Competition and sustainability of Ecuadorian microfinance institutions (MFIs)
Fernando Xavier Naranjo Galindo[1]
Información del artículo
Fecha de recepción: 14 de Noviembre de 2021.
Fecha de aceptación: 6 de Abril de 2022.
Abstract
Competition is often praised for enhancing efficiency in the process of resource-allocation. However, it could also put at risk the sustainability of firms operating within certain industries such as the financial sector. This could have further managerial implications when it comes to social enterprises such as microfinance institutions (MFIs). Using data from Superintendencia de Economía Popular y Solidaria over the period 2016-2019, this study aims at analyzing the aspects of competition on sustainability of Ecuadorian MFIs. More specifically, the research focuses on savings and credit cooperatives (SACCOs). Relying on both the structural and non-structural approach to measure competition at a firm level, findings are in line with an important portion of the microfinance literature claiming that competition is negatively associated with the main measures of financial sustainability and portfolio quality.
Keywords: competition, financial sustainability, microfinance, savings-credit cooperatives, Ecuador, Latin America
JEL Classification: G2 Financial Institutions and Services
Competencia y sostenibilidad de las instituciones de microfinanzas (IMFs) ecuatorianas
Resumen
A menudo se elogia la competencia por mejorar la eficiencia en el proceso de asignación de recursos. Sin embargo, también podría poner en riesgo la sostenibilidad de las empresas que operan en ciertas industrias como el sector financiero. Esto tendría implicaciones gerenciales adicionales cuando se trata de empresas sociales como las instituciones de microfinanzas (IMFs). Utilizando datos de la Superintendencia de Economía Popular y Solidaria durante el período 2016-2019, este estudio tiene como objeto analizar los aspectos de la competencia en la sostenibilidad de las IMFs ecuatorianas, específicamente en las cooperativas de ahorro y crédito (SACCOs). Con base en el enfoque estructural y en el no estructural para medir la competencia a nivel de empresa, los hallazgos están en línea con una parte importante de la literatura en microfinanzas que afirma que la competencia está negativamente asociada con las principales medidas de sostenibilidad financiera y calidad de la cartera.
Palabras clave: competencia, sostenibilidad financiera, micro finanzas, cooperativas de ahorro y crédito, Ecuador, América Latina
Clasificación JEL: G2 Instituciones Financieras y Servicios
Introduction
From an economic perspective, competition is commonly considered an important factor to increase efficiency in the process of resource allocation by lowering market prices and making goods and services accessible to most part of the population, as well as improving the quality in which they are delivered. In this sense, governments and policy makers often implement measures to limit the market power of agents operating under monopolistic structures, either by direct regulation or by encouraging the entry of new competitors. This is also expected to have a positive impact on the well-being of the society since economic agents can obtain the goods and services they value.
However, the hybrid nature of social enterprises such as microfinance institutions (MFIs) has raised the question whether higher levels of competition lead to better outcomes in terms of the compliance with the double bottom line: financial and social performance. On one hand, higher competition could lead to more efficiency due to agents’ incentives to lower costs and drive innovation (Claessens, 2009); on the other, it has also been associated with lower levels of portfolio quality (Assefa et al., 2013) and multiple loan taking by borrowers (McIntosh & Wydick, 2005) which could lead to over indebtedness and default.
Over the past years, microfinance activities have increased significantly and rapidly in a wide range of developing countries in terms of providers and clients (Kar, 2016). According to Mackinnon et al. (2020) Ecuador has become one of the most attractive markets for microfinance investment funds. Yet nearly half of the adult population does not own an account at a financial institution (Demirgüç-Kunt et al., 2015) and commercial banks have more and more started to expand their services to the poorer segments. In countries with a less developed financial sector and a high level of financial exclusion like Ecuador, the impact of grants and subsidies seems to be limited and self-sufficiency emerges as the main pathway to provide financial services in a greater scale.
Using data from Superintendencia de Economía Popular y Solidaria (SEPS, the regulatory body of MFIs in Ecuador, over the period 2016-2019 (four years), this study aims at analyzing the aspects of competition and its effects in terms of financial sustainability. Information on MFIs is available for segments 1, 2 and 3, mostly corresponding to savings and credit cooperatives (SACCOs), and mutualists. In line with the microfinance literature, the relation between competition and sustainability is expected to be negative.
To the best of knowledge, this study represents the first attempt to specifically analyze the aspects of competition in the Ecuadorian microfinance industry. Although Ecuador has more and more attracted the eyes of academics due to its growing microfinance activity, the literature on competition remains scarce. Moreover, there is a special need to seriously address this topic since the seek for financial sustainability could lead MFIs to increase competition not only amongst their pairs, but also with commercial banks which could have further implications for both providers and clients.
The document is organized as follows: section 1 presents the literature review and hypothesis development, section 2 provides information about data and methodology used to build the research, section 3 shows the obtained results and the consistency of outcomes using two different measures of competition, and section 4 concludes.
Literature review
Competition and its effects
Microfinance institutions (MFIs) can be defined as hybrid organizations that seek both financial and social goals. In the literature, this is referred to as the double bottom line. The hybrid nature of MFIs often translates into schemes and business models that differ from those of traditional profit-maximizing structures. As analyzed by Morduch (1999) the movement has been able to demonstrate that it was possible to lend money to poor households in order to improve their living standards, and to do so in a profitable manner; however, the poverty alleviation goal through microfinance still lacks of consistent evidence.
The context where MFIs carry out their operations should be considered into the analysis of financial and social performance. Institutions that rely mainly on subsidies could be motivated to follow a more developmental logic, serving clients who have been excluded from the traditional financial sector. This might push institutions to locate themselves in rural or remote areas (Vanroose, 2016). However, in places where MFIs strive for self-sustainability MFIs may have more incentives to locate themselves in more developed areas and serve more profitable clients. Although the commercialization movement of the industry has led to innovation resulting in better products and services to serve a wider range of clients, it has also raised ethical questions such as the potential for mission drift.[2]
In this regard, the question of subsidization and sustainability of microfinance providers is still at the core of academic and ethical debates. According to Armendáriz and Morduch (2010, p. 340), it is possible to achieve financial self-sufficiency while serving poor clients and ensuring an important depth of outreach; nontheless this is not always feasible when operating in rural areas, especially of Africa and Latin America where costs are higher. Therefore, subsidies seem to be justified under these circumstances. In addition, the reliance on subsidies could affect the incentives of institutions to reduce costs, preventing them from working efficiently (Armendáriz & Morduch, 2010).
Several factors may determine the extent to which MFIs are able to achieve sustainability. Vanroose (2008) develops a cross-country analysis with data of 115 countries and finds that MFIs reach more clients in richer countries of the developing world, suggesting that there is a need of a certain level of development for microfinance to start reaching significant levels of clients; likewise, countries that have received more international aid present larger microfinance markets. Moreover, Ahlin et al. (2011) study the performance of MFIs according to their macroeconomic environment and find that economic growth has a positive effect on operational self-sufficiency (OSS) since it helps reducing default rates and costs per borrower.
Sustainability of MFIs may also be explained by the degree of development of the traditional financial sector and the microfinance industry itself. Vanroose and D’Espallier (2013) find that MFIs increase their outreach and profits in countries with less developed financial sectors since they capture the market underserved by banks, whereas in countries with more developed financial sectors, competition with banks pushes MFIs down the poor segments. Likewise, Cull et al. (2014) combine data on bank penetration of 99 countries and 346 MFIs from 67 countries to analyze the effect of the scope of the banking system on proftability and outreach of MFIs; the authors find that higher bank penetration pushes microbanks towards the poorer segments of the economy.
In line with Robinson (2001) regarding the debates on sustainability, Hermes and Lensink (2011, p. 878) highlight the differences between the financial system approach and the poverty lending approach of MFIs. The financial system approach stresses the idea that institutions should become financially sustainable by being able to cover lending costs with operational revenues, whereas the poverty lending approach advocates for the provision of credit to help overcome poverty by subsidizing microfinance services (i.e., interest rates). Hermes et al. (2011) analyze the cost efficiency of MFIs by using a stochastic frontier analysis (SFA) to understand the relationship between financial sustainability and outreach, and find strong evidence that outreach is negatively related to efficiency. In their study, for instance, higher efficiency leads to an increase in average loan size and a decrease in outreach to women.
The seek of sustainability may push MFIs to compete among each other or with other type of financial institutions. Tuckman (1998, p. 176) defines competition as the pursuit of the same objective by two or more firms that can create rivalry among them for capital, labor, board members, contracts, grants, customers and revenues. The author employs the term “basis of competition” to define the way organizations choose to compete, depending on the industry and customer needs. Claessens (2009) argues that competition in the financial sector leads to lower costs and more efficiency, higher levels of product innovation and diversification, and better quality of services.
As stated by Cull et al. (2011, p. 154), competition may emerge as a result of a growing number of commercial banks downscaling their operations to offer services to poorer segments. This is also pointed out by Vanroose and D’Espallier (2013) who explain how commercial banks could start targeting poorer clients once MFIs have proven them creditworthy. Beyond the benefits of competition, however, Kono and Takahashi (2010, p. 53-54) refer to it as one of the challenges for microfinance; for instance, when there are too many MFIs operating in a region, borrowers who did not complete repayments in one institution could keep obtaining loans from other institutions which would lead to an increase in the probability of default. In order to solve this issue, McIntosh et al. (2005) state that there should be an informational system to be shared amongst MFIs.
McIntosh and Wydick (2005) develop a behavioral model to analyze the effects of the entry of new competitors within the same pool of borrowers. They find three possible adverse effects of competition: first, competition can reduce de ability of socially motivated lenders to generate rents from wealthier clients and keep serving poorer clients (cross-subsidization); second, non-profit client-mazimixzing institutions may undercut profit-maximizers to capture most pofitable clients and keep serving poorer clients which could prevent the emergence of a competitive microfinance market; third, competition may harm the information process between lenders and could increase multiple-loan taking, thus the likelihood of default.
Likewise, Navajas et al. (2003) propose a model of credit market competition considering moral hazard and adverse selection in the Bolivian microfinance industry to analyze the evolution of loan terms due to increasing competition and the impact on borrowers repayment behaviors. The study shows that althought competition has changed the type of contracts and broaden the borrowing opportunities from different segments among the poor, the overall effect on the poorest remains ambiguous since increased competition could prevent socially oriented lenders to keep cross-subsidizing poorer borrowers, but could also limit monopolistic structures and foster innovation of products and services which may translate into an increase in outreach.
Vogelgesang (2003) analyzes repayment behavior using data of Caja Los Andes in Bolivia within the period 1996-2000 which was charaterized by increasing levels of competition, important levels of indebteness and the beginning of an economic crisis. The author finds two opposite results: first, a higher level of competition is associated with a higher level of indebtenes (multiple-loan taking from different institutions at the same time), thus worsening the repayment behavior specially in times of crisis; second, in more competitive markets clients are more diligent and repay loans ontime. The latter might be due to better screening standards and incentive mechanisms of MFIs, but also to the awarness of clients about the importance of micro-loans in their daily activities.
Measuring competition
There are several ways to measure competition. Bikker and Haaf (2002) present a review of wide array of approaches to measure competition and market concentration in the banking industry; according to the authors, the Herfindahl-Hirschman Index appears to be one of the most common measures of market concentration due its simple structure and data requirement. Toh et al. (2020) argue that this procedure can be considered part of the traditional industrial organization method following the structural approach and consists of measuring competition regarding concentration levels, where higher concentration is associated with lower competition.
Assefa et al. (2013) use the Lerner Index to assess the effect of competition on financial and social performance of MFIs; using data of 362 MFIs from 73 countries, the authors find that higher competition is associated with lower levels of portfolio quality that could be explained by multiple loan taking by clients and more relaxing selection standards by MFIs. Toh et al. (2020) classify this procedure as part of the new-empirical methods that follow the non-traditional approach to measure competition and take into consideration the elasticity of the demand for the products and services offered by financial institutions.
In the same line, Chortareas et al. (2012) analyze the determinants of interest rate margins in Latin American banks from 1999 to 2006. They use both traditional and non-traditional approaches to address competition and find that traditional measures such as concentration or market share have no or little impact on interest rate spreads. Nevertheless, they observe that lower spreads are related to more efficient and competitive financial markets. Additionally, they point out a positive relationship between the level of bank capitalization and interest rate margins, as well as a negative relationship between margins and economic growth.
Hussain et al. (2020) study the effect of competition freedom on financial and social performance of MFIs in five South-East Asian countries, combining measures of regulatory efficiency and market oppeness. They find that higher competition freedom, such as business, monetary and investment freedom have positive effects on financial performance, but a negative effect on social outputs. These results suggest that less restricted economic environments may fooster efficiency in operations of MFIs, harming their incentives to keep serving the poorer segments.
Kar (2016) introduces the use of the Boone indicator as a measure of competition in the microfinance industry; it considers the impact of efficiency on performance, suggesting that more efficient firms earn larger market shares and profits. In addition, Kar and Swain (2018) use the Boone indicator to measure competition and assess its effects on financial and social performance of 568 MFIs of ten developing countries with significant microfinance activity; the authors find that higher levels of competition improve financial sustainability but harm social outcomes as they observe an increase in the average size of loans and a reduction of outreach to women clients. The latter study suggests that the commercialization movement of the industry could lead to mission drift with MFIs focusing on better-off clients, thus shifting away from the poorest of the poor.
Hossain et al. (2020) also use the Boone indicator to measure competition and analyze its effects on financial sustainability and social performance of MFIs for the period between 2005-2014, and find that competition negatively affects sustainability, as reflected on the estimators for operational self-sufficiency (OSS) and financial self-sufficiency (FSS) of MFIs. Regarding social performance, the study shows that competition has a negative effect on both the breadth of outreach (number of active borrowers) and the depth of oureach (average loan size). This is to say that competition can lower the breadth of outreach but increase the depth of outreach.
The Ecuadorian microfinance industry
The proliferation of microfinance institutions (MFIs) in Ecuador could be attributed to its macroeconomic environment characterized by high levels of informality and inequality, as well as a general trend of steady growth (Ahlin et al., 2011). Authors like Demirgüç-Kunt et al. (2015) already positioned Ecuador as one of the most developed microfinance markets in the world. In this context, Beisland et al. (2019, p. 123) distinguish four main types of microfinance providers in the country: commercial banks, specialized microfinance banks, savings and credit cooperatives (SACCOs) and non-governmental organizations (NGOs).
According to Superintendencia de Economía Popular y Solidaria (2021), there exist 513 regulated microfinance institutions (MFIs) in Ecuador. This number is broadly dominated by savings and credit cooperatives (SACCOs) which account for 509 institutions; the rest includes 4 mutualists, 1 public institution (Corporación de Finanzas Populares y Solidarias), and 1 Caja Central (FINANCOOP) that gathers several SACCOs. Additionally, non-governmental organizations operate with the mission of providing access to credit, but to the best of knowledge there is currently no official information about their number, financial statements, and scope of operations.
In observation to the resolutions of Junta de Política y Regulación Monetaria y Financiera (2015), one of the regulatory bodies of the financial sector in Ecuador, MFIs are classified in 5 segments considering their total assets. Table 1 presents this segmentation. The gross loan portfolio of institutions in segments 1, 2 and 3 represents 97% of the total gross loan portfolio of MFIs in Ecuador (Superintendencia de Economía Popular y Solidaria, 2021). Segments 4 and 5, on the other hand, consist of smaller and more local MFIs. The latter includes community associations such as cajas de ahorro, bancos comunales and cajas comunales.
Table 1.
Segmentation of Ecuadorian MFIs by total assets
|
Segment |
Assets (USD) |
|
1 |
> 80’000.000 |
|
2 |
20’000.000 - 80’000.000 |
|
3 |
5’000.000 - 20’000.000 |
|
4 |
1’000.000 - 5’000.000 |
|
5 |
< 1’000.000 |
Note. Adapted from Superintendencia de Economía Popular y Solidaria (2021).
From 2009, the Ecuadorian financial sector has experienced important reinforcements on the regulatory framework mainly driven by the limits on interest rates. According to the resolutions of Banco Central del Ecuador (2009), the maximum interest rate for each segment of credit will be published on a monthly basis and it will be mandatory for all financial institutions, including MFIs, to fix their prices in line with those limits. The impacts of such regulations on the interaction between credit market forces cannot be overlooked. For instance, Bogan et al. (2015) argue that interest rate ceillings may lead MFIs to operate under losses thus limiting the supply of credit and harming customers whose demand is inelastic.
Despite the regulatory policies that have limited the development of the microfinance industry, Ecuador has consistently become one of the most attractive markets for microfinance investment funds (Mackinnon et al., 2020). In this regard, the industry represents an interesting context for research on competition as firms have not been able to freely choose their prices (interest rates).
Methodology
Hypothesis development
The negative effect of competition on sustainability has been stressed by authors like Assefa et al. (2013) and Hossain et al. (2020) whose studies consider measures of operational and financial sustainability, but also portfolio quality. These negative effects could be partially explained by a reduction of MFIs margins due to competition as pointed out by Chortareas (2012), but also to multiple loan-taking from borrowers that often leads to more relaxing credit policies and lower portfolio quality.
Nontheless, one could also think that institutions striving for sustainability would try to explore and capture new markets and clients which could also lead to higher profits. This is in line with the market-failure hypothesis pointed out by Vanroose & D’Espallier (2013) who argue that MFIs could target clients that were previously excluded by the traditional financial sector and also with the contributions of Kar and Swain (2018) regarding the enhancement of financial soundness and productivity of firms that face increasing competition.
Therefore, this research will attempt to test whether greater levels of competition have a negative impact on the main financial indicators related to profitability, sustainability and portfolio quality of MFIs. Considering the above-mentioned literature, the effect is expected to be negative.
Hypothesis 1: Higher levels of competition negatively affect MFIs’ financial performance and sustainability.
Data and methods
Data on MFIs is obtained from Superintendencia de Economía Popular y Solidaria (SEPS), the regulatory body of MFIs in Ecuador. This information is open access through the institutional website and consists of balance sheets, profit and loss statements, credit granted and number of operations of MFIs in segments 1, 2, 3, including mutualists over the period 2016-2019 (four years). Despite data availability, year 2020 was excluded from the analysis to avoid distortions of estimators due to the COVID-19 pandemic. Information is presented at year level and the latter timeframe was defined due to data availability. This results in 579 observations from 163 MFIs, mostly savings and credit cooperatives (SACCOs) which represent 36% of the total number of institutions. Data at a macro-level such as gross domestic product (GDP) growth, inflation and private credit as a percentage of GDP are retrieved from Banco Central del Ecuador (BCE, 2009), Instituto Nacional de Estadísticas y Censos (INEC, 2021) and the World Development Indicators (The World Bank, 2021), respectively.
This research is built in three steps: first, a measure of MFI competition is calculated using a structural approach based on market concentration and regressed on different indicators of sustainability and diversification; second, an alternative measure of competition is applied using the non-structural approach considering prices and costs to check for consistency of outcomes. In both stages, competition is measured at a firm level. And third, a statistical comparative analysis is presented to determine whether MFIs compete with commercial banks in terms of markets, clients and products.
To test hypothesis 1, available information allows to build an unbalanced panel data set[3] to observe the evolution of firms over time. The process of panel balancing has not been carried out to avoid potential bias in the results and a loss of valuable information about firms. After conducting a Durbin-Wu-Hausman test to assess the efficiency of random and fixed effects estimators, Equation 1 presents the fixed effects model proposed to evaluate the relation between competition and financial sustainability:
Where is a measure of sustainability of firm
in year
;
is a measure of competition of firm
in year
;
is a vector of control variables at a firm
level;
is a vector of control variables at a macro
level;
represents the individual fixed effects;
and
is the error term.
To measure sustainability (dependent variable), the study uses operational self-sufficiency (OSS) and financial self-sufficiency (FSS) following Cull et al. (2007), Hossain et al. (2020) and Kar and Swain (2018). Profitability measures as conditions for sustainability such as return on assets (ROA) and return on equity (ROE) are also considered. Lastly, in line with the contributions of Assefa et al. (2013) on sustainability of MFIs in respect to their portfolio quality, portfolio at risk 30 days and 90 days (PAR 30 and PAR 90, respectively) are included.
Competition (main independent variable) can be measured either at industry or firm levels. Since this study is carried out in a single country, the most suitable approach is to measure competition at a firm level to identify patterns of behavior within firms over time. Market share is therefore used as a proxy for competition following the structural approach which associates higher market concentration with less competition (Toh et al., 2020). The indicator is calculated in respect to the total credit provided by MFIs in segments 1, 2 and 3 during each year. Thus, other financial institutions including public and private banks, as well as MFIs classified in other segments are not considered to calculate the market share.
Moreover, following Assefa et al. (2013) this study uses the Lerner Index as a more widely accepted measure of competition in the financial sector. This is done in the second part of the empirical analysis. To build the index, the price and marginal cost must be obtained. The expression can be written as shown on Equation 2.
Where P represents price and MC is the marginal cost. Since prices differ across credit products offered by MFIs, portfolio yield is used as a proxy for price. The original procedure to calculate the marginal cost consists of obtaining the first derivative of the total cost function which is often a complex procedure, and it depends on data availability. This study uses the average cost instead. Theoretically, the index should range from 0 to 1, being 0 full competition and 1 complete market power.
The use of average costs instead of marginal costs to obtain the index is justified by the assumption of constant returns to scale. “Under constant returns to scale, average cost and marginal cost are the same.” (Martin, 1984, p. 504). In the same line, Hartarska et al. (2013) argue that risk must be incorporated when estimating financial institutions’ cost function since higher risk would most likely lead to higher management costs. When risk is considered, institutions operate at minimum costs with constant returns to scale (Hughes & Mester, 1998).
In addition, a set of control variables at a firm and a macro level is included. At a firm level, regressions control for assets as a proxy for size (Mersland & Strøm, 2009; Assefa et al., 2013; Hossain et al., 2020), capital ratio as a measure of risk aversion and leverage (Maudos & De Guevara, 2004; Tabak et al., 2012; Hossain et al., 2020) and portfolio yield as an indicator of price (Assefa et al., 2013). Unfortunately, available data does not allow to control for age of MFIs which is often used in the literature. Following authors like Ahlin et al. (2011) and Vanroose and D’Espallier (2013), variables at macro level that are expected to have an impact on MFIs’ performance and sustainability include economic growth, inflation, credit to GDP, and rural population.
It is important to acknowledge that the use of macro variables intends to increase the accuracy of the relation between competition and sustainability, but significant variations between MFIs are mostly expected to be explained at an individual level since this study focuses on a single country (Ecuador), thus the same macro environment would be affecting institutions across time. Furthermore, macroeconomic variations tend to better explain outcomes in the longer run, whereas this study considers a time framework of four years.
Data about location of the firm, such as city or province, is not available. However, institutions analyzed in this study belong to segments 1 to 3 (the largest MFIs measured by total assets) and mutualists, which mostly operate at a national level. Thus, yearly financial statements report transactions carried out across the country, making it difficult to separate results by region. Lastly, time fixed effects were considered in preliminary regressions but omitted in the final model because of collinearity.
Table 2 presents a summary of the dependent and independent variables considered in this research. As above mentioned, indicators include measures at a firm and macro levels.