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The Cost Structure of Microfinance Institutions in Eastern Europe and Central Asia

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The Cost Structure of Microfinance Institutions in Eastern Europe and Central Asia
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    T HE W ILLIAM D AVIDSON I NSTITUTE   AT THE UNIVERSITY OF MICHIGAN THE COST STRUCTURE OF MICROFINANCE INSTITUTIONS IN EASTERN EUROPE AND CENTRAL ASIA  By: Valentina Hartarska, Steven B. Caudill and Daniel M. Gropper    William Davidson Institute Working Paper Number 809 January 2006   1THE COST STRUCTURE OF MICROFINANCE INSTITUTIONS IN EASTERN EUROPE AND CENTRAL ASIA January 18, 2006 Valentina Hartarska Department of Agricultural Economics and Rural Sociology 210 Comer Hall Auburn University Auburn, Al 36830 Phone: 334-844-5666 Email: Hartarska@ auburn.edu Steven B. Caudill Department of Economics Auburn University, AL 36830 Fax (334) 844-4615 Email: scaudill@business.auburn.edu Daniel M. Gropper Department of Economics Auburn University, AL 36830 Fax (334) 844-4615 Email: groppdm@auburn.edu Abstract Microfinance institutions are important, particularly in developing countries, because they expand the frontier of financial intermediation by providing loans to those traditionally excluded from formal financial markets. This paper presents the first systematic statistical examination of the performance of MFIs operating in Eastern Europe and Central Asia. A cost function is estimated for MFIs in the region from 1999-2004. First, the presence of subsidies is found to be associated with higher MFI costs. When output is measured as the number of loans made, we find that MFIs become more efficient over time and that MFIs involved in the  provision of group loans and loans to women have lower costs. However, when output is measured as volume of loans rather than their number, this last finding is reversed. This may be due to the fact that such loans are smaller in size; thus for a given volume more loans must be made. JEL: G200, G210, O160 Keywords: Eastern Europe, banking, microfinance, efficiency   2 Introduction Microfinance institutions are important, particularly in developing countries, because they expand the frontier of financial intermediation by providing loans to those traditionally excluded from the formal financial markets. The contribution of microfinance institutions (MFIs) to poverty alleviation has attracted significant attention in recent years. For example, the United Nations declared 2005 to be the International Year of Microcredit. Although usually small, MFIs control significant resources and serve significant numbers of borrowers. For example, in Eastern Europe and Central Asia (ECA) alone, these organizations have an asset  base of about $1 billion and serve about 500,000 active borrowers (Foster, Green, and Pytkowska, 2004). Despite the growing importance of MFIs there have been no studies of MFI performance in the ECA region. While there has been a substantial prior literature on the cost structure of European banks (see, for example, Altunbas, Gardener, Molyneux, and Moore 2001; Altunbas and Molyneaux, 1996; Pastor, 2002; and Pastor, Perez, and Quesada, 1997) there have been only a few recent systematic studies of bank performance in the ECA region (Fries and Tasci, 2005; Hasan and Marton, 2003; and Bonin, Hasan, and Wachtel, 2005a, 2005b). There is no systematic empirical work to date on the performance of MFIs, but there have  been a few empirical studies in the related areas of relationship lending and community banking (see, for example, Berger and Udell, 1995; Berger, Hasan, and Klapper 2004; Berger, Klapper, Miller, and Udell, 2003; and Berger and Udell, 2002). This paper adds to the literature by presenting the first systematic statistical examination of the performance of MFIs operating in Eastern Europe and Central Asia. Using high-quality data for a sample of MFIs from the region from 1999 to 2004, we estimate a cost function, incorporating characteristics which the literature suggests are likely to influence productivity but whose impact on MFIs in the ECA region has not been empirically estimated. For example, theoretical work suggests that group lending methodology decreases the costs of serving marginal clientele by mitigating problems of adverse selection (Ghatak 1999; Armendariz de Aghion and Collier, 2000) and moral hazard (Stiglitz, 1990; Laffont and Rey, 2003; Rai and Sjostrom, 2004). The empirical evidence for non-ECA MFIs shows that group lending is associated with higher repayment rates (Gomez and Santor, 2003). Armendariz de Aghion and Morduch (2000) argue, however, that individual lending contracts with dynamic incentives may   3  be more cost-effective in countries in the ECA region. One goal of this paper is to provide empirical evidence on the issue of the relative costs of group lending. To fulfill their poverty alleviation mission MFIs often target women because the majority of the poor are female. Because women have less access to capital, the return to capital may be, on average, higher than for men. Therefore, if capital is not fully fungible within the family, endowing women with capital may be growth-enhancing. Moreover, the limited labor mobility of women can decrease monitoring costs and reduce the incidence of strategic default. To date, empirical studies have not focused on the cost consequences of targeted lending to women in ECA region; this paper provides the first evidence of the impact of this practice on the cost structure of MFIs. Another unique aspect of MFI operations is the presence of subsidies. Although the ultimate goal of microfinance institutions is to become financially self-sustainable, in practice all receive direct and indirect subsidies. The empirical impact of these subsidies on efficiency is not well understood (Armendariz de Aghion and Morduch, 2005). We present empirical evidence on how subsidies affect MFI productivity. To examine and measure these various effects, we estimate three cost functions, each using different measures of output. Our first formulation uses the number of loans as an output measure, which is most consistent with the objective functions of these institutions. The second formulation uses volume of loans as an output measure. Our third formulation combines both the number and volume of loans as outputs. Our most consistent finding across specifications is that the presence of subsidies is associated with higher MFI costs. This result is consistent across all three output specifications and across several measures of subsidy. Our other findings depend on the particular output measure used. When output is measured as the number of loans, we find that MFIs become more efficient over time. With output measured as the number of loans we also find that MFIs involved in the provision of group loans and loans to women have lower costs. However, when output is measured as the total volume of loans, this last finding is reversed; MFIs involved in the provision of group loans and loans to women have higher than average costs. This may be due to the fact that group loans and loans to women are typically small, so that for a given volume of loans, a greater percentage of loans of these types would indicate more transactions and thus higher costs.   4 Microfinance Institutions Microfinance has been defined as “a collection of banking practices built around  providing small loans (typically without collateral) and accepting tiny savings deposits” (Armendariz de Aghion and Morduch, 2005, p.1). Microfinance institutions provide financial services to the entrepreneurial poor who generally do not have access to traditional banking services. MFIs pursue a double bottom line of outreach and sustainability . On the one hand, MFIs fulfill an outreach mission by providing financial services to the poor. On the other hand, MFIs must operate like other financial institutions, lending to creditworthy clients and earning  positive returns on their loan portfolios in order to sustain and expand their operations ( sustainability ). Because sustainability is an important goal of these organizations, we assume that MFIs strive to minimize costs of operation for any given level of operations. Since poor customers generally have no credit history and little collateral, MFIs must use innovative lending practices to reduce risks associated with asymmetric information between lender and borrower. In fact, several studies have focused on understanding the mechanisms of lending practices such as group loans , a type of joint-liability loan, whereby the MFI delegates screening, monitoring, and contract enforcement costs to a group, and individual uncollateralized loans, whereby repayment is “secured” with a promise of access to larger loans in the future conditional on current loan repayment (Conning, 1999; Navajas et al.,  2000). Other studies have focused on the impact that MFIs have on borrowers (Brau and Woller, 2004). One way in which MFIs differ greatly from other financial institutions is that many aspects of MFI operations are characterized by subsidies. For example, the MFI equity base used to begin operations is typically contributed by an international donor. These donors include governments in developed countries, international organizations such as the World Bank, or intermediaries and international networks such as Opportunity International and FINCA International. If additional funds are required, donors may offer outright grants or loans at either subsidized or commercial rates, with the recent trend toward providing loans rather than grants. In addition, MFIs may receive a variety of in-kind transfers and subsidies in the form of technical assistance and/or free physical capital. These subsidies affect the prices of labor and capital. In-kind subsidies can come in the form of outside funds for salaries of senior management or outside funds for personnel training. Subsidies of this kind are provided via technical assistance contracts paid for by either the Technical Assistance (TA) agency or a
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