The finance of microfinance: liquidity creation in deposit-taking microfinance institutions

Abstract

As microfinance moves beyond its traditional function as a niche development tool and towards becoming an integrated and self-sustainable part of the formal financial market, the need to deepen our understanding of its players and their financial and organisational behaviour increases. However, with primary focus in most research being on the social and cultural side of microfinance, the study of the financial behaviour of its institutions has been neglected. This thesis explores the ability of microfinance institutions (MFIs) to function as liquidity creators for the market, on par with more traditional financial intermediaries. Using fixed effects estimations, it evaluates a range of financial and developmental drivers of liquidity creation (LC), including deposit insurance, capital ratio and risk profile. In addition to these, essays 2 and 3 evaluate the impact of specialisation and the regulatory framework, as well as a range of conditions unique to development and microfinance, such as joint lending methodologies, profit-status and the Human Development Index (HDI). In essay 1, I find that microfinance institutions are able to create liquidity for the surrounding market, on par with, and at times surpassing, more traditional financial intermediaries. These results are similar across geographical regions and organisational types, and are positively impacted by the presence of formal regulation. However, contrary to the suggestion of traditional banking theory, the presence of deposit insurance does not appear to have significant impact on the level of liquidity created, nor does it appear to be primarily pushed by the institution’s risk profile. Instead, my findings suggest that the primary drivers of liquidity creation should be found elsewhere. In essay 2, I find strong, consistent and positive correlation between levels of liquidity creation and the use of joint lending methodologies by microfinance intermediaries, in particular group loans. The effect is observed across all 4 LC measurements, and in both models presented. The findings support the theoretical suggestion that joint lending serves as a form of risk mitigator for MFIs in the absence of traditional collateral. In addition, it suggests that while microfinance institutions as previously found are able to create liquidity on par with traditional intermediaries, the mechanisms behind the successful production are different. The unique conditions in developing and emerging financial markets appear to drown out the effects of most (though not all) of the more traditional financial drivers. Finally, in essay 3, a two-tiered approach is used to study the effect of formal regulatory and supervisory frameworks, using MIX and World Bank data in cross-country and regional estimations. The results suggest a consistent, strong and positive effect of regulation, across very diverse areas, in terms of formalised financial frameworks and levels of development. The thesis adds to the relatively new and still scarce empirical research on liquidity creation in general, and brings attention to the unique conditions facing financial intermediaries in emerging and especially developing financial markets. It specifically provides some first insights into the creation of liquidity in microfinance, and explores the drivers of LC by studying the impact of a range of traditional, development- and microfinance-specific variables. The empirical work adds an in-depth, cross-country look at the creation of liquidity, and provides academics, policy-makers and practitioners alike with a much needed new insight into the external financial performance of microfinance institutions, and their ability to live up to their societal role as liquidity creators for the surrounding market.