To be of continuous and reliable service to poor families with small businesses, microfinance institutions (MFIs) must operate in a sustainable manner. This means that MFIs must be managed efficiently. In this regard, this Policy Notes analyzes the extent of the efficiency of MFIs and the factors affecting such efficiency. The aim is to provide better information to regulatory agencies in regulating and supervising MFIs.microfinance institutions, cooperative rural banks

Desrochers, Martin

Lamberte, Mario B.

English

Research Papers in Economics

No. 2002-16 December 2002
Mario B. Lamberte and Martin Desrochers*
Policy Notes
Effecting Efficiency
to Sustain MFIs:
The Case of Cooperative
Rural Banks
PHILIPPINE INSTITUTE
FOR DEVELOPMENT STUDIES
Surian sa mga Pag-aaral
Pangkaunlaran ng Pilipinas
__________
*The authors are President, Philippine Institute for Development
Studies (PIDS) and Research Associate, University of Laval, Quebec,
Canada, respectively.
PIDS Policy Notes are observations/analyses written by PIDS research-
ers on certain policy issues. The treatise is holistic in approach and
aims to provide useful inputs for decisionmaking.
This Notes is based on PIDS Discussion Paper Series No. 2002-12
entitled "Efficiency and expense preference in the Philippines' coop-
erative rural banks" by the same authors. The views expressed are
those of the authors and do not necessarily reflect those of PIDS or
any of the study's sponsors.
25
1977 1977 1977 1977 1977
2002 2002 2002 2002 2002
Microfinance and poverty alleviation
The 1999 Annual Poverty Indicators Survey (APIS) shows
that 64 percent of the poorest 40 percent of Filipino fami-
lies relied on entrepreneurial activities or business for
their main source of income. Unfortunately, apart from
experiencing fluctuations in their incomes from these busi-
nesses, these families also often have to use their small
businesses' working capital or sell whatever marketable
assets they have, e.g., cow, carabao, farm implements
and others, in times of emergencies such as sickness
and natural calamities. There is a need for them there-
fore to secure funding that would help them address both
livelihood and consumption financing requirements.
As the 1999 APIS report also indicated, however, very
few of them—in fact, only 24 percent of the 5.8 million
poorest families with businesses—had obtained credit
from various sources. With the lack of reliable access to
institutional finance, most of them had—and will con-
tinue—to rely on meager funds from savings and/or in-
formal sources, thereby further limiting their capacity to
raise their incomes.
In this regard, development practitioners and policy-
makers view microfinance as one of the solutions to the
growing demand for financial services by poor families.
They also regard it as a possible answer to the reality
that most formal financial institutions do not serve the
poor because of the former's perception that the poor
are high risks and are not able to provide the required
physical collateral. These financial institutions also be-
lieve that transactions with the poor involve high costs
and low profits. In this sense, their business culture is
not geared towards servicing the poor and low-income
families. Through microfinance, therefore, poor families
will be able to have access to financial services like sav-
ings, credit, and insurance facilities. These will give them
opportunities to smoothen their consumption, manage
their risks, build their assets gradually, develop their
microenterprises, enhance their income-earning capac-
ity and enjoy an improved quality of life.December 2002
Policy Notes
2
For poor families to have continuous and reliable access
to financial services, though, microfinance institutions
(MFIs) must operate in a sustainable manner. As such,
the sustainability of MFIs is of crucial importance for the
benefit of the poorest of the poor and a thorough review
of the characteristics of a healthy MFI, especially in terms
of efficiency, should thus be given high priority by all regu-
latory agencies supervising such institutions.
This Notes therefore analyzes the extent of the efficiency
of MFIs and the factors affecting such efficiency, with
the aim of providing better information to regulatory agen-
cies in regulating and supervising MFIs.
Focus on cooperative rural banks
In the Philippines, MFIs can be categorized into the fol-
lowing: (a) rural banks, including cooperative rural banks
(CRBs); (b) credit-granting nongovernment organizations
(NGOs); and (c) credit unions/cooperatives.1 Through the
years, MFIs have steadily increased the volume of their
loans to their clients. Yet, despite this, their combined
market share has remained below 5 percent (Agabin
1998).
What could be the reason for this? One answer is that
some MFIs may not have survived through time due to
unsustainability. And a large factor for this, in turn, was
due to inefficiency.
In this regard, this Notes focuses on the CRBs because
unlike other banks, they have greater diffusion of owner-
ship that could increase opportunities for managers to
engage in expense preference behavior. This kind of be-
havior may then lead to inefficiency that may in turn un-
dermine their sustainability. Thus, regulators should be
more conscious in closely monitoring their transactions.
A CRB has a dual personality: that of being a coopera-
tive, on one hand, and a bank, on the other. As such, it is
governed by both banking and cooperative laws, particu-
larly the New Rural Bank Act or RA 7353, the General
Banking Law of 2000 or RA 8791, the Cooperative Code
or RA 6938 and the Cooperative Development Authority
(CDA) Act or RA 6939. CRBs are organized primarily to
provide financial and credit services to cooperatives and
may perform any or all of the services offered by stock
rural banks such as accepting deposits and lending money
to individual borrowers. Only duly established coopera-
tives and federations of cooperatives which are registered
or re-registered with the CDA under Republic Act 6938
may become stockholders/organizers of CRBs.
One interesting development that has taken place in the
last few years is the broadening in the ownership of CRBs
where CRBs are no longer exclusively owned by farmer
associations or cooperatives but also by other types of
nonfarm associations such as market vendors. On the
average, a CRB services around 5,000 individual borrow-
ers (Guanlao 1999).
Thus, through the years, CRBs have metamorphosed from
an almost inconspicuous to a now strategic segment of
the rural financial system. From about 15 CRBs in 1975,
there were about 50 operating CRBs supervised by the
Bangko Sentral ng Pilipinas (BSP) and registered with the
CDA as of 2000. At the same time, CRBs have also been
increasingly diversifying their loan portfolio across major
economic activities over time. As such, in contrast to the
1980s, CRBs’ loans today are less concentrated in the
agricultural sector. A substantial change in the way they
finance their lending operations over the years has like-
wise been noted. Before the mid-1980s, a big chunk of
__________
1Some small thrift banks are also going into microfinance.
CRBs, unlike other banks, have greater diffusion of
ownership that could increase opportunities for
managers to engage in expense preference behavior. This
kind of behavior may then lead to inefficiency that may
in turn undermine their sustainability. Thus, regulators
should be more conscious in closely monitoring their
transactions.3 No. 2002-16
Policy Notes
CRBs’ liabilities consisted of borrowings from the Cen-
tral Bank and other special credit programs of the gov-
ernment. The radical change in rediscounting and inter-
est rate policies in the mid-1980s has encouraged them
to mobilize deposits and to rely less on the rediscount-
ing window of the Central Bank for funds.
An increase in deposit financing is a normal trend for
growing MFIs. As confidence of consumers towards the
institution grows, governmental and grant financing can
be reduced in favor of greater amounts of bank deposits.
While this trend is very positive, it also brings about an
additional consideration—the decentralization of the
sources of financing from a few major donors to various
small depositors. Greater diffusion in sources of funds
enables managers to act more freely and thus gives room
for expense preference. This creates a vicious cycle called
“growth-diffusion of financing-failure.’’ In order to avoid
this cycle, regulators should always keep the phenom-
enon in mind and thus closely monitor the expenses of
CRBs.
CRBs’ efficiency: extent and factors affecting it
Given the above information, it is thus important to see
the extent of the efficiency (or inefficiency) of CRBs and
to know the factors that bring up such condition so that
regulators will be aware of what to closely monitor.
Estimating the extent of cost efficiency among 50 CRBs
in 1995-1999, the results of the authors' study showed
that on the average, the costs of these CRBs were 10.25
percent higher than the most cost-efficient CRB.2 In addi-
tion, the results noted that the extent of cost efficiency
varies very little among asset size groups.3
The extent of cost efficiency of the CRBs could have been
affected by four sets of factors. One set refers to the
economic environment where they operate. Among the
three proxy variables for economic environment, namely,
(a) geographic location (i.e., rural vs. urban areas), (b)
growth of regional domestic product, and (c) banking den-
sity, only the latter was found to have a significant im-
pact on the CRBs’ efficiency. More specifically, CRBs op-
erating in a province where banking density is less tended
to be less cost-efficient. It seems that lack of competi-
tion does not motivate CRBs to improve their efficiency.
The second set of factors relates to corporate governance.
Corporate governance can be defined as the combina-
tion of all measures that ensure that managers act in
the best interest of investors, e.g., investors receive an
adequate return on their investment. It was demonstrated
that an adequate corporate governance scheme can re-
duce agency costs within corporations. Concentration of
ownership induces managers to be more efficient since
major stakeholders have stronger negotiating power when
they face managers and have better incentives to keep
track of decisions made by the latter.
Conversely, diffused ownership of an institution such as
a CRB could induce managers to become inefficient. This
view is generally known as the “large shareholders
theory.” Another theory related to corporate governance—
the “free cash flow theory”—stipulates that significantly
large free cash flows available can give rise to expense
preference behavior of managers. Still another, mean-
while, which is included under the “managers’ compen-
sation theory,” suggests that a higher compensation for
managers may give them sufficient incentives to improve
cost efficiency. A number of studies have argued that
performance-based compensation is preferable to fixed
compensation in order to give adequate incentives to man-
agers to maximize the value of the firm. The empirical
results found significant support for the first two theo-
ries but not for the third theory. More specifically, CRBs
that have more widely dispersed ownership and have more
cash flows available for perks are likely to be more cost-
inefficient.
__________
2The original paper applied two models to cost and profit functions.
This Notes utilizes the results of the model using stochastic frontier ap-
proach for estimating cost efficiency.
3The CRBS were grouped into the following asset-size groups: (a)
below P20 M; (b) P20 M to less than P30 M; (c) P30 M to less than P60
M; and (d) above P60 M.December 2002
Policy Notes
4
For further information, please contact
The Research Information Staff
Philippine Institute for Development Studies
NEDA sa Makati Building, 106 Amorsolo Street
Legaspi Village, Makati City
Telephone Nos: 8924059 and 8935705;
Fax Nos: 8939589 and 8161091
E-mail: mlamberte@pidsnet.pids.gov.ph
jliguton@pidsnet.pids.gov.ph
The Policy Notes series is available online at
http://www.pids.gov.ph
The third set of factors relates to agency costs. Three
variables representing different dimensions of agency
costs have a statistically significant effect on CRBs’ cost
efficiency. The ratio of deposits over credit—a measure
of funds acquired from members and depositors that are
not used for financial intermediation but rather wasted in
inefficient operations such as maintaining luxury offices,
cars for managers, etc.—is negatively correlated with cost
efficiency. A similar result is obtained for the proportion
of fixed assets to total assets. A higher proportion of
fixed assets to total assets means that assets are di-
verted into unproductive uses of funds. Contrary to a
priori expectations, however, the sufficiency of financial
margin to cover operational expenses tends to raise the
cost inefficiency of CRBs. This result, though, needs to
be investigated further.
The fourth set of factors is related to the proclivity of
CRBs to expose themselves to greater risk. Among the
three measures of risks, namely, credit risk, leverage ratio
and interest rate risk, only the first appears to have a
statistically significant, negative correlation with cost ef-
ficiency. In other words, inefficient CRBs tend to accept
higher credit risk than efficient ones.
Interestingly, the extent of support provided by the gov-
ernment to CRBs significantly improves cost efficiency.
At first blush, this seems to be contrary to common be-
lief but it is to be noted that CRBs that received financial
assistance from the government have been closely moni-
tored by the BSP. As such, the intervention of the govern-
ment in the activities of some CRBs proved to be fruitful.
Conclusion and policy implications
The effort to alleviate poverty in the Philippines can be
enhanced with the creation of efficient and sustainable
MFIs. In order to increase the sustainability of such insti-
tutions, regulatory agencies must know the extent of the
efficiency of MFIs and identify the factors that contribute
to such state.
This Notes has focused on CRBs, one type of MFIs whose
basic characteristic of having a much wider diffusion of
ownership makes its operations more prone to being cost-
inefficient.
By recognizing the areas where CRB's efficiency may be
improved, regulatory agencies can formulate appropri-
ate policies and regulations meant to correct them. For
instance, the findings suggest that CRBs tend to be more
cost-efficient in a more competitive environment, that is,
where bank density is high. As such, the BSP should take
this into account in its policy regarding bank entry and
branching. In particular, limiting entry to microfinance-
oriented banks, which is BSP’s current policy, proves to
be less optimal than a much more comprehensive liberal
bank entry and branching.
Closely monitoring CRBs, regardless of whether they ob-
tain financial assistance from the government or not, can
also help in improving CRBs' efficiency. On the whole,
the results of this study suggest that BSP should play a
more active role in monitoring MFIs that have greater
diffusion of ownership.      
The effort to alleviate poverty in the Philippines can
be enhanced with the creation of efficient and
sustainable MFIs. In order to increase the sustain-
ability of such institutions, regulatory agencies must
know the extent of the efficiency of MFIs and identify
the factors that contribute to such state.

Effecting Efficiency to Sustain MFIs: The Case of Cooperative Rural Banks

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Effecting Efficiency to Sustain MFIs: The Case of Cooperative Rural Banks

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