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Are Public Development Institutions Crowding Out Private Investment in Microfinance?

This paper suggests that the rapid growth of foreign private lending to microfinance institutions (MFIs) in the last several years has led to a surprising reversal of roles between government-owned development institutions and private lenders. Development institutions (International Financial Institutions – IFIs) are concentrating their loans in the strongest MFIs, leaving private lenders to look for opportunities among smaller, riskier borrowers. A MicroRate commissioned study of funding patterns confirmed that IFIs are not complementing private lenders; they are crowding them out of the most attractive parts of the MFI market – this report documents what was found.

The paper asks: Why are development institutions concentrating on MFIs that can attract private lenders? In discussing this, it points to the nature of IFIs. Their official mission is to go where the private sector does not yet dare to tread; to assume risks that private capital would find unacceptable. Often, IFIs have adhered to these principles. However, in recent years the risk-based division of labour between IFIs and private capital has broken down. there are powerful incentives for IFIs to maximize their microfinance exposure, and to do so by concentrating on the largest and safest borrowers. Microfinance has acquired such a positive image, that a sizeable exposure in this sector has become a sign of a IFIs commitment to development. This is reinforced by an IFI’s need to disburse its microfinance budget each year. Since IFIs are not primarily profit-driven their success is often defined by the amounts that have been lent. If a budget has been allocated to microfinance, that budget must be spent – and spending it on a few large loans to top MFIs is far quicker, cheaper, and less risky than lending to, and nurturing immature institutions.

The paper argues that by forcing private lenders out of the most lucrative segment of microfinance, IFIs are hampering the development of the very institutions on which the sector will depend in the long run. Instead, it suggests, their best role is to strengthen the overall capacity and transparency of the industry, and to act as a catalyst for private capital that would not otherwise invest in microfinance.

In light of the findings of the study, the following five recommendations are given:

First make IFI funding transparent
Maximize commercial participation in innovative capital markets transactions
Seed the next generation of microfinance institutions
Help develop mechanisms to cover foreign exchange risk
Promote further private sector channels for microfinance and finance industry infrastructure