard errors in parentheses. *Significant at 10%; **Significant at 5%; ***Significant at 1%. I: regulatory and nonprofit status; II: all institutional variables; III: institutional variables under fixed effect model; IV: institutional variables with country dummies

Consistent with the results from the NB regressions, SIZE, CAPITAL, LOANS, SAVING and WRITEOFF are key determinants of average loan size and the percentage of women borrowers. MFIs with smaller asset bases and lower savings tend to have proportionally more female clients. On the other hand, WRITEOFF is negative and statistically significant; as the write-off ratio increases, the percentage of women borrowers decreases. One possible explanation for this result is that women are more reliable debtors: “due to strong social and family ties, [women] often follow a more conservative investment strategy which in turn results in lower default rates for MFIs” (Sehgal, 2008). In the simplified regression model (I), REG and NGO are statistically significant for both WOMEN and AVGLOAN; regulated institutions reach proportionally fewer women and have larger average loan balances, while NGOs reach proportionally more women and have smaller average loan balances. After controlling for institutional characteristics, however, REG is insignificant. NGO remains significant in the WOMEN fixed effect (III) specification and in the AVGLOAN regressions. In general, then, NGOs reach proportionally more women 140 and extend smaller loans, perhaps due to their focus on poor, isolated or marginalized populations. 141 As MFI size increases, average loan size increases. More leveraged MFIs also have larger average loan balances and, by extension, a potentially wealthier client base. Finally, in the fixed effect model (III), AGE is negative and statistically significant; older MFIs have smaller average loan sizes. This latter finding is consistent with the results of other empirical analyses (see, for example, Olivares-Polanco, 2004; Makame and Murinde, 2006).

140 An examination of the MIX database confirms this trend. NGOs reporting to the MIX Market consistently serve approximately 80 percent of women clients, whereas banks and non-bank financial institutions rarely serve more than 50 or 60 percent. In 2006, of the 446 institutions in the MIX database, the highest percentage of women clients were found at the following types of institutions: young and small-scale, NGOs and credit unions, nonprofit and unsustainable. The lowest percentages were found in mature, for-profit, large-scale banks and non-bank financial institutions (Frank, 2008). 141 According to Frank (2008) of Women’s World Banking, there is a relationship between an MFI’s legal structure, its predominant lending methodology, its average loan size and the gender composition of its client base. NGOs typically offer group lending to small, household-based businesses that require frequent profit withdrawals for household expenditure. Such businesses comprise the female-dominated “income-generating” segment of the market. Regulated financial institutions, on the other hand, tend to offer individual lending. They target growth-oriented businesses in the male-dominated “microenterprise” segment of the market. A second explanation for the higher percentage of women clients at NGOs relates to institutional profitability. Regulated MFIs may increase average loan sizes in order to improve margins (larger loans are less costly to administer); this shift in strategy often coincides with a reduction in the percentage of female borrowers, as women generally have smaller businesses and therefore demand smaller loans.

72 Finally, MFIs in Bolivia and Ecuador tend to have proportionally fewer women borrowers and relatively larger average loan sizes than MFIs in the other Latin American markets under investigation. It is perhaps interesting to note that both Bolivia and Ecuador have highly commercial microfinance industries; this fact, together with the empirical results, may indicate that commercialization weakens the social mission of MFIs.

5.4 Conclusion

The findings indicate that regulatory status (regulated or unregulated) and institution type (bank, non-bank financial institution or NGO) do not explain variation in MFI financial performance. Instead, institutional characteristics – MFI size, age, saving-to-asset ratio, capital-to-asset ratio, loan-to-asset ratio and write-off ratio – are statistically significant determinants of sustainability (OSS) and profitability (ROA). First, age and size have a salutary impact on both OSS and ROA, suggesting important gains from scale. The loan-to- asset ratio is also positive and significant; MFIs with a greater focus on lending achieve better financial results. Third, lower leverage is associated with higher OSS, all else constant; while financial leverage has the potential to magnify returns, it may also undermine sustainability if the return is lower than the cost of borrowing. 142 Whereas the effect of regulatory status on financial performance is unambiguously negligible, a more subtle conclusion emerges from the outreach analysis. Without controlling for institutional differences, REG and NGO are significant predictors of breadth and depth of outreach. 143 When MFI-specific characteristics are included in the regression, however, the significance of regulatory status disappears. NGO remains significant in two of the NB regressions and, contrary to expectations, NGOs tend to have more borrowers than regulated MFIs with similar institutional features. The NGO dummy is negative and statistically significant in the AVGLOAN model across all specifications. Furthermore, there is some evidence that NGOs have a greater percentage of female clients than regulated MFIs (NGO is positive and statistically significant at the one percent level in the fixed effect specification only). In general, institutional variables are important determinants of breadth and depth of outreach. Larger MFIs tend to have more borrowers, higher average loan sizes and

142 A survey of Indian MFIs indicates that a substantial proportion of institutions are over-leveraged; the accumulation of debt in excess of prudential norms may be due to operational losses or increased borrowing to fund outreach objectives (Micro-Credit Ratings International Limited, 2005). 143 In the financial regressions, by contrast, REG and NGO are insignificant across all specifications.

73 proportionally fewer female clients. A higher capital ratio (less leverage) is also positively related to breadth of outreach; this latter result is surprising, as one of the primary motivations for increasing leverage (i.e. decreasing the capital ratio) is to expand outreach. 144 Overall, there is limited evidence of a tradeoff between financial sustainability (OSS, ROA) and social impact (NB, AVGLOAN, WOMEN). Nevertheless, there is some evidence of a tradeoff between breadth and depth of outreach; some of the institutional variables that positively impact breadth of outreach – size and focus on lending, for example – negatively impact depth of outreach (via larger loan sizes and/or fewer female clients). Furthermore, if AVGLOAN 145 and WOMEN are accurate proxies of adherence to poverty alleviation objectives, the results indicate that NGOs may have stronger social missions. In terms of country effects, MFIs in Peru have higher OSS and MFIs in Bolivia and Ecuador have lower ROA relative to the rest of the sample. Perhaps the most interesting results emerge in the outreach regressions. MFIs in Bolivia and Ecuador have fewer borrowers, higher average loan sizes and proportionally fewer women clients. In the financial and outreach regressions, significant country dummies indicate that country A differs from country B. This finding is interesting, but as an explanation it is pre- embryonic: “after all, one of the fundamental goals of comparative…analysis is to replace (proper) country names with variables” (Jackman and Miller, 2004 (156)). In the next section, a new regression model is presented to evaluate the specific macroeconomic, political and institutional factors that affect cross-country differences in average MFI financial performance and outreach.

144 A number of scholars find that leverage has a positive impact on outreach (see, for example, Kyereboah-Coleman, 2007). 145 It is important to recognize the limitations of average loan size as a meaningful proxy for depth of outreach. According to Marulanda and Otero (2005), various factors influence average loan size, including the type of credit methodology, the term of the loan, the range of products and services offered and the degree of client retention. For example, the consolidation of a client base with a credit history induces institutions to make larger loans. For these reasons, higher average loan sizes do not necessarily imply mission drift; instead, they may simply reflect the maturation of an institution or of the industry as a whole.

74 5.D Do Macroeconomic and Institutional Environments Influence MFI Performance?

Individual MFIs are often evaluated for purposes of emulation and replication; however, few studies examine the crucial connection between MFI performance and country-specific environments. As discussed in Section III, the development of microfinance is highly uneven across Latin America; Bolivia, Peru and Ecuador are the regional leaders, while larger countries such as Venezuela and Argentina fall into a distinctly lower tier. 146 In this context, it is important to examine the following question: what are the macroeconomic and institutional determinants of MFI financial performance and outreach? The Economist Intelligence Unit’s Microscope on the Microfinance Business Environment in Latin America and the Caribbean finds a positive relationship between the Microscope rankings and microfinance penetration rates: the more favorable a country’s business environment, the higher the ratio of microfinance clients to total population. However, it posits no association between country size and wealth, on the one hand, and the favorability of the microfinance environment, on the other.147 Vanroose (2007) also investigates regional disparities in microfinance across Latin America and concludes that the level of inflation, industrialization and financial liberalization, among other factors, are key determinants of outreach. The main drawbacks of the study are its limited scope and small number of observations. 148

146 The Economist Intelligence Unit’s Microscope on the Microfinance Business Environment in Latin America and the Caribbean reveals considerable variation in the environment for microfinance. In the inaugural survey (2007) of 15 Latin American and Caribbean countries, Bolivia is ranked highest (with a score of 79.4 out of 100), followed by Peru (74.1), Ecuador (68.3) and El Salvador (61.5). Eight countries receive scores below 50, with Venezuela (27.4) and Argentina (26.8) at the low end of the spectrum. The ratings are based on 13 indicators – regulation and supervision of microcredit operations, governance and accounting standards, capital market and judicial system development, political stability, credit bureaus and MFI development – and provide an indication of the business climate for regulated and non-regulated MFIs. 147 In fact, smaller and less affluent countries (Bolivia, Ecuador and El Salvador) outperform larger and more prosperous countries, whose microfinance business environments range from mediocre (Chile and Mexico, tied in eighth place) to subpar (Brazil) to very poor (Argentina). It is interesting to note that Brazil, Venezuela, Uruguay and Argentina outperform Bolivia, Peru and Ecuador in conventional macroeconomic evaluations of investor-friendly environments; however, a sound macroeconomic and political climate does not guarantee a vibrant microfinance industry. In general, then, it is necessary to distinguish between the microfinance environment and the general business environment. The three Andean leaders (Peru, Bolivia and Ecuador) have the most enabling supervisory and regulatory regimes, with sustainable MFIs offering a diversity of products and services in a competitive market. On the other hand, countries with strong or above-average investment climates may lack microfinance-specific frameworks and thus perform poorly in the Microscope ranking. 148 Vanroose performs a cross-sectional regression using data on 281 MFIs in the year 2001 and focuses solely on outreach. The empirical analysis in this paper has a wider scope of inquiry; it investigates both financial performance (operational self-sufficiency and return on assets) and outreach (number of borrowers, percentage of

75 This section first provides a discussion of the crucial link between microfinance and the macroeconomy. It then presents an empirical model to evaluate cross-country differences in MFI financial performance and outreach. Understanding such linkages enables us to develop appropriate policy recommendations.

5.1 Review of the Literature on Microfinance and the Macro Environment

A number of empirical studies evaluate how key macroeconomic variables – size of the economy, income levels, price and exchange rate fluctuations, foreign direct investment, official development assistance and remittances, among other factors – influence microfinance operations. In addition to these quantitative measures, institutional quality, economic freedom and social cohesion are also considered.

a) Macroeconomic Factors

Macroeconomic conditions affect the financial performance of MFIs, as well as the scope and nature of financial services that they can offer. Economic policies that affect the rate of inflation, the pace of economic growth and the degree of market openness also affect the ability of microentrepreneurs to operate their businesses.

Inflation

Inflation is present in all economies (to varying degrees) and must be considered when designing and pricing loan and saving products. High inflation not only dampens economic growth by discouraging investment, hindering productivity growth and undermining political and social stability, but it also weakens MFI portfolios (Rhyne, 2001). 149 For example, Vander Weele and Markovich (2001) discuss the deleterious effects of hyperinflation on the financial performance of MFIs in Bulgaria and Russia. Hartarska (2005) also studies MFIs in

women borrowers and average loan size). Furthermore, the model uses panel data and thereby captures the performance of MFIs over time. 149 Inflation represents a real cost to MFIs, as expected future price changes must be covered by the interest rate charged on loans.

76 Central and Eastern Europe and confirms that high inflation adversely affects operational sustainability. 150 Over the past several decades, many Latin American countries have experienced inflationary periods. During the “lost decade” of the 1980s, hyperinflation and economic stagnation eroded the real value of MFI portfolios throughout the region and placed additional constraints on growth and sustainability (World Bank, 1997). In Brazil, in particular, a combination of high inflation and restrictions on NGOs serving as financial intermediaries hindered the development of the microfinance industry (World Bank, 2009).

Exchange Rate Fluctuations

Foreign exchange rate risk also affects microfinance operations. MFIs generally raise capital denominated in hard currencies but lend funds in their local currency. As such, they are highly susceptible to currency fluctuations. According to Crabb (2004), foreign exchange rate risk is not only prohibitively expensive to manage, but it also restricts the ability of MFIs to access debt capital and other sources of funding. 151 MFIs that operate in environments with exchange rate volatility can mitigate risk by indexing loan contracts to a hard currency (such as the U.S. dollar) or commodity, maintaining funding and assets in U.S. dollars, utilizing debt rather than equity and providing short-term loans that allow for periodic interest rate adjustments. 152

Economic Growth

Macroeconomic instability affects MFIs directly through monetary variables such as real interest rates and indirectly via its impact on clients. Stagnant or falling GDP levels result in lower incomes, reduced demand for microenterprise goods and services and, more generally,

150 Interestingly, Hartarska reports the additional finding that institutions operating in inflationary environments tend to reach more borrowers. One plausible explanation for this result is that banks are even more reluctant to serve poor clients in a high-inflation setting and microfinance institutions fill the void. 151 While foreign exchange risk management is a significant problem for any financial institution, Crabb (2004) points out that “the problem is much greater for MFIs that are forced to borrow abroad and operate in an unstable economic environment” (51). 152 Because borrowing funds in foreign currencies can result in both foreign exchange gains and losses, donors and practitioners need to weigh the costs and benefits of such a strategy (Ledgerwood, 1999 (27)).

77 increased risk and uncertainty. Financial market stability, by contrast, enhances the viability of both microenterprises and microfinancial services (Yaron, Benjamin and Piprek, 1997). 153 Ahlin and Lin (2006) explore the impact of the macroeconomy on 329 MFIs in 70 countries over a four- to eleven-year period. They conclude that economic growth has a significant and salutary impact on MFI financial sustainability and default rates. Overall, the results suggest that macroeconomic variables are important determinants of MFI performance, although institutional characteristics are also highly significant. In other studies, Robinson (1992) and Patten and Rosengard (1991) argue that sound macroeconomic management and the operation of market forces facilitated Bank Rakyat Indonesia’s improbable turnaround from a loss-making institution to a profitable and viable enterprise (Buttari, 1995). Finally, MFIs may play a countercyclical role in times of crisis. Patten, Rosengard and Johnston (2001) argue that microfinance acted as a shock absorber during the Indonesian financial crisis of the late 1990s. Furthermore, Gonzalez (2007) finds that there is no statistically significant relationship between changes in GNI per capita growth and MFI portfolio risk. 154

Infrastructure Investment

Investment in infrastructure and social services also affects the microfinance industry. Roads, electricity grids, water and sewage systems, communication facilities and other structural developments are integral to the operation of MFIs and the businesses that they support. If entrepreneurs are unable to deliver their goods to market or access health care services due to a lack of transport services or poor regional connectivity, both their activities and their use of financial services are affected (Ledgerwood, 1999). In general, inadequate infrastructure can lower the demand for credit, undermine loan repayment capacity and discourage the establishment of microfinance operations (due to high transaction costs and risks) (CGAP, 2003).

153 On the other hand, stagnant economies with high unemployment may actually provide a seedbed for the expansion of microfinance operations. 154 While these results suggest that microfinance portfolios are resilient to economic shocks, the empirical evidence in support of this proposition is mixed; microfinance institutions fared considerably less well during the Bolivian macroeconomic crisis of 1999 to 2001 (Marconi and Mosley, 2006).

Wages, Per Capita Income and Demographics

According to Rhyne and Rotblatt (1994), much of the success of rural microfinance in Asia depends on low wages and high population density. Schreiner and Colombet (2001) find these propitious conditions absent from Argentina, a country whose microfinance industry lags behind such unlikely places as Bangladesh and Bolivia. 155 Westley (2005) also argues that regions with higher GDP per capita have less developed microfinance sectors. A number of Caribbean countries, for example, have higher income levels, lower unemployment rates and better social safety nets than Latin American countries. 156 Finally, Vanroose (2008) studies the relationship between the macroeconomic framework in 115 developing countries and the uneven outreach of microfinance institutions in these regions. Contrary to expectations, the findings indicate that microfinance is more present in the richer countries of the developing world. 157 Population density also plays a positive role, which may explain the relative absence of microfinance institutions in rural areas. 158

b) Institutions and Governance

In the vast literature on microfinance, a systematic discussion of the relationship between MFI financial performance and social impact on the one hand and country-specific institutional and governance structures on the other is relatively scarce. However, many scholars have studied the sources of institutional differences across countries and the channels through which various institutions and policies affect development. These theories on institutional development and governance quality also apply to microfinance.

155 In Argentina, high wages and sparse populations raise the costs of small loans, while the continued presence of public development banks smothers innovation. 156 These factors tend to inhibit microenterprise formation and lead to a smaller ratio of microenterprises to population. 157 Honohan’s (2004) empirical work indicates a different relationship, although the correlation is tenuous. He regresses microfinance penetration variables on population size or GDP per capita and finds a marginally significant relationship, according to which a large population and high GNP per capita (or low poverty) are associated with lower microcredit penetration. However, the goodness of fit is low (the R-squared is only 0.08 if output is measured in logs, and level-form regressions perform even worse). Honohan concludes that the highly unequal global distribution of microfinance penetration is largely random. 158 Vanroose finds that GNI per capita is positive and statistically significant. This outcome is surprising; however, it is possible that, controlling for other factors, a country must achieve a minimum level of economic development before microfinance penetration reaches significant levels. Such an explanation may also account for the predominance of urban MFIs, as per capita incomes are typically higher in urban areas.

Governance Structure

The value of constraints on government has been emphasized by early writers, such as Montesquieu (1748) and Smith (1776), as well as by the new institutional economic literature (Buchanan and Tullock, 1962; North and Thomas, 1973; North, 1981, 1990). More recently, the literature on economic growth (Knack and Keefer, 1995; Mauro, 1995; Hall and Jones, 1999; Acemoglu et al., 2001, 2002; Easterly and Levine, 2003; Dollar and Kraay, 2003; and Rodrik et al., 2004) “has reached close to an intellectual consensus that the political institutions of limited government cause economic growth” (Glaeser et al., 2004 (272)). Using data on 558 MFIs in 80 countries for the period 2002 to 2007, Mueller and Uhde (2008) provide empirical evidence that the quality of external governance 159 positively affects an MFI’s return on assets and operational self-sufficiency. Zeller and Meyer (2002) cite China as an example of a country in which administrative interference, among other factors, resulted in “meager outreach and high fragility of rural MFIs.”

Political Stability

Alesina, Ozler and Roubini (1996) argue that political instability, defined as “the propensity of an imminent government change” (197), inhibits economic growth. 160 Because instability increases policy uncertainty and thereby undermines productive economic decisions such as investment and saving, foreign investors tend to prefer a stable political environment. Instability, corruption, civil war and political rivalries have direct economic effects such as internal displacement, emigration, capital flight and currency instability. However, they also have less tangible effects: people may be less likely to establish a permanent business or enter a particular trade in an uncertain political environment.161 Sharma (2004) argues that the Maoist insurgency in Nepal impeded the development of the microfinance industry, while an enabling environment in India facilitated its expansion. Desai (2007)

159 The quality of external governance is captured by Kaufmann et al. aggregate governance indicators. Rule of law (level of crime, black markets and property rights) and government effectiveness (government credibility, quality of public and civil service, bureaucracy) are both statistically significant determinants of MFI profitability, sustainability and outreach. 160 This negative effect of instability on growth is less strong for executive turnover in industrial democracies, which suggests that democratic institutions provide a secure investment environment even in the presence of government change. 161 During periods of acute unrest, MFIs may have to discontinue operations either temporarily or permanently (Ledgerwood, 27).

80 identifies the lack of political stability in contemporary Iraq as one of the principal barriers to the delivery of financial services to the poor. Lastly, the recent wave of political violence in Kenya and Pakistan has undermined microfinance operations (Nussbaum, 2008) in these regions.

Property Rights and Capital Markets

In addition to political institutions, economic institutions such as property rights and capital and goods markets are integral to growth. 162 Lack of collateral is a major constraint for small and microentrepreneurs (International Labor Organization, 2001). It is also a constraint for banks to the extent that it discourages the financing of potentially profitable business opportunities. 163 Although the majority of MFIs do not require collateral equal to the value of loans disbursed, laws relating to property and land user rights influence the behavior of borrowers and lenders (Ledgerwood, 1999). In the Philippines, for example, the absence of formalized property rights constitutes one of the principal barriers to the development of microfinance. 164 Furthermore, Crabb’s (2006) empirical analysis of 511 institutions in 90 countries reveals a positive correlation between property rights and MFI sustainability. As regards capital and goods markets, countries with heavy government involvement in the financial sector (via state-controlled allocation of credit or restrictive banking rules, for example) have less developed microfinance sectors (Crabb, 2006). In Bolivia, Colombia and Mexico, several features of financial liberalization – the adoption of universal banking, the closure or reform of public banks 165 , the removal of interest rate restrictions, the relaxation of reserve requirements and the elimination of direct credit – removed barriers to the

162 The importance of clearly defined property rights is almost universally recognized in the literature. Knack and Keefer (1995), for instance, argue that the security of contract and property rights indirectly affects growth through factor accumulation, investment and specialization. 163 Collateral is not only a regulatory requirement, but it also represents one of the fundamental principles of sound banking. 164 An estimated 50 percent of land in Manila is without clear title. Informal ownership – or, in the words of Hernando de Soto (2000), “dead capital” – creates a situation in which banks are unwilling to lend to the poor. Legally recognized land ownership, on the other hand, would give the poor “formally recognized assets employable as collateral in a commercial transaction” (Daley and Sautet, 2005 (10)). The recognition of moveable property rights and land user rights as collateral is particularly important for opening access to long- term financing for rural populations (Nagarajan and Meyer, 2006). 165 In Bolivia, for example, the closure of four state development banks left a vacuum in the market for financial services that was subsequently filled by MFIs (Rhyne, 2001).

81 involvement of formal financial institutions in microfinance and promoted the commercialization of the microfinance industry (Devaney, Loubiere and Rhyne, 2004).

c) Economic Freedom

What connection, if any, exists between economic development and economic liberty? 166 A number of empirical studies posit a positive relation between economic freedom 167 and growth (see, for example, Barro, 1991; Barro, 1994; Scully and Slottje, 1991; De Vanssay and Spindler, 1994; and Torstensson, 1994). 168 Although few microfinance studies examine directly the connection between economic freedom and microfinance, Crabb (2006) is a notable exception. Using the Heritage Foundation’s Index of Economic Freedom 169 to study the relationship between the degree of economic freedom in a country and the sustainability of its MFIs, Crabb uncovers a positive relationship between these two variables.170 Hartarksa and Nadolnyak (2007) obtain a different result in their cross-sectional regression of 114 MFIs: economic freedom and property rights are not statistically significant determinants of MFI operational self- sufficiency.

d) Inequality and Social Cohesion

Finally, it is useful to consider the relationship between political institutions, economic policies and social structures. Much of the economic literature cites “poor institutional quality” and “misguided policy” as the principal causes of economic stagnation, endemic poverty and civil conflict (Easterly, Ritzan and Woolcock, 2006). Such explanations are

166 Economists have debated this question for centuries. While liberals eschew government intervention in the economy and embrace free market principles, others argue that state control, if applied intelligently and appropriately, can promote growth and development. 167 Economic freedom does not imply absolute freedom from state intervention. Instead, it considers such factors as personal choice, freedom of exchange and the operation of free market forces. 168 This conclusion makes intuitive sense, as “economic freedom is a philosophy that encourages entrepreneurship, disperses economic power and decision-making through the economy, and – most important – empowers ordinary people with greater opportunity and more choices” (The Heritage Foundation, 2009 (xii)). 169 According to the Heritage Foundation (2009), “in an economically free society, individuals are free to work, produce, consume, and invest in any way they please, with that freedom both protected by the state and unconstrained by the state.” Furthermore, “governments allow labor, capital and goods to move freely, and refrain from coercion or constraint of liberty beyond the extent necessary to protect and maintain liberty itself.” 170 Crabb provocatively argues that “if a government wants to contribute to microlending a long-term and effective poverty alleviation tool [it] should simply increase the amount of economic freedom.”

82 logically followed by prescriptions for institutional reform. However, even “seasoned politicians and policy-makers of good will…characteristically encounter constraints that are at once more enduring and less tangible in nature” (Easterly, Ritzan and Woolcock, 2006 (103)). For example, insufficient social cohesion 171 in developing countries impedes the implementation of pro-development policies. In this context, the inability to construct effective institutions perpetuates a cycle of underdevelopment and institutional deficiency. The degree of social cohesion within a country, as measured by the inclusiveness of its communities, institutions and norms, arguably affects not only broad macroeconomic fundamentals, but also the microfinance industry. 172 The literature suggests that existing social ties improve access to credit for the poor. 173 In fact, a large number of MFIs provide credit on the basis of “social collateral,” through which a borrower’s reputation or social network takes the place of traditional physical or financial collateral (van Bastelaer, 2000). Few empirical studies evaluate the connection between social cohesion and microfinance, perhaps because the former is difficult to measure. However, in their study of 329 MFIs from 70 countries, Ahlin, Lin and Maio (2008) find that inequality, as measured by the Gini coefficient, is a negative predictor of MFI operational self-sufficiency and growth in client outreach.

In conclusion, the literature suggests that country-specific environments are important: macroeconomic instability, economic stagnation and systemic financial crises are major obstacles for MFIs, while political, social and cultural factors also shape the development of the microfinance industry. 174 In the section that follows, I apply these theoretical findings to my empirical analysis of the Latin American microfinance industry.

171 Measures of social cohesion include income equality, ethnic harmony, civic participation and trust, among other variables. There is increasing evidence that social cohesion is critical for economic prosperity and sustainable development: “[it] is not just the sum of the institutions which underpin a society – it is the glue that holds them together” (World Bank, 2009). 172 Microfinance itself contributes to social cohesion by enlarging the political and economic resources of poor households, empowering women and promoting socio-cultural freedom (Quinones and Siebel, 2000). It has the power to challenge the status quo in countries where “[the] culture is often loaded against the poor, including in the areas of education and patriarchal norms and behavior” (Perlas, 2005). Significantly, “the apotheosis of this type of finance is the impact on the social capital and the self-reliance of its clients” (Quinones and Fernando, 2003 (6)). 173 Unfortunately, many rural areas lack the basic conditions – namely, productive activity, cultural cohesion and strong social values – required to offset economic constraints and enable innovations in sustainable microfinance (United Nations Capital Development Fund, 1999). 174 See, for example, Honohan, 2004; Marconi and Mosley, 2005; Sriram and Kumar, 2005; Crabb, 2006; Ahlin and Lin, 2006; and Ahlin, Lin and Maio, 2008.

5.2 Theoretical and Empirical Specifications

The empirical analysis in this section examines factors that affect cross-country differences in MFI financial performance and outreach success using the data set described in Section 5A.

a) Empirical Model

The empirical specification used in the analysis is as follows:

YAVG,it = constant + β1GDPCAP i + β2POPDENS i + β3INFL i + β4ODA i + β5REMITT i + β6FINDEPTH i + δ1BFREEDOM i + δ2POLSTAB i + δ3PRIGHTS i + δ4REGQUAL i + εit

Table 15 defines the dependent and independent variables in the regression.

Table 15: Variable Definitions

Variable Definition Dependent Variables OSS AVG Average OSS (operational self-sustainability) for all MFIs in a given country for a particular year. ROA AVG Average ROA (return on assets) for all MFIs in a given country for a particular year.

NB AVG Average NB (log of number of borrowers) for all MFIs in a given country for a particular year.

WOMEN AVG Average WOMEN (percentage of female borrowers) for all MFIs in a given country for a particular year.

AVGLOAN AVG Average AVGLOAN (log of average loan size) for all MFIs in a given country for a particular year. Independent Variables A. Macroeconomic GDPCAP Logarithm of gross domestic product (GDP) per capita (measured in current US$). Source: IMF. POPDENS Logarithm of population density, calculated as the midyear population divided by land area in square kilometers. Source: World Bank. INFL Inflation, based on changes in the consumer price index. Source: IMF. ODA Logarithm of official development assistance and official aid per capita (measured in current US$). Consists of disbursements of loans made on concessional terms and grants from official agencies. Source: OECD. REMITT Logarithm of worker remittances and employee compensation per capita (measured in current US$). Includes transfers by migrants who are employed or intend to remain employed for more than a year in another economy in which they are considered residents. Source: World Bank. FINDEPTH Liquid liabilities (M3 as % of GDP), calculated as the sum of currency and deposits in central bank (M0), plus transferable deposits and electronic currency (M1), plus time and savings deposits, foreign currency deposits and certificates of deposit (M2), plus travelers checks, foreign currency time deposits, commercial paper, and shares of mutual funds or market funds held by residents. Source: World Bank.

84 C. Political and Economic Freedom BFREEDOM Business freedom, or the ability to create, operate and close an enterprise quickly and easily. Burdensome regulatory rules are the most harmful barrier to business freedom. Higher scores (approaching a maximum of 100) indicate a higher level of freedom. Source: Heritage Foundation. PRIGHTS Property rights, in particular the ability of individuals to accumulate private property that is secured by clear laws enforceable by the state. Higher scores (approaching a maximum of 100) indicate a higher level of freedom. Source: Heritage Foundation. POLSTAB Political stability and absence of violence, or the likelihood that the government will be destabilized or overthrown by unconstitutional or violent means, including domestic violence and terrorism. Higher scores correspond to better outcomes. Source: Kaufmann et al. REGQUAL Regulatory quality, or the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development. Higher scores correspond to better outcomes. Source: Kaufmann et al.

Dependent Variables

To examine cross-country performance indicators, I use the following dependent (Y AVG ) variables: OSS AVG , ROA AVG, NB AVG , WOMEN AVG and AVGLOAN AVG. These variables represent average financial and outreach measures in a given country for a particular year.

For example, OSS AVG for Argentina in 2007 is calculated as the mean OSS of Argentinean MFIs in 2007. For each dependent variable, the country-level data set includes a maximum of 165 observations (or 11 observations (1997-2007) for each of the 15 countries represented in the sample). As noted in Section 5A, the number of MFI observations differs across countries; Peru and Bolivia are overrepresented in the sample, while smaller countries, such as Argentina, Paraguay and the Dominican Republic, are underrepresented. There is a risk that the small number of observations for the latter group of countries may skew the average financial and outreach data if the MFIs are not representative of the industry as a whole. Nevertheless, the composition of the data set mirrors the contemporary microfinance landscape in the region; the average performance indicators in my empirical analysis are similar to the MIX Market (November 2007) country benchmarks for Latin America.

Independent Variables

In order to assess the macroeconomic determinants of MFI financial and outreach success, I control for GDPCAP (log of GDP per capita), POPDENS (log of population density), INFL

85 (inflation), ODA (log of official development assistance per capita), REMITT (log of remittances per capita) and FINDEPTH (financial depth). BFREEDOM (business freedom), PRIGHTS (property rights), POLSTAB (political stability) and REQUAL (regulatory quality) are also included in the regression. From the literature on microfinance and the macroeconomy, one would expect richer (higher GDP per capita) countries with lower population densities and higher inflation rates to have lower MFI sustainability, profitability and breadth of outreach. Remittances, business freedom, property rights, political stability and regulatory quality are likely to have a positive impact on financial performance and outreach.

b) Cross-Country Analysis: Financial Indicators

Table 16 presents the empirical results for the financial performance regressions. The dependent variables in Column I and Column II are operational self-sustainability (OSS AVG ) and return on assets (ROA AVG ), respectively.

Table 16: Empirical Results for MFI Financial Performance

Dependent Variable: OSS AVG Dependent Variable: ROA AVG GDPCAP -0.109 -0.0622 (0.0741) (0.0409) POPDENS -0.119*** -0.0367 (0.0304) (0.0149) INFL -0.425* -0.146 (0.217) (0.0947) ODA -0.0463 -0.0276 (0.0343) (0.0126) REMITT 0.118** 0.0352 (0.0499) (0.0289) FINDEPTH -0.450 -0.108 (0.292) (0.0764) BFREEDOM 0.00224 0.000353 (0.00324) (0.00153) POLSTAB 0.000640 -0.000140 (0.00198) (0.000542) PRIGHTS -0.00562 -0.000575 (0.00443) (0.00219) REGQUAL 0.00721*** 0.00213 (0.00232) (0.00150) R-squared 0.280 0.218 No. obs 84 79 Prob>F 0.0000 0.0045 Note: standard errors in parentheses. *Significant at 10%; **Significant at 5%; ***Significant at 1%.

86 The results indicate that GDP per capita does not have a significant impact on MFI performance. This outcome seems to support the Economist Intelligent Unit’s (2007, 2008) finding of a disassociation between country wealth and the favorability of the microfinance business environment. In particular, a number of less prosperous countries in Latin America and the Caribbean (Bolivia and Nicaragua, for example) have strong microfinance climates, while others (such as Haiti and Honduras) have considerably less favorable business, investment and regulatory conditions for microfinance. Second, lower population density is associated with higher operational sustainability and return on assets. While the literature generally posits a positive relationship between population density and financial success (due to higher transaction costs, fewer economic opportunities and poor infrastructure in low-population density regions), the potential return from microfinance operations may be greater in low-density areas (due to the lack of competition and the ability to charge higher interest rates). Looking at the summary statistics in Table 8 (please refer to Section 5A), a number of countries with low population densities – Nicaragua, Paraguay and Peru, for example – also achieve high average OSS and ROA. Inflation also has a negative impact on both OSS and ROA and is statistically significant in the former specification. Inflation erodes the capital base of MFIs, increases price and exchange rate volatility and makes it difficult to mobilize resources, especially savings (Helms, 2006). It is possible that Latin American MFIs have not developed sufficient safeguards to perform successfully in inflationary environments. On the other hand, countries with persistently low inflation rates and relative macroeconomic stability tend to have more mature microfinance sectors (Rhyne, 2001). Fourth, remittances per capita have a positive impact on OSS. Remittances are resilient to market fluctuations and counter-cyclical in times of recession. 175 Due to the (person-to-person) nature of remittance flows, the former also elude the intervention of corrupt governments and the restrictions imposed by the IMF and World Bank on soft loans and development grants (Ramirez, Dominguez and Morais, 2005). For these reasons, coupled with the fact that a significant number of MFI borrowers receive money from relatives

175 Of course, if the economic downturn is global (rather than local or regional), remittance flows may not exhibit these stable properties. A recent CGAP conference (2008) on Microfinance and the Financial Crisis highlights the impact of the current financial crisis on remittance flows to developing countries. In particular, job losses in the United States and Europe are adversely affecting MFIs, microentrepreneurs and other remittance recipients.

87 working abroad 176 , it is understandable that remittances have a salutary impact on MFI sustainability. Finally, REGQUAL has a positive impact on sustainability and profitability (although it is not statistically significant in the ROA specification). Poor regulatory quality is associated with unfair competitive practices, price controls, discretionary tariffs and other market-unfriendly policies in such areas as foreign trade and business development, while strong regulatory frameworks are characterized by price liberalization, effective commercial law and adequate bank supervision. Interestingly, countries with strong regulatory ratings, such as Mexico, Brazil and Costa Rica, do not have the most developed microfinance industries. Still, MFIs in these countries outperform in terms of OSS. Thus, a strong regulatory environment for formal financial institutions is not necessarily indicative of a mature and competitive microfinance sector. While the connection between the macroeconomy and MFI sustainability is interesting, the lack of a relationship between financial performance on the one hand and governance and economic freedom on the other is also revealing. Business freedom, political stability and the security of property rights fail to explain cross-country differences in MFI sustainability and profitability. This finding is somewhat surprising given that many cross- country studies of financial intermediaries and firms have found these variables to be significant (Hartarska and Nadolnyak, 2007).

c) Cross-Country Analysis: Outreach Indicators

Table 17 presents the empirical results for the outreach regressions. The dependent variables

in Columns I, II and III are log of the number of borrowers (NB AVG ), percentage of women borrowers (WOMEN AVG ) and log of average loan size (AVGLOAN AVG ), respectively.

176 For example, a study conducted by El Comercio, a Paraguayan MFI, shows that 20 percent of its clients receive remittances.

Table 17: Empirical Results for MFI Outreach

Dependent Variable: Dependent Variable: Dependent Variable: NB AVG WOMEN AVG AVGLOAN AVG GDPCAP -1.31*** 0.0501 0.101 (0.288) (0.0350) (0.141) POPDENS -0.657*** 0.0625*** -0.239*** (0.162) (0.0159) (0.0814) INFL -1.87* -0.224*** 0.192 (1.00) (0.0655) (0.286) ODA -0.481*** 0.00993 0.0699 (0.126) (0.0160) (0.0586) REMITT 0.951*** 0.00246 0.169* (0.191) (0.0214) (0.0935) FINDEPTH -0.596 0.0585 0.0964 (1.15) (0.117) (0.681) BFREEDOM -0.00950 -0.00215 -0.0132* (0.0125) (0.00161) (0.00792) POLSTAB -0.0230*** -0.00103 0.00917** (0.00724) (0.000666) (0.00404) PRIGHTS -0.0102 0.00219 -0.0125** (0.0153) (0.00171) (0.00608) REGQUAL 0.0365*** -0.00125 0.0176*** (0.00695) (0.000899) (0.00505) R-squared 0.544 0.396 0.404 No. obs 86 83 85 Prob>F 0.000 0.000 0.000 Note: standard errors in parentheses. *Significant at 10%; **Significant at 5%; ***Significant at 1%.

Breadth of Outreach: NB

The results indicate that GDPCAP, POPDENS, INFL, ODA and POLSTAB negatively affect breadth of outreach. First, MFIs in poorer countries reach more borrowers than MFIs in richer countries, all else equal. This situation may arise due to higher demand for microfinance services in poorer countries. Second, population density is negatively correlated with breadth of outreach: a higher population density is associated with a smaller number of borrowers. It is important to note that this latter result depends on the inclusion of Haiti, El Salvador and Costa Rica, countries with both high population densities and undeveloped microfinance sectors. If these three countries are excluded from the analysis, population density loses its statistical significance. 177 Third, higher levels of inflation undermine outreach, presumably due to the added risk of extending loans in inflationary environments.

177 The literature on microfinance posits a positive correlation between population density and MFI outreach. In rural areas, for example, low population density constitutes one of the principal barriers to the establishment of sustainable microfinance operations and broad-based outreach (Charitonenko and Campion, 2003).

89 Fourth, the level of official development assistance per capita has a negative impact on the number of borrowers. Finally, the Kaufmann et al. political stability indicator is negative and statistically significant. It is possible that MFIs flourish in unstable political environments due to the unwillingness of formal financial institutions to lend to low-income populations in such circumstances. REMITT is a positive and statistically significant determinant of the number of borrowers; there appear to be synergies between microfinance and foreign-based wage- earning opportunities. Ahlin, Lin and Maio (2008) reach a similar conclusion in their analysis of 329 MFIs from 70 countries; in particular, their analysis shows that higher remittances (as a percentage of GDP) are associated with lower default rates and improved operational sustainability. MFIs in countries with better regulatory environments (REGQUAL) also tend to reach more borrowers. Microfinance is already expensive due to high per-unit transaction costs; however, the costs of financial intermediation increase further in the presence of inappropriate or burdensome regulatory requirements. 178

Depth of Outreach: WOMEN and AVGLOAN

GDPCAP does not have a significant impact on WOMEN or AVGLOAN; contrary to expectations, MFIs in poorer countries do not have proportionally more women borrowers or relatively smaller average loan sizes. On the other hand, there is an important relationship between population density and depth of outreach: MFIs in countries with higher population densities serve proportionally more women and extend smaller loans. REMITT is positive in both regressions and statistically significant in the AVGLOAN specification. 179 Remittances from abroad may support the expansion of small-

178 According to an Inter-American Development Bank survey (1997) of 23 bank superintendencies in Latin America and the Caribbean, it is possible to identify regulatory obstacles to microfinance in almost every country. In Argentina, for example, high minimum capital requirements for banks and finance companies discourage the entry of commercial institutions into the microfinance market. In Brazil, loan loss provisions and restrictive interest rate ceilings do not allow sufficient flexibility when lending to small and microentrepreneurs. And in Honduras, restrictions on institutional ownership and inappropriate methods of portfolio evaluation are among the principal legal barriers to microfinance activities (Wenner, 1997). 179 In a 2003 MIF-PHC study, women received the majority of remittance funds in every country surveyed (Mexico, El Salvador, Guatemala, Honduras and Ecuador). Women use remittances for investments, savings and businesses (Mahler, 2006), and MFIs are responding to the unmet demand for remittance-based products and services. For example, Fonkoze, a Haitian microfinance institution, offers savings and currency exchange services in addition to solidarity group and individual loans. Significantly, 96 percent of Fonkoze borrowers are women (Ramirez, Dominguez and Morais, 2005).

90 scale businesses (leading to demand for larger loans) or increase access to microfinance services (by serving as collateral on loans). Lastly, POLSTAB and REGQUAL are positively related to average loan size. MFIs in countries with unstable political systems and more violence may find it difficult to extend large loans; at the same time, a strong regulatory framework for financial institutions – as exists in Bolivia, Costa Rica and Peru, for example – may encourage the formalization of microfinance institutions via upscaling and the entry of commercial banks via downscaling. 180

Interestingly, the institutional variables that are insignificant in the OSS and ROA regressions – business freedom, political stability and property rights – figure prominently in the NB and AVGLOAN regressions. In a number of cases, however, the direction of causality may appear counter-intuitive; for example, greater business freedom and stronger property rights are associated with smaller average loan sizes. One possible explanation for this result is that MFIs in countries with secure property rights and broad economic freedoms focus on a relatively poorer clientele because mainstream financial institutions capture the upper end of the small and microenterprise market.

Conclusion

In conclusion, “while the macroeconomy is not an MFI’s destiny, its effect is significant and should not be ignored” (Ahlin, Lin and Maio, 2008). Macroeconomic stability (low inflation) and a strong legal framework (better regulatory quality) have a positive impact on MFI financial viability and breadth of outreach. Remittance flows also contribute to MFI sustainability and outreach. On the other hand, the significance of business freedom, political stability and property rights is less clear. It appears that MFIs can flourish in politically unstable countries with less economic freedom and uncertain property rights. Still, it should be noted that the ability of MFIs to operate successfully in insecure environments does not imply a causal relationship; in fact, improving the business environment for microfinance by strengthening property rights and promoting microenterprise activities, among other things, can contribute positively to the development of the microfinance sector (Economist Intelligence Unit, 2008).

180 Banks, in particular, have larger average loan sizes than other providers. For the data set used in the analysis, banks have the highest average loan sizes, followed by non-bank financial institutions and NGOs.

VI. Looking Ahead

“The vision of microfinance is quite simple - to create systemic change in financial systems worldwide. Instead of the exclusive financial systems that have for decades benefited and protected the wealthy, microfinance intends that they serve the impoverished majorities, help lift them out of poverty, and make them full participants in their country's social and economic development. In the next ten years, our task is to make certain that millions of poor men and women currently unserved can access financial services. How do we get there?” – Mario Otero, President & CEO of ACCION International

In this section, I summarize the key empirical results from Section V, make a number of policy recommendations and suggest areas of future study. I then conclude my paper with a discussion of the future prospects and challenges for the Latin American microfinance industry.

Summary of Results, Policy Recommendations and Suggestions for Further Research

a) Empirical Results

The empirical analysis in this paper examines three fundamental issues: first, the relative financial performance (in terms of operational self-sustainability and return on assets) of regulated and unregulated MFIs; second, the relative outreach success (in terms of depth of outreach (number of borrowers) and breadth of outreach (percentage of women borrowers and average loan size)) of regulated and unregulated MFIs; and finally, cross-country differences in MFI performance. A number of salient results emerge from the analysis. First, it is evident that regulated MFIs do not have a monopoly on strong financial performance. Although regulated institutions in the sample have a higher average OSS and ROA than unregulated institutions, regulatory status alone does not explain the observed difference in sustainability and profitability. Instead, institutional characteristics are highly significant: larger and more mature MFIs with a higher capital ratio (less leverage), a stronger focus on lending (higher loan-to-asset ratio) and a lower risk exposure (lower writeoff ratio) tend to outperform. 181

181 This is not to say that regulation is unimportant; however, the positive effect of regulation on OSS and ROA seems to operate through institutional characteristics rather than regulatory status as such. In other words, regulated MFIs achieve better financial results because they have institutional characteristics that enhance

92 In terms of outreach, the results indicate that regulatory status and nonprofit status significantly affect depth and breadth of outreach without controlling for institutional characteristics. However, when MFI-specific variables are included in the regression, regulatory status does not seem to explain broader outreach (a greater number of borrowers) and possible mission drift (a smaller percentage of women borrowers and higher average loan sizes) at regulated institutions. Again, institutional characteristics – size, capital-to-asset ratio, loan-to-asset ratio, saving-to-asset ratio and write-off ratio – have considerable explanatory power. Furthermore, the NGO dummy retains its significance in a number of specifications; on average, NGOs achieve greater depth of outreach than banks and non-bank financial institutions.182 From a cross-country perspective, macroeconomic variables such as the rate of inflation and per capita remittances help to explain cross-country differences in average MFI performance. In particular, inflationary environments undermine MFI sustainability and outreach, while remittance flows contribute positively to these two objectives. Among institutional factors, business freedom, political stability and the security of property rights do not have a significant impact, while regulatory quality is important. Controlling for other variables, MFIs in countries with stronger regulatory frameworks are more sustainable and serve more borrowers.

b) Policy Recommendations

“Diverse channels are needed to get diverse financial services into the hands of a diverse range of people who are currently excluded. Making this vision a reality entails breaking down the walls—real and imaginary—that currently separate microfinance from the much broader world of financial systems.” – Helms, 2006

From the empirical analysis, I would like to highlight two key policy insights: first, the viability of multiple approaches, methodologies and institutions in microfinance and, second, the importance of an enabling macroeconomic and regulatory framework.

financial performance. This finding also implies that once an NGO has achieved a certain age, size, loan-to-asset ratio, capital-to-asset ratio and write-off ratio, transforming into a regulated financial institution may not (necessarily) induce further improvements in financial and outreach indicators. 182 Given this finding, NGOs considering transforming into regulated institutions should recognize a possible tradeoff between breadth and depth of outreach: although regulated MFIs in the sample tend to reach more borrowers, they also have lower percentages of female borrowers and higher average loan sizes.

93 Commercial microfinance is neither a panacea nor an end in itself. First, transformation is not a prerequisite for stellar performance; some NGOs are among the highest-performing MFIs in the microfinance industry (Frank, 2008). Second, regulatory status implies a profit orientation, which may not be the focus of all microfinance providers. MFIs with strong poverty alleviation missions, for example, may find it difficult or undesirable to transform into profitable entities. 183 In such cases, the most appropriate model for microfinance delivery may be a membership-based organization such as a credit union or a rural cooperative. For high-risk activities, such as targeting extremely marginalized populations or funding microenterprise start-ups, a subsidized NGO may be the most appropriate institutional model. 184 Finally, small MFIs may find that the reporting duties and capital requirements associated with regulation impose costs that limit product innovation and outreach (Bebczuk, 2008). In order to undertake microfinance profitably, commercial banks must devote considerable time to product design and field experimentation, while NGOs must adjust to a for-profit structure with new owners and regulators. 185 In many cases, institutions fail at these critical tasks: the commercial microfinance landscape is littered with unsuccessful attempts by commercial banks to enter the microfinance market niche and unsuccessful attempts by NGOs to transform into banks or specialized finance companies (Rosengard, 2000). Yet a few cases of downscaling and upscaling – Bank Rakyat Indonesia in Bangladesh and BancoSol in Bolivia – have produced remarkable results. 186 And as Rosengard (2004) argues,

183 While the provision of financial services to the very poor is not inconsistent with a focus on commercialization, microcredit is inappropriate for people who fail to establish a minimum repayment capacity (Marulanda and Otero, 2005). In other words, credit is not a substitute for the provision of social services by governments. 184 Marulanda and Otero (2005) argue that NGOs will continue to play an important role in extending credit to underserved populations, especially in rural areas: “the very fact of not being regulated and not having to administer savings collected from the public actually gives these NGOs the operational flexibility to take on these challenges.” Rafael Llosa of MiBanco in Peru envisions NGOs penetrating “rural and remote areas where the competition is low,” while Stelio Gama Lyra Junior of Banco do Nordeste (CrediAmigo) in Brazil suggests that “the primary role for NGOs in the coming years will be to develop sustainable financial services for very small towns” (Rhyne and Otero, 2006 (54)). Even in countries where regulated MFIs have significant market penetration, NGOs can provide crucial advisory services to microentrepreneurs. 185 According to Rosengard (2004), “banks must…change the way they make loans if they are to tap the microenterprise market profitably: the design of loan products must meet business needs and projected cash flow of prospective borrowers; loan processing must be swift and decentralized; staff must be familiar with local markets and communities; loans must be priced to generate a surplus after covering all financial, operational, and loan loss costs; and accounting, reporting, and supervision systems must be accurate and transparent.” Similarly, “the transformation from an NGO to a regulated financial institution is extremely difficult, and poses many strategic, operational, and regulatory challenges.” 186 Entities that today are considered to be among the industry leaders in Latin America – BancoSol, FIE and Caja Los Andes in Bolivia, Finansol (now Finamerica) in Colombia, Financiera Calpia in El Salvador,

94 “the microfinance institutions that have the largest and longest-term impact are those that are financial sustainable.” 187 Under what circumstances, then, should banks downscale and NGOs upscale? Commercial banks have an enormous capacity to deliver microfinance services. 188 Unfortunately, the downscaling landscape is characterized by a “revolving door syndrome” in which many banks leave the microfinance market segment after a couple of years. 189 Today, the banks that have the most profitable microfinance operations approach the business as a serious venture, leveraging existing infrastructure and developing specialized products, staff and systems (Young et al., 2005). 190 Similarly, the most powerful examples of NGO formalization have the following commonalities: a conscious management decision to pursue scale, a willingness to take calculated risk and an emphasis on commercial business principles, regardless of governance structure or legal status (CGAP, 2004). 191 For NGOs and other unregulated microfinance providers, institutional transformation may be appropriate for a number of reasons. First, large MFIs with significant operating assets may not be able to realize economies of scale as unregulated institutions. Second, even if unregulated MFIs have the infrastructure to expand loan portfolios and outreach, funding constraints may impose upward limits on growth. In this context, regulation can overcome obstacles to institutional development by opening access to commercial capital and savings deposits (Tucker and Tellis, 2005). Finally, low operational standards are an argument for regulation because regulated MFIs are subject to

Compartamos in Mexico, MiBanco in Peru and Procredit in Nicaragua – have common roots as NGOs that transformed into regulated financial institutions. 187 Today, it is the MFIs that cover all costs (operating expenses, cost of funds and loan losses) and generate a surplus for reinvestment in new products, delivery systems and technologies that collectively represent the leading edge of the global microfinance industry. 188 The inherent advantages of commercial banks include extensive branch networks, established back office systems, a large capital base, access to loanable funds, a system of private ownership that encourages sound governance and efficiency, and a wide range of deposit, loan and other financial services. 189 According to Westley (2007), there are two main causes for this syndrome: a technical failure and a commitment failure. The former reflects an inability to understand microfinance-specific credit methodologies, while the latter suggests an unwillingness to spend the time and resources required to develop microfinance into a profitable business segment. 190 As of December 2005, 30 downscaling banks in Latin America and the Caribbean were serving over one million microenterprise clients with US$1.8 billion in loans. These banks account for one-third of the region’s total microcredit (Westley, 2007). 191 Examples from Latin America include BancoSol and Caja Los Andes in Bolivia, Financiera Calpia in El Salvador, MiBanco in Peru, Compartamos in Mexico and CONFIA in Nicaragua. Globally, XAC Bank in Mongolia, OMB in the Philippines, SHARE in India and K-Rep in Kenya are considered successful transformations (Fernando, 2004).

95 far more scrutiny than unregulated MFIs in terms of reporting requirements and accounting standards. 192 Overall, there is room for multiple approaches to the provision of financial services to the poor. As Rosengard (2000) argues: “Potential markets are not only large, but also heterogeneous. Competition should benefit the microfinance consumer by lowering costs and improving service. The guiding principles should be institutional diversification, product differentiation, and market segmentation. Match the model with the mission. Disregard the microfinance evangelists proselytizing one way of doing business” (9).

A second policy issue relates to the country-specific environmental factors that enable or hamper the financial and outreach success of MFIs. The empirical analysis in Section V reveals an important link between MFI performance and the macroeconomy. Other studies reach similar conclusions: unfavorable macroeconomic or sociopolitical conditions tend to undermine microfinance operations. 193 In this context, perhaps “the greatest contribution that a government can make to the microfinance industry…is to assure a macroeconomic equilibrium in which depositors, borrowers and shareholders can simplify economic planning and make long-term decisions” (Sanabria, 2000). Furthermore, while MFIs can operate successfully under a range of regulatory conditions, a strong regulatory framework enhances MFI sustainability and breadth of outreach. 194

c) Suggestions for Further Research

Further empirical work is required in order to develop a deeper understanding of the impact of regulation on financial performance and outreach in Latin America. First, one of the principal limitations of the empirical analysis in Section V is the absence of data on the total number of MFIs in a given country. By including as an explanatory variable the size of the microfinance market, it is possible to control for the level of competition in a country, as well as the maturity of its microfinance industry. 195 Second, the literature suggests that the

192 A greater emphasis on sustainability promotes operational efficiency, creates positive incentives for saving and loan repayment, and reduces dependency on external funding. 193 See, for example, Crabb (2006), Ahlin, Lin and Maio (2008) and Bogan (2009). 194 Cuevas (1996) suggests that successful MFI formalization is particularly sensitive to regulatory conditions. 195 In their cross-country study of MFI sustainability and outreach, Hartarska and Nadolnyak (2007) include the number of MFI competitors as an explanatory variable. They find that this variable is positive and statistically significant (although not robust) at the 10 percent level in the outreach specification. According to

96 informal sector is the principal market for both MFIs and microenterprises; thus, incorporating data on the size of the informal market (either as a macro-level explanatory variable for average financial and outreach success or as a more precise measure of a country’s total population) may yield a more accurate picture of the macroeconomic determinants of MFI performance. In order to evaluate further the existence and magnitude of mission drift for regulated MFIs, it would be useful to broaden the outreach analysis by considering other client characteristics, such as the percentage of borrowers below the poverty line or the number of first-time borrowers. While the MIX Market provides such data, it is only available for a small number of MFIs. A number of macro-level indicators – human capital and inequality, among other variables – may also explain cross-country differences in the poverty level of MFI clients. 196

The Future of Microfinance in Latin America

In their study The Profile of Microfinance in Latin America in 20 Years: Vision & Characteristics , Marulanda and Otero (2005) provide an overview of the contemporary Latin American microfinance landscape and discuss important industry trends over the coming decade. This section highlights some of the key findings of the report, incorporating future projections by scholars, industry leaders and microfinance providers.

a) Prospects and Trends

Continued Commercialization

“The picture so far is breathtaking. Where small, heavily subsidized microcredit schemes used to be the norm, hundreds of profitable microfinance providers of all institutional shapes and forms are now offering a wide range of financial services…to ever-larger numbers of poor people in their communities. In a sure sign that microfinance is going mainstream, the authors, this weak result may be attributed to poor data quality: the variable is based on data collected by the Microcredit Summit Campaign and reflects the year 2002 only. While a similar variable was also considered for the empirical analysis in this paper, it was later excluded; existing data is incomplete and, in many cases, does not accurately reflect the number of MFIs serving Latin American markets. 196 In assembling the country-level data set for the analysis in Section 5D, I collected data (from various World Bank and United Nations databases) on a wide range of social indicators: literacy rate, secondary school attainment, inequality (GINI coefficient), slum population, poverty gap at US$1 per day and percentage of population below the national line. However, because these statistics are based on infrequent household surveys and, as such, are not available for the entire period under study (1997-2007), they were not used in the analysis.

97 domestic and international commercial banks are now entering the fray, motivated by the excellent performance of poor clients and the promise of new information and delivery technologies to reduce cost and risk.” – Helms, 2006

Over the last several years, two commercial approaches to the provision of microfinance services – upscaling and downscaling – have accelerated. These trends will continue to shape the microfinance landscape in Latin America. Conventional banks, in particular, will play a greater role in microfinance over the coming decade. 197 The large infrastructure, sophisticated internal systems and ready capital of these institutions make them attractive microfinance delivery vehicles. But banks also face significant barriers in reaching a market that they historically either excluded or ignored. In this context, a “symbolic relationship” between NGOs and commercial banks – with the former leveraging their success at social engineering and the latter focusing on financial intermediation – is needed (Padhi, Bibhudutt). 198

Connecting Microfinance and the Capital Markets

“The reason why the connection with capital markets is a watershed lies in the fact that, if accomplished, it will make the outreach of microfinance to date . . . a mere prologue for what will come.” – Michael Chu, former president of ACCION International (1998)

As MFIs shed their traditional image of alternative banks that offer unconventional credit to marginalized clients, they are accessing the capital markets to raise funds for lending operations. In 1997, BancoSol in Bolivia launched a $3 million bond. Finamerica, a non-bank financial institution in Colombia, issued a $2 million convertible bond in 2001. The following year, Mexico’s Compartamos raised US$20.5 million with its float on the Mexican stock exchange and another MFI, MiBanco of Peru, issued a US$6 million bond (Conger, 2003). These market operations are a strong indication of the increasing integration of MFIs into the formal financial system. 199 They also signal the diversification of microfinance funding sources, enabling lenders to expand their credit portfolios. 200

197 In a qualitative survey of over 30 industry leaders in Latin America, all but one of the institutions surveyed expect commercial banks to be important players in the next ten years (Marulanda and Otero, 2005). 198 ACCION International is already working with large commercial banks in Haiti, Ecuador and Brazil to implement a “service company model.” This innovative approach involves the creation of a separate private company that operates like an MFI but uses the parent bank’s capital and systems. 199 It is particularly noteworthy that high net worth individuals and institutional investors (including pension funds, mutual funds and insurance companies) were major buyers. 200 According to Compartamos project manager Carolina Velasco, “Getting into the debt market is very good for us; it diversifies our funding sources, reducing our levels of risks associated with our funding” (Conger, 2003 (22)).

98 With the prospect of commercial investment, MFIs are improving transparency and accountability. As of March 2009, 234 MFIs in Latin America and the Caribbean had credit ratings (The Rating Fund, 2009). Ratings are concentrated in the Andean region, where the microfinance industry is highly developed, and in Brazil and Mexico. In the future, formal performance assessments will likely become a necessary condition for access to funding, as well as one of the principal determinants of the price of such funding (Farrington, 2005). Perhaps the most notable change in the microfinance investment landscape is the entry of private investors. 201 Individuals and institutions – from international investment banks to pension funds to private equity funds – are making substantial investments in MFIs. Over the past three years, forty specialized microfinance investment funds were created. In 2006 alone, over $2 billion in commercial capital poured into microfinance investment vehicles; by 2007, this investment had grown to over $3 billion (CGAP, February 2008).

Client Expansion, Product Diversification and Technological Innovation

“The challenge today is to roll out the methodology refined by microfinance institutions on a mass scale: to engage more types of distribution systems, more technologies and more talent to create financial systems that work for the poor.” – Elizabeth Littlefield, 2005

In terms of client outreach, the target market is expanding to poorer segments of the population, as well as low-income salaried workers. In fact, urban, commercially oriented MFIs have successfully entered rural areas in a number of countries.202 Still, Rhyne and Otero (2006) predict that most commercial MFIs will focus on clients hovering just below and just above the poverty (rather than people in the bottom half of those living below the poverty line).

201 The socially responsible investment market is huge, with over US$4 trillion in assets. Socially responsible investors are attracted to MFIs for their double bottom line strategy: positive social impact and compelling financial value (CGAP, February 2008). But microfinance is not only an attractive proposition for socially responsible investors; it is also capturing the interest of mainstream investors with a purely commercial focus. 202 Banco Solidario in Ecuador began a rural lending program in September 2001 and, as of December 2003, the program was reaching nearly 4,000 individual and group borrowers with a cumulative portfolio of nearly $5.4 million. El Comercio, a Paraguayan finance company, operates nearly 50 percent of its branches in rural locations. Compartamos – the largest MFI in Mexico and one of the most profitable in Latin America – began as a rural-based institution and, although it has recently penetrated urban areas, the majority of its clients live in rural communities with limited access to financial services. Finally, Banco do Nordeste in Brazil is now considering adopting a village banking methodology based on the Compartamos model. These examples illustrate the viability (and profitability) of commercial microfinance in rural areas (Manndorff, 2004).

99 At the same time as they diversify their client bases, MFIs are innovating new products. Microfinance is not just about loans; ultimately, microfinance represents a vision for inclusive financial systems that sees “poor people everywhere enjoy[ing] permanent access to a wide range of quality financial services, delivered by different types of institutions through a variety of convenient mechanisms” (CGAP, 2006). Finally, technology is poised to play a crucial role as MFIs scale up their operations. New delivery channels and information systems enable MFIs to improve management decision-making, tighten cost controls, expand distribution channels, increase deposit mobilization and enhance customer service, among other advantages (CGAP, 2005). Microfinance providers are also exploring ways to incorporate financial service delivery into existing infrastructure, such as retail shops and post offices (Littlefield and Rosenberg, 2004).

b) Key Issues and Challenges

Operational Concerns

Despite regional differences, MFIs in Latin America confront similar operational challenges. First, as competition increases 203 , MFIs will face pressure to increase efficiency, improve loan terms and decrease interest rates.204 The subprime mortgage crisis offers a valuable lesson for the microfinance sector: strong underwriting standards – even in the face of intense competition – are critical for long-term institutional viability. 205 More generally, in order to survive in a competitive environment MFIs “must learn to look outside themselves by adding externally focused competencies in the areas of market research and analysis of competitive advantage” (Drake and Rhyne, 2001 (219)). 206

203 Heightened competition stems from three sources: i) the expansion of self-identified MFIs; ii) the entry of new commercial players into the microfinance market; and iii) the emergence of businesses such as consumer lending with a similar target group as traditional microfinance (Drake and Rhyne, 2001 (200)). 204 Some institutions have already demonstrated an ability to respond to competitive pressures by increasing productivity and reducing costs. BancoSol, for example, reduced its operating expense ratio to the single digits, a rate considered unattainable less than a decade ago (Rhyne and Otero, 2006). 205 The impact of consumer lending on MFIs is a major concern, as consumer lenders tend to offer fast approval for individual loans and target the same clientele as enterprise-based microlenders (MIX Market, September 2008). 206 In the absence of competition, MFIs can focus on internal objectives – streamlining operating systems, improving productivity and increasing client volumes – while ignoring external conditions. A competitive environment forces MFIs to shift their core objectives, replacing a preoccupation with growth with a concern for market share (Drake and Rhyne, 2001). Experiential evidence suggests that larger MFIs have a comparative advantage in a competitive environment (Ramirez, 2004).

100 A second challenge moving forward is to increase the availability of funds. The current global financial crisis underscores the importance of a diverse and stable source of funding: MFIs are experiencing downward pressure on margins due to the rising cost of capital. In addition, the economic turbulence is restricting the ability of MFIs to pursue initial public offerings (IPOs). 207 Overall, MFIs need to focus on stabilizing existing funding sources while developing alternative lower cost funds (such as local currency deposits). Finally, in the context of continued commercialization – increasing emphasis on efficiency and profitability, coupled with the entry of private investors – it is important to revisit the mission drift debate: will profits be reinvested for the benefit of clients (via lower interest rates, new products and more remote service provision) or redistributed in the form of dividends to shareholders?

Commercial Microfinance and the Double Bottom Line

“The time has come to make microfinance fully part of the mainstream, so it can boost equitable economic growth while at the same time lifting millions of people out of poverty with self-determination, self-respect and dignity.” – Elizabeth Littlefield, CGAP CEO and World Bank Director (2005)

Microfinance practitioners that embrace commercialization argue that commercial capital is necessary to meet the immense demand for financial services among the poor: “microfinance will only realize its potential if it is integrated into a country’s mainstream financial system” (CGAP, 2004). But concerns about the effect of profit-maximizing behavior on poverty reduction and other development goals persist. Arguments for “concessional finance” (CGAP, 2004) and “smart subsidies” 208 (Morduch and de Aghion, 2007 (244)) to complement private capital reflect a certain reluctance to embrace the prospect of full-fledged commercialization. Evaluating the social impact of microfinance providers is difficult due to the complexity of poverty issues and the absence of rigorous assessment measures (Sebstad and

207 A survey by Microfinance Insights of 120 MFIs and 40 investors from around the world reveals that over 25 percent of non-deposit taking MFIs have decreased their lending over the past year and 20 percent have reduced their staff size. Forty-one percent of MFIs have faced higher interest rates from lenders and 37 percent have revised downward their growth projections. Nevertheless, investor confidence remains strong: over 80 percent of investors have not reduced their portfolio allocation toward MFIs due to the global recession. 208 The term “smart subsidies” refers to “carefully designed interventions that seek to minimize distortions, mistargeting and inefficiencies while maximizing social benefits” (Morduch and de Aghion, 2007 (245)).

101 Chen, 1996; Khandker, 1998; Morduch, 1998; de Aghion & Morduch, 2007). As a result, “social performance assessment and management has failed to achieve the same clarity, consistency and level of acceptance as financial performance assessment and management” (Copestake, 2006). Still, the former is as integral to sustainable microfinance as the latter. Significantly, the experience of leading MFIs suggests that a double bottom line strategy does not imply a lack of concern for the poor 209 : “the most encouraging aspect of sustainable microfinance is that when the profit motive and development impact reinforce each other, and in fact, depend on each other, a powerful synergy is created whereby self- interest and community interest converge” (Rosengard, 2004). But if, as Rosengard (2004) suggests, “profits and progress can be complementary, not competitors,” then MFIs need accurate methods to document social gains. Applying an analytical framework for the joint realization of financial value and social impact may be a valuable addition to industry best practices (Tulchin, 2003).

Broadening the Scope of Microfinance: Breadth and Depth of Outreach

“The stark reality is that most poor people in the world still lack access to sustainable financial services…. The great challenge before us is to address the constraints that exclude people from full participation in the financial sector.” – Kofi Annan, 2003

Two challenges stand out with regard to microfinance outreach in Latin America: penetrating underserved markets in large countries and reaching farther down the socioeconomic ladder. The Latin American population is heavily concentrated in five countries: Argentina, Brazil, Colombia, Mexico and Venezuela account for 73 percent of the region’s total population. Four of the five countries are also included in the group of 25 countries with the most unequal distribution of income in the world. 210 Meeting the demand gap in large countries – and creating a policy environment that supports the integration of microfinance into mainstream financial markets – is a daunting task. However, some microfinance

209 For example, while village banking MFIs top the MIX Market’s “depth of outreach” ranking for Latin America, some of the region’s largest and most successful institutions – Compartamos of Mexico and CrediAmigo of Brazil – are also found among the institutions that reach farthest down the socioeconomic ladder (MIX, 2007). 210 While three of the region’s leading MFIs – CrediAmigo in Brazil, Compartamos in Mexico and Cooperativa Emprender in Colombia – account for nearly 0.5 million of the 4.4 million microfinance clients in Latin America, these institutions are far from meeting the potential demand for microfinance services among microentrepreneurs. According to various estimates, there are between 30 and 65 million self-employed individuals and microentrepreneurs working in Argentina, Brazil, Colombia, Mexico and Venezuela (Berger, Goldmark and Miller-Sanabria, 2006).

102 practitioners argue that emerging market countries may be able to “leapfrog the traditional trajectory of microfinance and use a more commercial approach to skip straight to massive scale” (Helms, 2006). 211 From a regional perspective, the majority of Latin America’s poor live in major urban centers (Marulanda and Otero, 2005). Commercial, regulated MFIs in Latin America tend to target this urban clientele. However, poverty remains highly concentrated in rural areas, such as northeastern Brazil, northern Mexico, northwestern Venezuela, the Pacific coastline, central areas of Honduras and Nicaragua and northern parts of Peru and Chile (Berger, Goldmark and Miller-Sanabria, 2006 (248)). Few MFIs operate in these regions for a number of reasons: dispersed and uneven demand for financial services, high information and transaction costs, poor infrastructure, and a lack of client information, among other factors (CGAP, 2006). One of the principal challenges for Latin America MFIs going forward will be to develop profitable operations in frontier markets.

The Role of Government

“The regulatory and policy environment will determine which regions and countries will close the demand gap most successfully.” – Elisabeth Rhyne and Maria Otero, 2006

In January 2007, the state-owned Banco Industrial de Venezuela announced plans to purchase PRODEM, one of the most important MFIs in Bolivia. In April, Venezuelan President Hugo Chavez proposed a US$1 billion bond to fund soft loans for small businesses in Ecuador, Nicaragua and Haiti. 212 In May, Evo Morales established Banco del Desarrollo Productivo with a US$60 million credit line for low-interest microloans. Government funding for commercial microfinance is not new; however, it has been gaining ground in recent years under populist regimes. 213 These governments eschew so- called international “good practice” and blame the free market orthodoxy of the West for deepening poverty and social inequality. They also experience immense pressure to deliver

211 While South America leads the region in terms of MFI financial performance and outreach, Central America and the Caribbean are working to close the gap. The Mexican microfinance market is experiencing particularly strong growth, as institutions attract investors looking to capitalize on the sector’s strong profitability (MIX Market, September 2008). 212 The Venezuelan government also recently announced a $223 million program to create 800 new community microbanks. In some cases, countries adopt coordinated or mutually reinforcing policies, as occurred in 2006 when Venezuela donated $100 million to the Bolivian government for state-run microfinance (CGAP, 2006). 213 Armando Gutiérrez Navarro, general manager of the Prestanic MFI in Nicaragua, said interference had risen markedly with the recent change in government (CSFI, 2008).

103 resources to poor and remote constituencies. 214 In Latin America, in particular, new state programs “[reflect] frustration with persistent poverty levels and with the pace, price and geographic coverage of private sector financial service delivery” (CGAP, October 2006). Political interference may take a variety of forms: caps on interest rates, direct or indirect subsidies, government-sponsored institutions, and directed lending, among other actions. In Ecuador, politicians have cracked down on MFIs that charge exorbitant interest rates (Counts, 2008). After a series of difficult years for Peruvian rice farmers (due to the El Nino phenomenon and a rice crop plague), Alberto Fujimori’s regime introduced policies restricting banks and MFIs from imposing loan recovery measures on delinquent famers (Llanto, 2008). Finally, a CSFI (2008) study reports cases of governments promoting debt forgiveness. In the Dominican Republic, for example, populist attacks on MFIs are undermining the repayment culture: “there is no greater disincentive to the operation of an MFI than people understanding that they do not have to pay their debts” (20). The trend toward increased public involvement in microfinance is paradoxical given the unequivocal failure of subsidized credit during the 1970s and 1980s. The collapse of state-run programs provided the initial impetus behind innovations in microfinance. With the success of early lending experiments and the subsequent rise of a commercial microfinance industry, governments are once again subsidizing the provision of financial services to the poor: “some governments want to turn back the clock, implementing interest rate caps, and politicians increasingly see microfinance as an attractive target for their attentions” (Rhyne and Otero, 2006). In Latin America, the potential damage from populist approaches is significant: “particularly because scale and success bring high visibility, actions to restrain or interfere with microfinance are more likely to appear in exactly those countries where microfinance grows fastest” (Rhyne and Otero, 2006). A number of Latin American countries have large, profitable and competitive commercial microfinance industries and, in this context, the “microfinance industry [may become] a victim of its own success” (Bate, 2007). 215 “Will Latin America’s ‘21 st -century socialism’ end up nationalizing microfinance institutions?” According to Bate (2007), government activism in microfinance may be less

214 A number of governments in BRIC and Middle Eastern countries, for instance, have created microcredit schemes as a solution to the potentially destabilizing impact of rising youth unemployment. 215 The soft conditions and weak enforcement procedures associated with special government credit projects undermine the general repayment culture, as borrowers view loans as political or social transfers and do not feel compelled to fulfill their debt obligations (Meyer and Nagarajan, 2000).

104 driven by ideological principles than by the goal of increasing access to financial services among poor households. Furthermore, isolated state initiatives currently represent a small fraction of the US$6 billion in loans mobilized by Latin American MFIs. Still, the prospect that governments could yield to political temptation and undertake counterproductive measures – such as subsidizing institutions to compete directly with MFIs, imposing interest rate ceilings, or allowing NGOs to become formal intermediaries without proper capitalization, supervision and oversight (Economist Intelligence Unit, 2007) – is worrying.

In conclusion, governments would do well to remember a lesson from the past: excessive government intervention, benevolent or otherwise, has an unfortunate tendency to stymie or reverse growth and development. 216 As microfinance enters a critical stage of development, the absence of arbitrary bureaucratic meddling and misplaced government policy is of utmost importance.

216 To cite Gonzalez-Vega and Graham (1995): “Governments have frequently attempted to use financial markets to pursue a broad range of nonfinancial objectives, with disastrous consequences (Adams, Graham, and Von Pischke, 1984). Prominent among the reasons for the generalized failure of most state-owned agricultural development banks were precisely attempts to use them as instruments to promote a number of (development) objectives (growth of agricultural production, adoption of new technology, agrarian reform and regional development) at the expense of sound financial intermediation, when such directives created excessive costs and risks for the organizations. Moreover, arbitrary (politicized) criteria adopted in the approval of loans contributed to worsen, rather than improve, resource allocation” (3).

105 VII. Appendices

Appendix 1: Contrasting Development Paradigms in Microfinance

Financial Systems Paradigm Poverty Alleviation Paradigm Underlying Development • Neoliberal market growth • Interventionist poverty Model alleviation and community development Strategy and Target Group • Create financially sustainable • Incorporate microfinance programs that increase access to into integrated programs for financial services for large poverty alleviation and numbers of economically active empowerment that focus on poor people the poorest segment of the population Instruments • Limited use of subsidies to • Extensive use of subsidies to disseminate information on best fund loan portfolio practices • Interest rates that do not • Commercial investment (both permit full cost recovery debt and equity) • Complementary programs in • Interest rate spreads that permit literacy and numeracy, cost recovery and profit health, nutrition, family generation planning and business skill • Program expansion to increase development outreach and economies of scale • Limited or no savings • Savings mobilization mobilization Definition of Sustainability • Financial self-sufficiency • Establishment of local-level participatory institutions for long-term community self- reliance Underlying Assumptions • Subsidized credit undermines • Depth of outreach more development important than breadth of • Poor people can pay interest outreach rates high enough to cover • Financial self-sufficiency not transaction costs and risk perquisite for achieving premium associated with lending institutional mission of in markets with asymmetries and serving the very poor imperfect information • Commercialization • Because the average loan size is inexorably results in profit small, MFIs must reach scale in motive displacing social order to become sustainable mission Operational Examples • Bank Rakyat Indonesia (BRI) • Grameen Bank • BancoSol in Bolivia • FINCA village banking • Association for Social programs Advancement (ASA) in Bangladesh Sources: Otero and Rhyne (1992); Otero and Rhyne (1994); Woller, Woodworth and Dunford (1999); Ledgerwood (1999); Mayoux (2000); Robinson (2001)

106 Appendix 2: List of MFIs in the Empirical Analysis by Country and Institution Type

Institution Name Country Name Institution Type 217

1 ACCOVI El Salvador NBFI 2 ACME Haiti NGO 3 ACODEP Nicaragua NGO 4 ACORDE Costa Rica NGO 5 ACTUAR Famiempresas Caldas Colombia NGO 6 ACTUAR Famiempresas Tolima Colombia NGO 7 Adelante Honduras NGO 8 ADICH Honduras NGO 9 ADIM Nicaragua NGO 10 ADMIC Mexico NBFI 11 ADOPEM Dominican Republic NGO 12 ADRA Peru Peru NGO 13 ADRI Costa Rica NGO 14 AFODENIC Nicaragua NGO 15 AgroCapital Bolivia NGO 16 AGUDESA Guatemala NGO 17 ALSOL Mexico NGO 18 Alternativa Microfinanzas Peru NGO 19 AMA Peru NGO 20 ANED Bolivia NGO 21 Apoyo Integral El Salvador NBFI 22 ASDIR Guatemala NGO 23 ASEI El Salvador NGO 24 Asociación Arariwa Peru NGO 25 Asociación Raíz Guatemala NGO 26 ASP Financiera Mexico NBFI 27 AYNLA Guatemala NGO 28 Banco ADEMI Dominican Republic NGO 29 Banco da Familia Brazil NGO 30 Banco Popular Brazil NGO 31 Banco Popular do Brasil Brazil Bank 32 Banco Solidario Ecuador Bank 33 BancoSol Bolivia Bank 34 BANTRA Peru Bank 35 BCSC Colombia Bank 36 BMM Córdoba Argentina NGO 37 BMM Salta Argentina NBFI 38 Caritas Peru NGO 39 CDRO Guatemala NGO 40 CEADe Brazil NGO 41 CEAPE MA Brazil NGO 42 CIDRE Bolivia NGO 43 CMAC Arequipa Peru NBFI 44 CMAC Cusco Peru NBFI 45 CMAC Del Santa Peru NBFI 46 CMAC Huancayo Peru NBFI

217 Institution types include non-bank financial institutions (NBFIs), non-profit institutions (NGOs) and banks.

107 47 CMAC Ica Peru NBFI 48 CMAC Maynas Peru NBFI 49 CMAC Paita Peru NBFI 50 CMAC Sullana Peru NBFI 51 CMAC Tacna Peru NBFI 52 CMAC Trujillo Peru NBFI 53 CMM Bogotá Colombia NGO 54 CompartamosBanco Mexico NGO 55 CONTACTAR Colombia NGO 56 CRAC Caja Nor Peru NBFI 57 CRAC Caja Sur Peru NBFI 58 CRAC Los Andes Peru NBFI 59 CRAC Señor de Luren Peru NBFI 60 CRECER Bolivia NGO 61 Credi Fe Ecuador Bank 62 CREDIAMIGO Brazil Bank 63 CrediComún Mexico NBFI 64 CREDIMUJER Costa Rica NGO 65 Credisol Honduras Honduras NBFI 66 CRYSOL Guatemala NGO 67 Diaconia Bolivia NGO 68 D-miro Ecuador NGO 69 Don Apoyo Mexico NBFI 70 ECLOF Ecuador Ecuador NGO 71 Eco Futuro Bolivia NGO 72 EDAPROSPO Peru NGO 73 EDESA Costa Rica NBFI 74 EDPYME Alternativa Peru NBFI 75 EDPYME Confianza Peru NBFI 76 EDPYME Crear Arequipa Peru NGO 77 EDPYME Crear Tacna Peru NGO 78 EDPYME Crear Trujillo Peru NGO 79 EDPYME EDYFICAR Peru NBFI 80 EDPYME Efectiva Peru NBFI 81 EDPYME Nueva Visión Peru NBFI 82 EDPYME PROEMPRESA Peru NBFI 83 Emprender Bolivia NGO 84 ENLACE El Salvador NBFI 85 EUREKASOLI Mexico NBFI 86 FACES Ecuador NGO 87 FADEMYPE El Salvador NGO 88 FADES Bolivia NGO 89 FAFIDESS Guatemala NGO 90 FAMA Nicaragua NBFI 91 FAMA ODPF Honduras NBFI 92 FAPE Guatemala NGO 93 FASSIL Bolivia NBFI 94 FDL Nicaragua NGO 95 FED Ecuador NGO 96 FIACG Guatemala NGO 97 FIDERPAC Costa Rica NGO 98 FIE Bolivia NGO 99 FIE Gran Poder Argentina NBFI

108 100 FIELCO Paraguay NBFI 101 Finamerica Colombia NBFI 102 Finamigo Mexico NBFI 103 Financiera Familiar Paraguay NBFI 104 Financiera Independencia Mexico NBFI 105 FINCA Ecuador Ecuador NGO 106 FINCA Guatemala Guatemala NGO 107 FINCA Haiti Haiti NGO 108 FINCA Mexico Mexico NGO 109 FINCA Peru Peru NGO 110 FINCA El Salvador El Salvador NGO 111 FINCA Honduras Honduras NBFI 112 FINCA Nicaragua Nicaragua NGO 113 FINCOMUN Mexico NBFI 114 FINDESA Nicaragua NGO 115 FINSOL Honduras NGO 116 FIS Argentina NBFI 117 FJN Nicaragua NGO 118 FMM Bucaramanga Colombia NGO 119 FMM Popayán Colombia NGO 120 FODEM Nicaragua NGO 121 FODEMI Ecuador NGO 122 FOMIC Costa Rica NGO 123 FONCRESOL Bolivia NGO 124 FONDECO Bolivia NGO 125 FONDESA Dominican Republic NGO 126 FONDESOL Guatemala NGO 127 FONDESURCO Peru NGO 128 Fonkoze Haiti NGO 129 FORJADORES DE NEGOCIOS Mexico NBFI 130 Fortaleza FFP Bolivia NBFI 131 FOVIDA Peru NGO 132 FRAC Mexico NGO 133 FUBODE Bolivia NGO 134 FUDEMI Nicaragua NGO 135 FUNBODEM Bolivia NGO 136 Fundación 4i-2000 Nicaragua NGO 137 Fundación Alternativa Ecuador NGO 138 Fundación CAMPO El Salvador NGO 139 Fundación Esperanza Internacional Dominican Republic NGO 140 Fundación Espoir Ecuador NGO 141 Fundación LEÓN 2000 Nicaragua NGO 142 Fundación MICROS Guatemala NGO 143 Fundación Mujer Costa Rica NGO 144 Fundación Paraguaya Paraguay NGO 145 Fundación San Miguel Arcángel Dominican Republic NGO 146 FUNDAHMICRO Honduras NGO 147 FUNDAMIC Ecuador NGO 148 FUNDEA Guatemala NGO 149 FUNDEBASE Costa Rica NGO 150 FUNDECO Costa Rica NGO 151 FUNDECOCA Costa Rica NGO 152 FUNDENUSE Nicaragua NGO

109 153 FUNDEPYME Nicaragua NGO 154 FUNDESER Nicaragua NGO 155 FUNDESPE Guatemala NGO 156 FUNED Honduras NGO 157 FUNSALDE El Salvador NGO 158 Génesis Empresarial Guatemala NGO 159 Genesiss El Salvador NGO 160 Grameen Chaco Argentina NGO 161 Grameen Mendoza Argentina NGO 162 HdH OPDF Honduras NBFI 163 ICC BLUSOL Brazil NGO 164 IDEPRO Bolivia NGO 165 IDER CV Peru NGO 166 IDESI La Libertad Peru NGO 167 IDESI Lambayeque Peru NGO 168 IDESPA Peru NGO 169 IMPRO Bolivia NGO 170 INSOTEC Ecuador NGO 171 Interfisa Paraguay NBFI 172 MCN Haiti NBFI 173 MiBanco Peru NGO 174 MicroCred Mexico Mexico NBFI 175 Microempresas de Antioquia Colombia NGO 176 MIDE Peru NGO 177 Movimiento Manuela Ramos Peru NGO 178 ODEF OPDF Honduras NBFI 179 Oportunidad OLC-COL Colombia NGO 180 PDAI Bolivia NGO 181 PILARH OPDF Honduras NGO 182 PRESTANIC Nicaragua NGO 183 PRISMA Peru NGO 184 PRISMA Honduras Honduras NBFI 185 ProCredit Bolivia Bolivia Bank 186 ProCredit Ecuador Ecuador Bank 187 ProCredit Nicaragua Nicaragua Bank 188 ProCredit El Salvador El Salvador Bank 189 PRODEM Bolivia NGO 190 PRODESA Nicaragua NGO 191 Progresar Argentina NGO 192 ProMujer México Mexico NGO 193 ProMujer Nicaragua Nicaragua NGO 194 ProMujer Peru Peru NGO 195 SEMISOL Mexico NGO 196 SFF Haiti NGO 197 SOGESOL Haiti NBFI 198 TE CREEMOS Mexico NBFI 199 UCADE Ambato Ecuador NGO 200 World Relief HND Honduras NGO 201 WWB Medellín Colombia NGO 202 WWB Cali Colombia NGO

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