Efficiency Drivers of MFIs: 47973 The Role of Age Microfinance institutions (MFIs) are becoming more efficient.1 This Brief sheds light on how the age of individual MFIs and the age of the industry affect efficiency improvements. On an MFI level we look into scale economies, cost structure, and process durations as potential efficiency drivers. On an industry level we look into knowledge spillovers from one MFI to the other and marketwide learning effects. BRIEF Operating expenses are the most important what effects efficiency improvements have for cost component of MFIs. Institutional efficiency individual clients as well as for the institution as is generally measured by dividing operating a whole. expenses by the size of the loan portfolio. An MFI is usually regarded as having become more Figure 2 reflects the efficiency trends for six efficient when it lowers this indicator.2 different age cohorts of MFIs between 2000 and 2007. Efficiency improves in every single Figure 1 shows the trend of efficiency for all MFIs age cohort, indicating that age is a determinant in the MIX Market sample over time.3 Efficiency of efficiency. has improved significantly over the last seven years, with the median operating efficiency ratio Age of individual MFIs as a falling from 28 to 19 percent. MFIs recorded driver of efficiency average efficiency improvements of roughly 10 percent annually. Age-related factors can be observed on three different levels: We analyze the role of age from two different angles: How does the age of individual MFIs · Higher numbers of loans may drive scale affect efficiency improvements? And how does economies. the age of the whole industry contribute to · Higher average loan sizes may improve the efficiency improvements? Finally, we illustrate cost structure. · More knowledge about customers may streamline processes. Figure 1: Median of operating expenses as % of gross loan portfolio over time Gonzalez (2008) shows that MFI efficiency is 30 strongly related to age, after screening out the 25 effect of other variables. This effect is strongest 20 in the first six years of institutional history, when cent 15 efficiency increases 2­8 percent annually. In the Per 10 following years this figure drops to 1­2 percent per year. Next to the obvious learning effects 5 that explain this finding, it seems reasonable 0 2000 2001 2002 2003 2004 2005 2006 2007 to assume that MFIs build up a solid customer Year base in their early years of existence, which significantly translates into greater efficiency. In Source: MIX. 1 In this Brief, efficiency should be understood purely as a technical term, not as a value judgment. 2 Efficiency also can be defined as cost per borrower. This measure factors in that small loans are inherently expensive, and therefore it uses the borrower as the reference unit. In this Brief, we use the more common definition of operating expenses/gross loan portfolio. 3 Weighting the distribution by asset size does not significantly change the finding of decreasing operating expenses as percentage of gross February 2009 loan portfolio. 2 Figure 2: Median of operating expenses as % of loan portfolio, by age cohort 45 40 35 1993/94 30 1995/96 25 1997/98 cent 20 1999/2000 Per 2001/02 15 2003/04 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 Year Source: MIX. subsequent years, this trend is still positive, but Do rising average loan sizes improve the cost structure? begins to level off, as most internal processes have already been tested and improved. If efficiency improvements are not driven by Do higher numbers of loans a higher number of loans per staff member, generate scale economies? is increasing loan size a driver? A common observation about growing MFIs is that their Gonzalez (2008) shows that as MFIs grow beyond average loan sizes increase over time. Industry 2,000 customers, there are no significant further data (Microbanking Bulletin Trend Lines) show efficiency gains resulting from economies of that young MFIs doubled their average loan scale, controlling for a range of other variables sizes over a three-year period, whereas mature like lending technology, geographical location, MFIs increased loan sizes by roughly 25 percent etc. On average, most productivity gains during the same period. Some assume that therefore are realized during the very early this reflects "mission drift," as the MFIs leave growth phase of an institution. A vast majority behind poorer borrowers and move to better of financially sustainable MFIs lie above this off ones. But it also can reflect a slowdown in threshold of 2,000 borrowers. This might be MFIs' growth, relaxation of limits on borrowers' one of the reasons why there has been little in first loans, or simply growth involving existing the way of productivity gains, measured in terms customers while continuing to serve smaller of loans per staff member, over the past decade ones. or so (see Figure 3). 3 Figure 3: Medians of loans per staff member over time 160 140 120 100 memberf 80 staf 60 per 40 20 Loans 0 1999 2000 2001 2002 2003 2004 2005 2006 Year Source: Microbanking Bulletin. Whatever explanation one picks, increasing from the benefits for poor clients of repeat loan sizes makes lending more efficient. For access to loans, from the MFI perspective, the same amount of money that you lend, you retaining customers is considerably cheaper have to assess only one customer instead of two than acquiring new customers. If an existing or three different customers. This means less customer asks for her second or third loan, an paperwork, less hassle, and--above all--less MFI already has much of the information it needs staff time involved. This trend flattens as loan to assess risk. As information about customers sizes increase. According to Gonzalez (2008), increases, the assessment process is shortened an increase in loan size from 10 percent of GNI and efficiency improves, regardless of whether per capita to 20 percent is expected to reduce the size of loans increases. operating expenses as a percentage of gross loan portfolio by over 7 percentage points (e.g., Age of the microfinance from 25 percent of loan portfolio to 18 percent). industry as a driver of efficiency But an increase in relative loan size from 30 to 40 percent is expected to improve efficiency by Beyond the age of individual MFIs, efficiency only around 3 percent. might also be improving as the microfinance industry as a whole matures. First, MFIs could Does more knowledge about customers be learning from each other. Some institutions shorten process durations? might let borrowers take larger loan sizes right from the beginning of operations, which would As MFIs age, they not only aim at growing their result in higher efficiency levels. It could be customer base, but they also try to extend that new MFIs that are part of large networks follow-up loans to existing customers. Aside like ProCredit or ACCION can benefit from Figure 4: Median OER after three years of establishment, by cohort February 2009 0.40 0.35 All CGAP publications 0.30 are available on the 0.25 CGAP Web site at OER www.cgap.org. 0.20 0.15 CGAP Median 0.10 1818 H Street, NW MSN P3-300 0.05 Washington, DC 0 20433 USA 1993/94 1995/96 1997/98 1999/2000 2001/02 2003/04 Year Tel: 202-473-9594 Fax: 202-522-3744 Source: MIX. Email: cgap@worldbank.org the expertise these networks offer in the form expenses on noncredit activities like savings © CGAP, 2009 of consulting services to their partners. As a services, insurance, and money transfers. Thus, consequence, efficiency gains can be realized the actual improvement in credit efficiency fairly early and are somewhat detached from a would be even greater than what these numbers learning curve that is specific to the MFI and its tell. One big question for the future of the experiences in the market it serves. sector is how low can costs go before they level off. In profitable MFIs, operating costs account Second, if the time to become efficient were for roughly half of interest yields (Rosenberg decreasing from one age cohort to the next, 2009), and thereby they represent the biggest then one could assume a marketwide learning cost block. Whether there is much potential effect as new entrants into the market avoid for reduction of operating costs remains to be the mistakes of previous entrants. And so more seen. efficient MFIs entering the market could be contributing to overall efficiency over time. References Figure 4 shows no such correlation: median operating efficiency ratios (OER) after three Gonzalez, Adrian. 2008. "Efficiency Drivers of years of establishment don't exhibit a discernible Microfinance Institutions (MFIs): The Case of pattern across the individual cohorts. Operating Expenses." MicroBanking Bulletin Highlights, Autumn. The task that lies ahead Hermes, Niels, and Robert Lensink. 2007. "The Data clearly show that every single cohort of Empirics of Microfinance: What do we know?" MFIs has been able to continually improve The Economic Journal, No. 117, February. efficiency over time. This development is very good news for the microfinance industry as Rosenberg, Richard. 2009. "The New a whole. It may be even likely that efficiency Moneylenders: Are the Poor Being Exploited improvements are systematically understated by High Interest Rates?" Occasional Paper 15. because, over the past years, many MFIs have Washington, D.C.: CGAP. spent an increasing proportion of operating AUTHORS Christoph Kneiding and Ignacio Mas