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. 1 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 2 "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