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CGAP just recently published a report (that I have co-authored) showing that operating expenses are the most important cost component of microfinance institutions (MFIs). Institutional efficiency is generally measured by dividing operating expenses by the size of the loan portfolio. A given MFI is usually regarded as having become more efficient when this indicator gets lower. The figure below shows the trend of efficiency for all MFIs in the MIX Market sample over time. Efficiency has improved significantly over the last 7 years, with the median operating efficiency ratio falling from 28 to 19 percent. MFIs recorded average efficiency improve¬ments of roughly 10 percent annually.
So what are the drivers of efficiency? Let’s take a look at the usual suspects:
- Extend more loans. In fact, research has shown that MFIs that grow beyond 2,000 customers don’t show significant further efficiency gains resulting from economies of scale, controlling for a range of other variables like lending technology, geographical location, etc. On average, most productivity gains therefore are realized during the very early growth phase of an institution. The vast majority of financially sustainable MFIs lie above this threshold of 2,000 borrowers.
- Increase loan sizes. The argument goes that higher loan balances make lending more efficient. For the same amount of money that you lend, you only have to assess one customer instead of two or three different customers. This means less paperwork, less hassle, and – above all – less staff time involved. Research has shown that these efficiency improvements become smaller as loan sizes increase.
- Know your customer. As MFIs age, they not only aim at growing their customer base, but at the same time try to extend follow-up loans to existing customers. Aside from the benefits for poor clients of repeat access to loans, from the MFI perspective retaining customers is considerably cheaper than acquiring new customers. If an existing customer asks for her second or third loan, an MFI already has much of the information that is necessary for the assessment process. As information about the customers increases, process duration decreases, and efficiency improves, regardless of whether the size of loans increases.
One big question for the future of the sector is how low costs can be gotten before they level off. In profitable MFIs operating costs account for roughly half of interest yields, and thereby represent the biggest cost block. If there is much potential for reduction, though, remains to be seen.