BSP-UP Professorial Chair Lectures 12 November 2012

Bangko Sentral ng Pilipinas Malate, Manila

Lecture No. 3

Truth in Microlending: Is Microfinance Overrated?

by

Dr. Emmanuel F. Esguerra BSP UP Centennial Professor

of Money and Banking

TRUTH IN MICROLENDING: IS MICROFINANCE OVERRATED?

Emmanuel F. Esguerra University of the Philippines Diliman

Abstract The paper examines the promise of poverty-reduction-without-subsidization that has propelled microfinance to the status of a growth industry worldwide. It explores to what extent the vision is being realized in the Philippines focusing on the tension between the avowed social mission of microfinance and the goal of financial sustainability. The data suggest that Philippine MFIs are generally able to combine financial sustainability with serving poor borrowers, using average loan size as an indicator of depth of outreach. The higher cost of servicing small loans, however, implies that MFIs have to charge higher interest rates or receive subsidies. There are indications that non-bank MFIs do both. Regarding outreach, it is noted that where actual client poverty status data are used instead of average loan size, it is not clear if the relatively small proportion of the poor among loan recipients is due to faulty targeting or the MFIs’ revealed preference. Finally, most rigorous impact evaluations of microfinance have found no strong evidence of its promised effects in terms of poverty reduction. Nonetheless, the paper argues that an expansion in the scope of financial services to include hitherto excluded segments of the population constitutes a social welfare gain. From this standpoint, microfinance has done well, even if it may not have directly reduced poverty. That is good enough.

Introduction Microfinance is widely acknowledged today as a tool for assisting people move out of poverty. Once almost the exclusive domain of non-governmental organizations (NGOs) and similar not-for-profit institutions, it has practically become a growth industry. The list is not limited to philanthropic foundations and local commercial banks, thrift institutions and finance companies, but includes as well multinationalslike Citigroup, Deutsche Bank, HSBC, and ABN Amro (The Economist [2005]) that have also gotten into the act, inspired by the prospect of commercial success while carrying out a noble mission. According to one assessment (Abrams and von Stauffenberg [2007]) international private lending to various microfinance institutions (MFIs) worldwide reached $1 billion in 20051. The Microcredit

1 The figure includes only direct retail lending to MFIs and excludes other forms of financing such as equity and guarantees, lending through wholesale lending institutions, or investments in microfinance investment vehicles.

Summit Campaign places the number of MFIs worldwide at over 3,000 with a reach of close to 155 million borrowers as of December 20072. A newfound enthusiasm for using the financial market to reduce poverty thus appears to have replaced the former disenchantment with the idea that debt can potentially help the poor improve their situation. The view that “debt is not an effective tool for helping most poor people enhance their condition” (Adams and Von Pischke [1992: 1468]) was especially compelling in the 1980s in the wake of various failed attempts to alleviate poverty through the provision of subsidized credit. Such view has become less persuasive in light of the much heralded success of several models of “banking with the poor”, of which the Grameen Bank and the Association for Social Advancement (ASA) of Bangladesh and BancoSol of Bolivia are prominent examples. To true believers, these successful approaches can be attributed to the application of sound banking principles that, by enhancing financial sustainability, minimizes the need for government or donor support and maximizes the ability of MFIs to reach out to poorer clients. Not everyone who believes that access to reliable financial services benefits the poor shares the view that full commercialization is the way forward, however. The debate sparked by the initial public offerings (IPO) of Mexico’s CompartamosBanco in 2007 (The Economist [2008]) and India’s SKS Microfinance in 2010 (The Economist [2010]) suggests a fissure in the flourishing microfinance movement. To supporters, the success of the IPO is proof of the correctness of a commercial approach to lending to the poor as it frees an MFIfrom the supply constraint of donor money putting it in an even better position to serve more of the poor. To critics,including Grameen Bank founder and 2006 Nobel Peace Prize winner Muhammad Yunus, the IPO represents a departure from the original mission of microfinance, its very success linked to policies that emphasize high interest rates and financial profitability in order to attract private investor capital (Malkin [2008]). Since the initial attempts at replicating the Grameen model in 1989, the Philippines has come a long way toward promoting microfinance as a tool for poverty alleviation. A National Strategy for Microfinance was drawn up and approved during the presidency of Fidel Ramos (1992-1998) to provide a framework for the promotion of microfinance as a sustainable activity. Accordingly, the government has focused its policies on enlarging the role of private MFIs in providing financial services to low-income groups. In keeping with this objective, Executive Order 138 (EO 138), promulgated during the term of Joseph Estrada (1998-2001), expressly proscribed non-financial government agencies from engaging in direct lending. The General Banking Law of 2000 opened the door to greater bank involvement in microfinance, recognizing its specific characteristics (e.g. non-collateralized lending), and authorizing the Monetary Board to establish rules for its practice amongst banks3. The country has been recognized time and again for having one of the better regulatory environments for microfinance in the world. This article surveys Philippine microfinance against the backdrop of competing views regarding the potential and limits of a commercialized approach to broadening access to

2As cited in Odell [2010]. 3 There is an Inclusive Finance Advocacy Staff (IFAS) within the BangkoSentralngPilipinas (BSP) to handle microfinance-related matters.

finance as a strategy to reduce poverty. It specifically examines the promise of poverty-reduction-without-subsidization that has excited the growing number of microfinance advocates in the country. It explores to what extent the vision is being realized in the Philippines, mindful of the tension between the avowed social mission of microfinance and the goal of financial sustainability. Are Philippine MFIs able to serve more of the poor? Are they financially sustainable? What do we know so far about the welfare impact of microfinance on its clients? When the central bank declares microfinance as its “flagship program for poverty alleviation” (Valdepeñas[2005]: v), and a President of the Republic refers to it as the “cornerstone of this country’s fight against poverty” (Arroyo, [2001]), one can only agree with the observation that “few recent ideas have generated as much hope for alleviating poverty in low-income countries as the idea of microfinance” (Morduch [2000: 617]). This paper is organized as follows: After a brief review of the evolution of organized microfinance in the country in first section, the second section presents some stylized facts about Philippine MFIs situating them in the broader context of the global microfinance movement. The third section draws on insights from cross-country empirical studies on the trade-off between financial sustainability and depth of outreach to examine how local MFIs are responding to the challenge of the “double bottom line”. The fourth section considers issues pertaining to outreach. The fifth section looks at some of the recent work on the welfare impact of microfinance. The sixth section concludes. Aggregate data from industry and government sources, as well as from published material are used throughout. From subsidies to sustainability As understood today microfinance refers to the provision of a range of financial services (e.g. loans, deposits, payment services, money transfers and insurance products)4 to customers routinely excluded by formal financial institutions for being too costly or risky to serve. The use of methods not normally associated with standard banking practices to reach low income or traditionally rationed clients is its defining attribute, although practical considerations favor a definition based on size of the transaction. The practice of microfinance has been around for as long as rotating savings and credit associations (ROSCAs), or paluwagans, and credit cooperatives have existed. The new element is that private banks are becoming increasingly involved on a voluntary basis. As a deliberate approach to promote certain economic activities or development goals in the Philippines, however, the origins of microfinance may be traced to the period of the late 1960s to the 1970s when government implemented a policy of preferential credit allocation to support specific sectors or activities considered critical to national development. Food self-sufficiency, small enterprise development, and income redistribution were among the ostensible objectives. Interest rate subsidies were a central feature of that policy. Government financial institutions as well as privately-owned rural banks were mobilized to extend loans for specific activities, supported by state funds in the form of special time

4 The term “microfinance” is more narrowly associated with small loans, or “microcredit”, in the popular consciousness though. Unless stated otherwise, this is the sense in which the term is used in this paper.

deposits, and by easy access to the central bank’s rediscount facility at concessional rates. The rural sector was a prime target of such interventions. The subsequent failure of subsidized credit programs in the 1980s led to a shift in policy from one inspired by a supply-leading approach to a more market-oriented one. Under the new policy regime, the responsibility for providing loan and deposit services was entrusted to the banks while the government was expected to concentrate on its role of providing the policy environment hospitable to financial intermediation. While these early reforms planted the seeds for a more stable rural financial market, credit remained elusive for most small rural borrowers5 , providing convenient fodder for the lobby of politicians and other organized interest groups for a return to directed credit programs6. Amidst the political pressure to revive credit subsidies and re-establish programs for designated non-bankable groups, a nascent movement drawing inspiration from the successful Grameen Bank in Bangladesh was laying the groundwork for an alternative to the traditional approach to bank lending. The alternative lay in using technologies borrowed from informal finance that maximized the use of social networks as collateral substitutes to solve the information asymmetry in loan transactions. Unfamiliar and ill-prepared to work with such technologies, banks could only yield the initiative to NGOs and similar organizations with a grassroots orientation. The government-sponsored Grameen Bank Replication Project in 1989 was implemented mainly with NGOs as conduits for microcredit to non-bankable groups. Since the initial step to replicate the Grameen model in the Philippines, various measures have been taken to promote microfinance and put the institutions providing it on a more solid foundation (see Alindogan [2005]). Among the early celebrated successes were the noticeably high repayment rates of borrowers, although it is not clear to what extent this was due to the lending technology itself or to the fact that lenders had shifted their focus from risky agriculture to non-farm enterprises where the lending technology had a higher chance of success. In 1997, the National Credit Council (NCC), an inter-agency body headed by the Department of Finance spelled out a National Strategy for Microfinance. According to the strategy, the specific targets of microfinance are households with incomes below the poverty threshold whose members are “engaged in some form of business but are either not served or underserved by the formal financial sector” (NSM [1997]). The NSM provided the framework for subsequent laws and issuances relating to finance for poverty alleviation; among the more important ones are: the Social Reform and Poverty Alleviation Act (RA 8425, 1997), the Agriculture and Fisheries Modernization Act (RA 8435, 1999), Executive Order 138 (1999), and the Barangay Micro Business Enterprises Act (RA 9178, 2002).

5 The reasons range from the mediocre performance of the agriculture sector to the wave of conservatism that dominated the rural banking industry due to the negative experience with government credit programs. (seeLlanto [2005]). 6 A good number of directed credit programs were in fact set up in the late 1980s to ease the access problem (see Esguerra [1996], Llanto [2005]).

With a more favorable policy environment, microfinance increasingly became an attractive proposition for the banking sector.Since the enactment of the General Banking Law of 2000 (RA 8791), around 2007 banks have become involved in varying degrees in microfinance. Thus the microfinance movement in the Philippines was born out of the experience with the failed credit programs of the 1970s and as a response to the revealed inability of the banking system, using traditional bank technologies, to extend its services to low-income groups even in a market-friendly policy setting. For while the “new view” of rural financial markets succeeded in convincing policy makers to liberalize interest rates to allow financial institutions to cover their costs and remain viable, it did little to improve credit access for classes of borrowers banks were not inclined to lend to in the first place (e.g. the unemployed, workers in agriculture). As Stiglitz and Weiss [1981] have shown, credit rationing is a rational response when, because of imperfect information, raising lending rates only attracts riskier loan applicants or causes borrowers to take on riskier projects that increase the probability of non-repayment. Microfinance is an institutional response to the problems of adverse selection, moral hazard, and weak contract enforcement in credit market environments where the cost of transacting is high and the use of traditional forms of collateral is severely limited by the level of economic development and the prevailing property relations. Through the use of various contractual designs (e.g. group lending, regular meetings, frequent collections, dynamic incentives), MFIs are generally able to reduce the problems associated with lending to low-income borrowers in a way that lenders using traditional bank technologies are unable to do. But important issues remain. Careful to avoid the inefficiencies associated with subsidization, key donors, such as those associated with the Consultative Group to Assist the Poorest (CGAP), have emphasized financial sustainability, or financial self-sufficiency, as a key performance standard for “good” microfinance. MFIs are “financially self-sufficient” if they can continue to profitably do business without the need for subsidies. Sustainability lies at the core of efforts of donors and leading advocates to have Philippine MFIs embrace market-based principles in their activities. An MFI is expected to progressively move towards becoming a for-profit, formal institution, or to operate as one, subject to prudential regulation, where the initial step entails “adopting a more business-like approach to administration, including the application of cost-recovery interest rates”. The process is referred to as “commercialization” (see Charitonenko [2003]). The idea is that financially sustainable, and thus permanent, MFIs should be in a better position to serve more of the poor. Although the logic in the sustainability argument seems self-evident, the path to sustainability is not a straight one and may lead MFIs to make choices that do not necessarily favor serving the original target – the poor – or exercising the resultant ability to reach more of the poor after some measure of sustainability has been achieved. This tendency describes “mission drift” or the intentional avoidance of low-income clients as MFIs are pressured to project a good bottom line for investors (Cull, Demirgüç-Kunt and

7 The list as of June 30, 2011 includes thrift, rural, and cooperative banks engaged either fully or partially in microfinance.

Morduch or Cull et al [2007], Ghosh and Van Tassel [2008]). The insistence on sustainability may induce MFIs to become more innovative and competitive, but it may also encourage conservatism and undermine the social mission if the reward for excluding a class of borrowers is a favorable financial outcome. Exclusionary tendencies are further reinforced by the difficulty of measuring achievement in poverty reduction compared with that for gauging financial sustainability (Woller and Schreiner [no date]). For instance, measures of financial success have long been well understood and widely accepted within the industry, whereas donors and practitioners have only belatedly become concerned with seriously measuring social performance (see Hashemi, Foose, and Badawi [2007]) and welfare impact. Faced with multiple objectives MFIs are bound to focus on those whose achievement can be more easily monitored or measured and rewarded. Managing the tension between performing up to the standard of sustainability on one hand and fulfilling the expectation of serving a greater number of low-income households on the other thus remains a challenge for the microfinance industry. Philippine microfinance: facts and figures As of June 2010, about 15,000 MFIs were operating throughout the country serving an estimated 5.1 million borrowers (MCPI [2010]). These include 25 NGOs, 200 banks and 14,700 cooperatives. The number ofNGOs engaged in microfinance is likely to be an underestimate. Being unregulated, NGOs do not report to any single entity, although about 30 are known to have a dominant presence in microfinance (Microfinance Information eXchange andMCPI [2006]). It is also not known how many cooperatives have functioning microfinance programs. For the same reason, it is difficult to say how many borrowers are being served by the various MFIsand, except for a few, how large their respective microfinance portfolios are. Rural banks are especially problematic as their activities are not normally confined to microfinance and data are not disaggregated enough to show the number of microfinance customers and the share of microfinance in total bank lending. The preceding caveats should be kept in mind when looking at Philippine microfinance data. Table1. Microfinance Sector Data* as of June 2010

Type of MFINo.

ReportingNo. of Active

Borrowers

Total Loans Oustanding (in million Pesos)

Average Loans Outstanding

Microfinance NGOs** 25 1,768,819 10,122.40 5,722.72 Microfinance Banks*** 200 876,109 6,716.39 7,666.16 Cooperatives**** 14,711 2,459,692 n.a. n.a.Total 14,936 5,104,620

*Data estimated from existing information from various sources

***Data from BSP, as of June 30, 2010

Source: Microfinance Industry Report - Philippines, MCPI 2011

**NGO data from MCPI and MIX market data as of December. 2009 (excluding data from banks and cooperatives

****Basic data from CDA, as of June 30, 2010. The estimate assumes that 80 percent of the members of multi-purpose cooperativees have loans and savings, of which 50% have microfinance loans. It was also assumed that 50% of the members of credit cooperatives have microfinance loans.

Data from the BSP show a total of 198 thrift, rural, and cooperative banks with various degrees of involvement in microfinance as of June 2011. These banks had extended loans to some 960,000 borrowers amounting to PhP 7.2 billion. They had also mobilized some PhP3.7 million in savings deposits. Table 2: Banks with Microfinance Exposure as of June 30, 2011

Outstanding Loans

Savings Component

(in PhP Million) (in PhP Million)Microfinance Oriented Thrift Banks 3 195.1 28,162 99.8 Microfinance Oriented Rural Banks 6 1,812.7 314,391 1,327.7 Sub-Total 9 2,007.8 342,553 1,427.5

Microfinance Engaged Rural Banks 148 3,829.5 530,325 1,834.6 Microfinance Engaged Coop Banks 21 810.3 78,120 248.2 Microfinance Engaged Thrift Banks 20 502.0 12,719 243.4 Sub-Total 189 5,141.8 621,164 2,326.2

Grand Total 198 7,149.6 963,717 3,753.7

Source: BSP

No. of Banks

No. of Borrowers

Table 3 shows that as of 2011the top 10 Philippine MFIs based on number of active borrowers is comprised mostly of NGOs. Moreover, 5 of the 7 NGOs in the top 10 MFIs in terms of number of borrowers are also among the leading MFIs in terms of gross loan portfolio. Collectively, the top 10 MFIsin either category account for more than 80 percent of total borrowers and the aggregate value of loans of all reporting MFIs. If the MCPI’sreported figures of 15,000MFIs serving 5.1 million borrowers in 2011 are reliable, then the preceding would suggest that the microfinance business is a highly concentrated business with the top 10 MFIs covering more than half of all borrowers. Table 3: Leading Microfinance Institutions, Philippines, 2010-2012

Gross Loan Portfolio

(PhP)

CARD NGO 783,600 1st Valley Bank 103,087,502ASA Philippines 590,053 CARD NGO 76,757,532

TSPI 290,816 CARD Bank 62,171,210KMBI 244,356 PR Bank 48,639,582

Life Bank Foundation 236,917 ASA Philippines 48,451,134TSKI 191,903 TSPI 43,183,581

Pagasa 161,692 G7 Bank 40,546,573NWTF 131,002 GM Bank Luzon 36,414,510ASKI 79,341 Green Bank 35,918,780CCT 66,204 ASKI 28,877,468

Source: MIXmarket 2012

MFI

Number of Active

Borrowers MFI

A benchmarking study conducted by MCPI and the Microfinance Information eXchange, Inc. (MIX) in 2006 reveals other interesting facts about Philippine MFIs. MIX is a non-profit, international data exchange outfit that provides information services on the microfinance industry. It collects data from MFIs around the world, standardizes these for comparability, and publishes the results in its semi-annual MicroBanking Bulletin. The voluntary nature of participation in the data exchange suggests that the MFIs in MIX are likely to be from a select group of good financial performers in their respective countries. The benchmarking study focused on the performance 45 Philippine MFIs in 2005. The 45 MFIs included 20 NGOs, 23 rural banks, a cooperative and a thrift bank. The study compares these MFIs with Asian MFIs and rest-of-the-world MFIs included in the MicroBanking Bulletin. The numbers reported in Table 4 are median figures. They show, first, that local MFIs are much older, with a median age of 19, compared with their counterparts in Asia and elsewhere in the world8 . Second, Philippine MFIs also tend to be smaller by comparison as measured by the size of their loan portfolios. Third, local MFIs cover fewer borrowers. In terms of financial structure, they are dependent on concessional fund sources for about one-fifth of their loan portfolios, albeit less so than Asian and other MFIs. Finally, their average loan balance per borrower, standardized by per capita GNI, is also lower relative to those of non-Philippine MFIs. This measure indicates depth of outreach, or the ability to reach the low-income segment of the credit market9.

Table 4: Philippine MFIs compared with non-Philippine MFIs, 2005

Philippine Asian A ll MFIsMFIs MFIs

Number reporting 45 101 446Age 19 11 9Active borrowers 8,858 18,487 12,432 Gross loan portfolio ($ thousand) 2,558.9 3,961.9 5,223.9 Commercial funding liabilities ratio (%) 79.0 62.9 58.6 Average loan balance per borrower/GNI per capita (%) 17.1 19.4 43.7Return on assets (%) -0.8 -0.7 0.9Operational self-sufficiency (%) 114.1 109.9 114.6Financial self-sufficiency (%) 97.6 100.6 105.4Financial revenue ratio (%) 31.6 24.1 25.8Yield on gross portfolio (real) (%) 32.7 21.9 24.4Total expense ratio (%) 31.0 25.6 25.0Operating expense ratio (%) 20.1 15.1 15.7Personnel expense ratio (%) 10.5 7.6 8.5Administrative expense ratio (%) 9.1 7.3 7.2Portfolio at risk > 30 days (%) 6.9 2.8 2.2

Source: MIX and MCPI [2006]

8 This is due to the inclusion in the Philippine sample of a good number of rural banks, many of which have existed since the 1970s or 1980s. 9 This is what is commonly used to measure an MFI’s ability to penetrate the low-income market. It presumes that the non-poor will not care to avail themselves of small loans.

Profitability-wise, Philippine MFIs are not doing well as indicated by negative return-on-assets (Table 4). While they are operationally self-sufficient (OSS), i.e. are able to generate sufficient operating revenue to cover operating expenses, financing costs, and provision for loan losses, they are only nearly financial self-sufficient, as indicated by a median FSS ratio of less than 100 percent10 . This means that their revenues cannot adequately cover their costs when the latter are adjusted to reflect market prices and potential loan losses based on a uniform assessment of default risk. Since these adjustments all have the effect of raising MFI costs, the FSS ratio is lower than the OSS ratio. Considering that many more MFIs are not included in the MCPI-MIX study, while those in the study are supposed to be the financially better performers among Philippine MFIs, the reported FSS ratio (see Table 4) suggests that lack of financial sustainability is par for the course in the local microfinance business11. The implication is that many of these MFIs would be hard put to sustain their activities at current levels without continuing subsidies, or charging higher interest. This same observation was made with reference to a much larger set of MFIs around the world (see Armendáriz deAghion and Morduch [2005]). Table 4 further shows that local MFIs have a higher financial revenue ratio, but their costs of delivering microfinance services are also generally higher relative to Asian and other non-Philippine MFIs. The latter may be related to the observation that they service mostly small loans, which involves higher transaction costs. As a result, Philippine MFIs charge interest rates and other fees that are about a third higher than those on loans from Asian or other MFIs based on a comparison of gross portfolio yields12. Their portfolio-at-risk is also higher than that reported for similar institutions in Asia or the rest of the world. Table 5 provides a closer picture of Philippine MFIs for 2005 and 2007 according to size or scale. It shows that financial sustainability is related to MFI size or scale and that smaller MFIsincur higher costs overall. They are also subsidized to the extent of 50 percent of their loanable funds. Nevertheless, small MFIs are able to attain a measure of financial sustainability by charging the highest interest rates relative to large and medium MFIs. If these are the same MFIs which cater to the poorest borrowers, then this implies that the poorest borrowers pay the highest interest for their microloans.

10 Compared with OSS, which measures the extent to which revenue covers only direct costs, FSS indicates whether enough revenue has been earned to cover both direct and indirect costs, including the adjusted cost of capital. FSS accounts for the cost of maintaining the value of equity relative to inflation, the cost of accessing liabilities at commercial rather than concessionary rates, and adjustments in loan loss expenses. 11 The MIX-MCPI data further reveal that local MFIs which failed to meet the standard of financial sustainability have a median FSS ratio of 84 percent. 12 Rather than use the stated loan interest rate, MIX uses gross portfolio yield, which includes interest and other fees as a proportion of gross loan portfolio, as a measure of interest rate. Being closer to what borrowers actually pay it is a measure of the effective interest rate. All references to interest rate in this paper are based on the published figure for real gross portfolio yield reported by MIX.

Table 5: Philippine MFIs by size, 2005 and 2007 2005 2007

Large Medium Sm all Large Medium Sm all

Number reporting 7 19 19 15 20 15Age 30 25 10 21 28 12Active borrowers 67,193 8,224 5,853 69,815 15,632 8,868 Gross loan portfolio ($ thousand) 11,365.3 3,156.6 695.6 12,995.8 4,090.7 1,057.3 Commercial funding liabilities ratio (%) 73.2 104.4 49.6 98.9 103.3 44.5 Average loan balance per borrower/GNI per capita (%) 23.6 28.6 7.1 17.0 19.7 7.4Return on assets (%) 2.8 -0.7 -2.7 1.9 -0.6 0.1Operational self-sufficiency (%) 126.1 113.2 112.7 114.3 112.1 104.6Financial self-sufficiency (%) 111.0 97.6 92.6 109.8 101.3 101.8Financial revenue ratio (%) 25.8 25.1 34.0 31.2 27.2 31.3Yield on gross portfolio (real) (%) 24.9 20.7 40.0 35.7 29.8 50.4Total expense ratio (%) 26.4 29.1 36.0 27.9 27.0 36.6Operating expense ratio (%) 16.0 14.3 26.9 20.7 16.6 25.7Personnel expense ratio (%) 5.2 7.6 13.9 11.5 10.0 14.8Administrative expense ratio (%) 8.7 8.2 10.2 9.4 7.3 11.4Portfolio at risk > 30 days (%) 4.2 6.5 7.0 3.3 4.8 7.2 Source: MIX and MCPI [2006] and [2008]

Sustainability-outreach tradeoffs The problem is that raising lending rates does not always result in higher profits. Given the already high nominal rates reported for Philippine MFIs, it may be asked by how much more they can be increased without portfolio quality deteriorating from the effects of adverse selection and moral hazard. Moreover, empirical evidence offers little support for the view that poor borrowers’ demand for loans is interest inelastic (Karlan and Zinman [2008], Briones [2009]). A higher interest rate is bound to discourage some potential debtors, contracting outreach and reducing further the likelihood that low-income clients will receive a loan. Of course, financial profitability can be improved by reducing operating costs; taking advantage of recent advances in information and communications technology and eliminating inefficiencies come to mind. Still, given the higher cost of lending to households that are physically hard-to-reach and expensive to monitor in the absence of collateral, would not focusing on financial sustainability result in a reduction of MFIs’ efforts to reach more of the poor? More to the point: are not the strong advocates of sustainability ignoring the trade-off between financial profitability and outreach? Is the trade-off more serious than they actually believe? While no study addressing the preceding question has been conducted for the Philippines, a few studies using cross-country data are instructive. Woller and Schreiner [no date] investigated the determinants of financial self-sufficiency using data from 13 village banking institutions13in as many countries in Latin America and Africa during the years 1997-1999. They found interest rates, administrative efficiency, loan officer productivity, and staff salaries to be significant determinants of financial self-sufficiency. However, they found no empirical support for the hypothesized trade-off between financial sustainability and depth

13 This MFI type, also known as village banks, employs a variant of the group lending technology to deliver small loans to poor borrowers.

of outreach for their sample of MFIs. An analysis of 27 Asian MFIs (in India, Bangladesh, and Myanmar) using 2002-2004 data similarly shows that extending financial services to the poor did not necessarily adversely affect the financial sustainability of a third of the MFIs (Sinha and Brar [2005]). These financially successful MFIs were able to reach down to the low-end market either because of their chosen location or the extensive scale of their operations. An apparent tradeoff between financial sustainability and outreach is reported in a paper by Hudon and Truca [2006], however, which examines the impact of subsidies on sustainability. The study covering 100 MFIs in Asia, Africa, Latin America, Eastern Europe and the Middle East over the period 2002-2005 shows that lower financial sustainability is associated with a higher “subsidy intensity”, a major reason why MFIs ought to avoid subsidies according to commercialization advocates. However, the authors found no evidence of moral hazard in the form of overpaid or unproductive staff due to the subsidies. Rather the association between lower financial sustainability and subsidy intensity derives from the MFIs’ higher cost of loan administration as a result of a greater focus on the poor (as shown by a lower ratio of average loan size to GDP per capita).The subsidy simply allows them to charge a lower interest than otherwise making their loans affordable to their target customers. Cull et al [2007] use a “high quality” data set of 124 MFIs in 49 countries to specifically examine whether financial sustainability is associated with a lower depth of outreach, and whether “mission drift” necessarily accompanies the effort to achieve financial sustainability. The effect of higher lending rates on portfolio quality, i.e. whether portfolio quality declines when lending rates rise, is also tested. Unlike earlier studies which either looked at only one type of MFI or did not test for the effect of lending method on performance, this study classified MFIs according to whether they practice group lending, village banking, or individual-based lending in dealing with loan customers. According to the authors,

Our results bring some good news for microfinance advocates. First, over half of the institutions in the survey were profitable after accounting adjustments were made (although average return on assets is negative overall). Others are approaching profitability and should be able to soon achieve financial self-sufficiency. Second, simple correlations show little evidence of agency problems, outreach-profit trade-offs or mission drift. The correlations thus attest to the possibility of raising interest rates without undermining repayment rates, achieving both profit and substantial outreach to poorer populations, and staying true to initial social missions even when aggressively pursuing commercial goals. [F108]

When the authors explicitly consider lender type in the regressions, however, the tradeoffs come to light underscoring the importance of institutional considerations in the relationship between profitability and outreach to poor borrowers. The study finds support for a negative relationship between profitability and the lending rate above some threshold level consistent with agency theory, although such relationship exists only for MFIs practicing individual-based lending.

The study notes further that MFIs that practice individual-based lending perform better financially than those relying on the group-based methodology. However, the latter perform much better with respect to depth of outreach. Although MFIs that make smaller loans are not necessarily less profitable when other relevant factors are controlled for, the negative association between loan sizes and average costs is suggestive of a tradeoff between profitability and outreach given that larger loan sizes imply less outreach to the poor (F131). Individual-based lenders are less likely to cater to low-income borrowers given the incentive to use their ability to exploit scale economies through larger average loan sizes. The tendency toward mission drift as they grow larger is also stronger with this lender type than with group-based lenders. Rural banks and microfinance NGOs in the Philippines, respectively, typify the individual- and group-based lenders analyzed by Cull et al, although a few NGOs have started offering individual loans to their mature customers in recent years. Established as non-profit organizations, NGOs target low-income borrowers who have traditionally been rationed by formal financial institutions. Their grassroots orientation makes them ideal for implementing the group lending method, which requires tremendous social preparation, as an approach to solving the informational problems in lending to asset poor borrowers with small borrowing requirements. Rural banks on the other hand are organized essentially as for-profit institutions designed to serve a much broader, more heterogeneous clientele, which makes individualized loan transactions more suitable. As a result, bank loans are on average larger than the typical NGO loan. Table 6 presents data on Philippine NGOs and rural banks gathered from the same data base used by Cull et al in their multi-country analysis ([2007] and [2008]). Without special access to institution level information, this paper is, however, limited to examining two-way tables. The close association between MFI organizational form, lending method, and customer orientation should be immediately obvious from the numbers. The first two columns of Table 6 show that rural banks have a much bigger loan portfolio than NGOs; however, their borrowers are far fewer, indicating that non-bank, non-profit MFIs still dominate the microlending business in the country despite vigorous donor efforts to promote commercialization in the last few years14. NGOs also have a much deeper outreach with an average loan balance per borrower to per capita GNI ratio of 7.4 percent versus the rural banks’ 34.5 percent. The joint liability feature of NGO loans tends to keep loan sizes small.

14 It should be noted that the data reported include all loans and borrowers of rural banks but exclude deposits and depositors, which constitute an important part of rural banks’ business and clientele.

Table 6: Philippine MFIs by various classifications, 2007

NGOs Rura l bank Non-profit For-profit Low-end Broad

Number reporting 25 23 25 25 30 20Age 12 33 12 32 12 33Active borrowers 20,126 9,386 20,126 10,477 21,929 6,850 Gross loan portfolio ($ thousand) 2,617.9 6,357.5 2,617.9 5,943.4 3,117.6 5,677.1 Commercial funding liabilities ratio (%) 43.4 122.8 43.4 122.8 51.5 123.9 Average loan balance per borrower/GNI per capita (%) 7.4 34.5 7.4 30.6 7.5 46.0Return on assets (%) 0.8 0.5 0.8 0.5 1.0 0.4Operational self-sufficiency (%) 106.7 114.3 106.7 113.6 108.9 114.0Financial self-sufficiency (%) 102.6 107.7 102.6 107.3 105.1 105.7Financial revenue ratio (%) 37.2 21.6 37.2 21.6 36.9 20.6Yield on gross portfolio (real) (%) 51.7 26.1 51.7 26.9 49.9 25.7Total expense ratio (%) 39.2 21.9 39.2 22.1 36.0 20.4Operating expense ratio (%) 31.2 12.2 31.1 12.5 27.2 11.0Personnel expense ratio (%) 19.3 5.6 19.3 5.8 15.8 5.0Administrative expense ratio (%) 11.3 6.7 11.3 6.7 11.4 5.9Portfolio at risk > 30 days (%) 3.3 5.5 3.3 6.1 3.3 6.7 Source: MCPI and MIX [2008]

Reflecting the pattern described in Cull et al’s two papers, Table 6 further shows that the median NGO and rural bank are both capable of operating profitably. Unlike the global sample, however, individual-based lenders (rural banks) in the Philippines do not necessarily show the highest profits. That NGOs pass the standard of financial sustainability suggests that non-profit organizations geared towards the low-end market can be self-sustaining. The last four columns of Table 6 simply confirm this. Using a different classification, they compare MFIs by business model and market orientation; they show that non-profit MFIs and MFIs oriented towards the low-income segment of the credit market perform just as well on financial sustainability as those that are organized for profit and cater to a broad clientele. Unlike rural banks, however, a significant share of NGOs’ loan portfolios is funded at non-commercial rates as indicated by a median commercial funding liabilities ratio of lower than 50 percent. Grants and concessional borrowings from various international and national sources and compulsory deposits of their own loan clients typically make up NGOs’ non-market fund sources. On the one hand, this indicates that subsidization need not be a deterrent to sustainability, contrary to what has often been claimed by advocates of microfinance commercialization (Figure 1). On the other hand, this state of affairs adds to the impression held (rightly or wrongly) in some quarters that NGOs have largely retained the benefits of subsidization instead of passing these on to their borrowers in the form of lower interest rates.

Figure 1: Sustainability, Outreach, and Subsidization of NGOs and Rural Banks

-

20.0

40.0

60.0

80.0

100.0

120.0

140.0

NGOs Rural banks

Perc

ent (

%)

Commercial fundingliabilities ratio (%)

Financial self-sufficiency(%)

Average loan balanceper borrower/GNI percapita (%)

Microfinance NGOs generally follow a high interest-rate strategy for maintaining profitability15. The median real effective interest rate (or real gross portfolio yield) reported by MCPI and MIX for Philippine NGOs is nearly 50 percent, compared with about 22 percent for rural banks. The higher cost of servicing small loans is often cited as the reason for high interest rates. Philippine MFIs specifically targeting low-income borrowers report an operating expense ratio of 27 percent compared with only 11 percent for those serving the broader market. The absence or lack of borrowing alternatives for low-income households could also be a factor sustaining the high interest rates, although little is really known about the competitiveness of markets where MFIs operate. In addition, the group lending feature of NGO loans safeguards against agency problems that the high interest charges might set off. This is an advantage that rural banks, which extend loans on an individual basis, possibly do not have (Cull et al [2007]), a suspicion reinforced by the higher proportion of portfolio-at-risk reported for such banks (Table 6). To justify their higher interest rates, NGO loans may also be bundled with other services, such as client training, business advice, skills enhancement, and other related services that NGOs can easily perform as multi-purpose organizations.

15 Using a multi-country sample of 555 sustainable MFIs from the MIX data base, Rosenberg et al [2009], after examining whether microcredit interest rates are “excessive”, conclude that “despite exceptional occasions, MFI interest rates generally seem quite reasonable and that there is no evidence of any widespread pattern of abuse.” [p.3].

Figure 2: Sustainable vs Non-sustainable MFIs

05

101520253035404550

FSS ≥100 FSS<100

Perc

ent

Average loan balance perborrower/GNI per capita(%)Operating expense ratio(%)

Yield on gross portfolio(real) (%)

Portfolio at risk > 30 days(%)

In the context of Cull et al’s “global analysis” of MFIs, the patterns in sustainability and outreach observed among MFIs in the Philippines place Philippine MFIs, the NGOs in particular, in the category of “exceptions” that have “managed to achieve profitability together with notable outreach to the poor.” [2007: F108] This is certainly good news for local microfinance practitioners and their supporters. However, the more successful Philippine MFIs continue to operate with subsidies in the form of grants and low-priced concessional funds even as their profitability ratios, adjusted for the presence of subsidies, show that they should be able to operate without these on account of the interest rates they charge their clients16. Examining if subsidies encourage inefficiencies that contribute to the high operating costs of MFIs is important because of the high microcredit interest rates that are often attributed to the high costs of lending to the poor. Mersland and Strǿm [2010] show that average loan size and other measures of “mission drift” are positively correlated with average costs. Where high operating costs can be traced to inefficiencies, a case can be made whereby subsidies cause lending rates to be high as MFIs strive to show funders a measure of financial sustainability even as the inefficiencies are allowed to persist. In this case financial self-sufficiency is attained at the expense of outreach through borrowers that are rationed out by the resulting high rates in spite of an MFI showing a good measure of depth of outreach. The coincidence of financial self-sufficiency and depth of outreach does not necessarily imply the absence of a trade-off (Woller and Schreiner [no date]). Reaching the poor Depth of outreach is a gauge of how well an MFI is able to extend its services to the poor. The usual indicator of depth of outreach is average loan size per borrower17. The indicator is a proxy for the socio-economic standing of an MFI’s customers, where it is assumed to

16 Cull et al [2008] observed a similar phenomenon in a sample of 346 MFIs from various countries but they constituted a minority. 17 For purposes of cross-country comparisons, the ratio of average loan size per borrower to GDP or GNI per capita is used.

vary directly with the income of the loan recipient. The indicator also assumes that poverty reduction has a greater chance of happening if the loan is received by the poor person himself instead of someone else. Thus, according to this measure, the smaller is the average loan per borrower of an MFI, the greater is the proportion of the poor among its clientele, and therefore the deeper is its outreach and the greater is its poverty-reducing impact. The fact that MFIs are able to show a good measure of depth of outreach is, however, inadequate as a basis for claiming that microfinance has improved access of the poor to credit. Where available, it is useful to compare field-level client poverty data with the commonly used measure of depth of outreach, as was done for 27 Asian MFIs in 2002-2004 (Sinha and Brar 2005]). The comparison showed that for average loan sizes below $100, or where the average loan size per borrower was below 20 percent of per capita GDP (MIX’s threshold for depth of outreach), average loan size had no correlation at all with the proportion of the poor among the MFIs’ customers. Only beyond $100 was the presumed negative correlation observed. These twin results indicate that while non-poor borrowers will generally demand large loans, they are “not deterred from accessing smaller loans, if these are available.” (Sinha and Brar: 5) The observation above suggests the difficulty of relying on other than direct information about the poverty status of microfinance clients for determining if MFIs are keeping to their declared social mission.MFIs do not exclusively target their services to the poorest. Examining the poverty targeting strategies of 25 MFIs from several countries Mathie [2002] notes that “although microfinance programs may have the social objective of reducing poverty, the intention of many is to achieve this not by targeting the poorest of the poor, but by targeting the poorest of the economically active” [p. 2]. Most MFIs in the Philippines say they do not target the very poor. According to government statements (NSM [1997] and BSP [2005]), microfinance targets the “entrepreneurial poor” (or the “e-poor”), defined as those who are already engaged in productive activity among the poor. This makes selection a function of where MFIs choose to locate as well as the distribution of the attribute “entrepreneurship” among the poor population. Consumption loans are also not generally considered microfinance even if they constitute a critical part of the poor’s strategy in coping with uncertainties in income and consumption as well as various emergencies. An evaluation of the impact of an Asian Development Bank-sponsored microfinance program on rural households in the Philippines showed that notwithstanding the program’s stated objective to reach poor households18 , only 10 percent among the program’s actual clients were poor, while only 4 percent were subsistence poor. Among prospective clients and qualified non-participating households that constituted the comparison group, similar proportions of the poor and subsistence poor were also found suggesting that either program targeting was faulty and failed to properly identify the poor, or that the program implementers did not consider the poor as the proper clients of the microfinance program (Kondo et al [2008]).

18Defined as the lowest 30 percent of the rural population in the income distribution.

Although it is not known if the finding of Kondo et al is generally true about microfinance programs in the Philippines, reported performance indicators by and large do not include the proportion of those below the poverty line among an MFI’s borrowers. The construction of a poverty scorecard for the Philippines not too long ago to help MFIs direct their services better to the poor suggests that as late as 2005 poverty targeting may have been largely ad hoc and unsystematic19 . Being the only attempt thus far to seriously examine outreach among Philippine MFIs, the Kondo et al study caused some unease in the microfinance community. After all, if direct access to credit is a key entry point to poverty reduction as microfinance advocates hold, then with limited outreach would not the expected poverty reducing effects of microfinance be mere chimera? Or can the poor benefit from microfinance through less direct channels? Accounting for impact Assessing the state of knowledge about the impact of microfinance on poverty in 2002, Zeller and Meyer [2002] warned about deploying public resources for microfinance development without the benefit of “rigorous research”. Fast forward to the present and a number of scientific papers later, Rosenberg [2010] observes that “we simply do not know yet whether microcredit or other forms of microfinance are helping to lift millions out of poverty.” [p.2] The impact of microfinance, microcredit in particular, on poverty and related welfare outcomes at different points in time has been examined by various authors. Montgomery and Weiss [2005] list 14 studies in Asia and six in Latin America from 1996 to 2004 that try to correct (though not always successfully or completely) for the sources of bias – sample selection and program placement – that typically characterize impact evaluations of microcredit. Goldberg [2005] similarly provides a review of published impact assessments until mid-2005. More recently, Odell [2010] reviewed impact studies conducted between 2005 and 2010, grouping them under three classes: experimental (randomized), quasi-experimental, and non-experimental. In general, impact studies have attempted to investigate the effects of microfinance on some of measure of welfare. A non-exhaustive list includes: (i) income, consumption and savings; (ii) financial transactions (e.g. borrowing); (iii) microenterprise growth, employment, profitability; (iv) asset growth; and (v) human capital investment. In a nutshell, the more recent studies show that “microfinance is good for microbusinesses”, but that “the overall effect on the incomes and poverty rates of microfinance clients is less clear, as are the effects … on measures of social well-being, such as education, health, and women’s empowerment.” (Odell [2010]: 6) Among the studies covered in the reviews cited above are two that specifically deal with the Philippines; only their results are briefly summarized here. The first, by Kondo et al [2008], evaluates a rural microenterprise finance program using a quasi-experimental design. The

19Informed by the 2002 Annual Poverty Indicators Survey (APIS), the scorecard allows field workers of MFIs to assess the likelihood that a program participant is poor based on 10 simple indicators (Schreiner [2007]). A few microfinance NGOs have used the scorecard also to find out if in fact the borrowers they had chosen before the introduction of the scorecard had incomes below the poverty line.

design involved choosing existing program areas (treatment) where the microfinance program had been ongoing for some time, and corresponding expansion areas (control) where program clients had been identified and prepared for the program but no lending had yet taken place. In both areas, qualified but non-participating households were also interviewed. Kondo et al employ a difference-in difference strategy to deal with the problems of selection bias and program placement bias. To deal with the issue of attrition bias, the study included an appropriate number of former clients who had either graduated or dropped out from the program. The authors found that access to program loans resulted in a positive, albeit weakly significant20, effect on per capita income, per capita total consumption, and per capita food expenditures. Moreover, these effects were regressive; positive only for the higher per capita income quintile while either negative or insignificant for households in the lower quintiles. Households that took out loans under the program also reduced their dependence on other sources of financing, while a higher proportion of households with savings accounts and balances in these accounts with participating and other MFIs was observed. Similarly, the microfinance program had a highly significant and positive impact on the number of microenterprises in which household members were engaged, although no effects were found on asset accumulation, health and education. The second impact evaluation dealing with the Philippines is a randomized study by Karlan and Zinman [2010], which investigates how individual loans made by First Macro Bank to microentrepreneurs have affected borrowingand other business-related decisions, profitability, household welfare, and subjective well-being. First Macro Bank is a for-profit institution receiving implicit subsidies from a USAID-funded program. The authors used a credit scoring model to separate marginal loan applicants from creditworthy and non-creditworthy ones. Borrowers were randomly selected from the pool of marginal applicants based on a pre-assigned probability. The study found that access to microloans did not necessarily lead to increased profits and business scale; neither did it raise household income or consumption, on average. The authors note that where profits increased, such effect was significant only for men and larger for those with higher incomes. Increased borrowing was also accompanied by reductions in the number of businesses and some labor shedding, which suggested that program participants used the credit to “re-optimize” business investment. For male participants, the increase in borrowing was associated with a drop in household member employment in other businesses and a higher probability of enrolling a child in school. Overall, a substitution of formal insurance for credit was also noted, even as access to informal risk sharing arrangements increased. No significant improvements in several measures of subjective well-being21were similarly found for program participants; in fact reducing them to a summary index resulted in a small, negative, albeit “marginally significant” welfare decrease for the entire sample.

20 Statistical significance is at the 10 percent level. 21 These included optimism, calmness, (lack of) worry, life satisfaction, work satisfaction, (lack of) job stress, decision-making power, and socio-economic status (p.16).

Karlan and Zinman’s finding that initially better-off participants gained the most from a microfinance program in Manila also shows up in Kondo et al’s [2008] study of a microenterprise finance project in Philippine rural areas. In fact, the same result was obtained by Hulme and Mosley [1996] in Indonesia and Coleman [2006] in Thailand for similar programs they evaluated though using other measures of welfare as well as alternative methodologies22. However, Karlan and Zinman’s findings regarding the participants’ use of other sources of borrowing, savings accounts, and business growth are evidently at variance with those of Kondo et al. Moreover, the finding of positive impacts only for males raises questions regarding the much vaunted advantages of focusing on women and microentrepreneurs (Karlan and Zinman [2010]:18). It is fair to say that quite a good deal of a priori expectations associated with microfinance failed to find empirical support from these two studies conducted in the Philippines. The same may be said in general about post-2005 microfinance evaluations which almost invariably found no evidence of the promised effects in terms of improved household income and consumption, much less in health, education, and women empowerment (See Odell [2010]). On the other hand, it may also be premature to conclude anything about the effectiveness of microfinance as a poverty reduction instrument. For one, “it remains to be seen if different studies arrive at different estimates due to true underlying heterogeneity across settings, or to differences (and flaws) in some methodologies” (Karlan and Zinman [2010]:18). On this, replication of research designs across settings seems to offer a promising way forward as exemplified by Roodman and Morduch’s [2009] paper. In their paper, the two authors re-examined three well-cited (and presumably influential) papers that used survey data from Bangladesh in 1991-92 and 1999 and employed different methodologies which produced contradictory results about the impact of microfinance (Pitt and Khandker [1998], Morduch[1999] and Khandker [2005]). They replicated the three studies applying the same methods to the same data used, as well as performed other related tests, and concluded that the evidence for impact presented in all three studies is not definitive. Conclusion The debate on whether a trade-off exists between sustainability and outreach is essentially a debate about the feasibility of the microfinance promise, which holds out the potential for poverty reduction combined with business success. Those who have been around long enough should get a sense of déjà vu on recognizing that the same question posed some three decades ago had managed to creep in through the back door: can credit be an effective instrument for reducing poverty? This paper has been essentially a reflection on that debate drawing on the existing literature and applying the insights on Philippine microfinance data.The data suggest that Philippine MFIs are generally able to combine financial sustainability with serving poor borrowers, using

22 Kondo et al [2008] is based on a quasi-experimental design originally implemented by Coleman in an earlier study (Coleman [1999]) with an innovation to deal with the attrition problem.

average loan size as an indicator of depth of outreach. The higher cost of servicing small loans, however, implies that MFIs have to charge higher interest rates or receive subsidies. There are indications that non-bank MFIs do both. Regarding outreach, the paper has noted that where actual client poverty status data are used instead of average loan size, it is not clear if the relatively small proportion of the poor among loan recipients is due to faulty targeting or the MFIs’ revealed preference. Finally, most rigorous impact evaluations of microfinance have found no strong evidence of its promised effects in terms of poverty reduction. So, is microfinance overrated? In a developing country where pervasive credit market imperfections prevent even the non-poor micro and small entrepreneurs from exploiting productive opportunities, the loosening of credit constraints results in a real welfare gain. This speeds up capital accumulation and growth making it possible for the poor to benefit in the process. Beck and Demirgüc-Kunt [2008] cite studies in both a developed and developing country which show that finance leads to lower income inequality (and poverty) mainly via labor market effects, i.e. by employing more of the labor force in the formal sector where wages are higher [p.385]. That is, the poverty reducing effects of microfinance need not necessarily depend on expanding the poor’s direct access to credit, or turning them all into microentrepreneurs. Besides, not everyone is cut out to be an entrepreneur. Yet the microfinance promise of delivery from poverty is built on stories of individuals succeeding in this or that microenterprise, never mind that they would have succeeded anyway without a loan from an MFI. It is this selective story-telling, probably by MFIs themselves to equally enthusiastic donors who in turn passed on the anecdotes to create still bigger stories, that has given rise to unreasonably high expectations of microfinance. If microfinance advocates have been put on the defensive as a result of the spate of empirical work showing that microfinance does not reduce poverty, it is only because they have promised too much. Microfinance will seem overrated only if we choose to assess it on the basis of its promise to reduce poverty. A more sober analysis informed by an appreciation of the role of financial markets should tell us that an expansion in the scope of financial services to include hitherto excluded segments of the population constitutes a social welfare gain. From this standpoint, microfinance has done well, even if it may not have directly reduced poverty. That is good enough.

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