Explaining Growth and Consolidation in RP Microfinance Institutions

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This study attempts to tackle the following problem. Will an understanding of the life cycle of firms in the microfinance industry explain their performance? This problem shall be answered through the following objectives: First, describe the performance of microfinance firms in the Philippines, through a growth trajectory, also termed as life cycle, by using relevant financial indicators; Second, determine the factors affecting the performance of microfinance firms by age group, making use of indicators which indicate portfolio quality, efficiency, sustainability and outreach.

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<p>Short Bio Jovi C. Dacanay graduated BS Statistics, MS Industrial Economics and MA Economics and is currently pursuing her PhD Economics in the Ateneo de Manila University. She lectures in Mathematical Statistics, Social Economics and Research Seminar in the University of Asia and the Pacific. Her research includes industrial economics, industrial organization of health care markets, economics of film and microfinance. She is currently involved in empirical work on the microfinance industry of the Philippines and has presented papers in international conferences and published in conference proceedings. Jovi C. Dacanay Instructor and Senior Economist School of Economics University of Asia and the Pacific Business Address Pearl Drive corner St. Josemara Escriv Drive Ortigas Business Center, Pasig City (1605), Philippines (063) 637-0912 to 0926 Home Address 54 Examiner St., Barangay West Triangle Diliman (1104), Quezon City, Philippines Direct Line: (063) 372-4008 to 4010 or 414-9383 Cellphone Number: (063) 09274942714 E-mail Address jovi.dacanay@uap.asia jovicdacanay@gmail.com jovicdacanay@yahoo.com 1</p> <p>Explaining Growth and Consolidation in the Microfinance Industry of the Philippines</p> <p>Abstract</p> <p>Microfinance industries have tried to mitigate the risks inherent among micro-enterprises as borrowers through a system or combination of group and individual lending. Microfinance is the supply of loans, savings and other financial services to the poor. The poor throughout the developing world frequently are not part of the formal employment sector. They do not have easy access to credit. This study attempts to tackle the following problem. Will an understanding of the life cycle of firms in the microfinance industry explain their performance? This problem shall be answered through the following objectives: First, describe the performance of microfinance firms in the Philippines, through a growth trajectory, also termed as life cycle, by using relevant financial indicators; Second, determine the factors affecting the performance of microfinance firms by age group, making use of indicators which indicate portfolio quality, efficiency, sustainability and outreach. The methodology of the study is based on an analysis of the life cycle and growth trajectory of small firms (Reid 2003). With the social performance preference of the industry, i.e. poverty alleviation via entrepreneurship, micro entrepreneurs usually have priority over loans. The growth stage of small firms are usually not phases of high profitability, debt is resorted to, yields on loans, in the case of the microfinance industry, has to increase through a better quality of loans. Thus, microfinance industries go through a next stage wherein borrowers are closely monitored. Once borrower quality of assured, the firm enters into a second growth phase wherein the firm resorts to equity financing in order to achieve its expansion phase. In this stage, the firm can pay dividends to investors and the firm resorts to decreasing its own borrowings. With the use of reported financial indicators in the MIX Portal from 46 regularly reporting MFIs all over the Philippines, a panel regression correcting for heteroskedasticity was done. The life cycle phases of the MFIs can be explained using the performance standard indicators for MFIs: portfolio quality, efficiency, sustainability and outreach. The results are consistent with the expected outcomes from the life cycle model of Reid (2003). The results show that even with a composition of micro borrowers forming part of the clientele, the performance of MFIs can be monitored and their behavior follows the behavior of market competitive small firms.</p> <p>Keywords: life cycle, financial viability, social performance, microfinance</p> <p>2</p> <p>Table of Contents</p> <p>1. Introduction</p> <p>4</p> <p>2. Literature Review</p> <p>5</p> <p>3. Theoretical Framework</p> <p>11</p> <p>4. Empirical Methodology</p> <p>23</p> <p>5. Results</p> <p>28</p> <p>6. Conclusion</p> <p>34</p> <p>References</p> <p>36</p> <p>Appendix 1. P.E.S.O. Standards</p> <p>38</p> <p>Appendix 2. Database</p> <p>40</p> <p>Appendix 3. Description of Firms</p> <p>58</p> <p>3</p> <p>Explaining Growth and Consolidation in the Microfinance Industry of the Philippines1. Introduction</p> <p>Background An effective financial sector serves as a link or mediator in order to allow a steady flow of funds to finance business operations and investments. Firms considered as high risk do not have access to such funds. Among such firms are micro-enterprises who only have access to funds for loans made available by the microfinance industry, if the proprietors of the business resort to commercial financing schemes. Firms engaged in micro-enterprise lending, hereby termed as microfinance, do not have the same access as other private enterprises to the funds provided by the commercial financial sector. Even if some firms lending to micro-enterprises are registered as non-government organizations, they operate as commercially established microfinance firms.</p> <p>Microfinance industries have tried to mitigate the risks inherent among micro-enterprises as borrowers through a system or combination of group and individual lending. Microfinance is the supply of loans, savings and other financial services to the poor. The poor throughout the developing world frequently are not part of the formal employment sector. They may operate small businesses, work on small farms or work for themselves or others in a variety of businesses. Many start their own micro businesses, or small businesses, out of necessity, because of the lack of jobs available. 1 The more stable microfinance enterprises have operated for less than 15 years. Analysts of the sector claim that the stability of a microfinance enterprise will be seen only when it is able to survive more than two decades. Due to the greater number of firms who have been operating for less than 15 years, the view that the microfinance industry is a high risk sector lingers and limits the amount of funds made available for loans and credit.</p> <p>1</p> <p>http://www.themix.org/about-mix/about-mix#ixzz1UUlL62Qg 4</p> <p>Problem and Objectives of the Study This study attempts to tackle the following problem. Will an understanding of the life cycle of firms in the microfinance industry explain their performance? This problem shall be answered through the following objectives: First, describe the performance of microfinance firms in the Philippines, through a growth trajectory, also termed as life cycle, by using relevant financial indicators; Second, determine the factors affecting the profitability of microfinance firms by age group, making use of indicators which indicate portfolio quality, efficiency, sustainability and outreach. 2. Literature Review Several studies on the microfinance industry have used finance theory to explain the operations of a micro-lender. These studies, however, usually rely on empirical investigations and results as a main source to explain the basic relationship between firm performance to growth and financing. Reid (1996, 2003) provide the theoretical underpinnings to relate the operations of small business enterprises (SBEs) with the financial needs. His theoretical approach uses the basic neo-classical economic assumptions on the behavior of a profitmaximizing small firm. According to Reid (1996), Vickers (1970) was the first writer to integrate the production aspect of the firm with the financial. The firm needs financial capital to hire inputs and to produce and to sell outputs. It acquires outside financial capital either in the form of debt, for which it pays a rate of interest, or in the form of equity, which has a required rate of return, to be interpreted as the cost of equity. The value maximization problem which the firm solves involves both the production function constraint, and also the financial capital constraint. Thus the solution of this problem not only determines what will be sold and how much will be hired of various factors, but also how much financial capital will be used, and in what ways. Subsequent studies such as Leland (1972) first combined production and finance in a dynamic theory of the firm (Reid, 1996). In his case, the theory of the firm adopted was based on so-called managerial principles. Therefore the goal of his firm was to maximize the total discounted value of sales (over a finite planning horizon) plus the final value of the equity. However, though this model started an important new line of enquiry, in itself it contained 5</p> <p>several flaws and inconsistencies. For instance, it required that the discount rate be equal to the borrowing rate, but yet that there was a decreasing efficiency of debt compared to a constant efficiency of retained earnings (Reid, 1996). More rigorous treatments of how a small firm combines production and financing in a dynamic theory of a firm had to be done. A synthesis of these approaches is provided by Hilten, Kort and Loon (1993).2 The type of firm being considered is a familiar one to small firms specialists. It has no access to the stock exchange, has limited access to debt finance, and its technology is subject to decreasing returns. It is assumed that production is a proportional function of capital, and sales are a concave function of output. In terms of its balance sheet, the value of capital assets is equal to the sum of debt and equity. 3 Equity can be raised by the retention of earnings, and there is assumed to be a maximum debt to equity (i.e. gearing) ratio determined by the risk class of the enterprise. It is assumed that there is a linear depreciation rate on capital. The mathematical development used to explain a dynamic theory of the firm led to the study of financial structure to the stages of development of a firm to risk. Modigliani and Miller (1958, 1963) highlighted the important issues involved in financial structure decisions namely: the cheaper cost of debt compared to equity; the increase in risk and in the cost of equity as debt increases; and the benefit of the tax deductibility of debt. They argued that the cost of capital remained constant as the benefits of using cheaper debt were exactly offset by the increase in the cost of equity due to the increase in risk. This left a net tax advantage with the conclusion that firms should use as much debt as possible. In practice firms do not follow this policy (Chittenden et al, 1996). Access to capital markets is not frictionless and influences capital structure. These findings lead one to look at the micro-enterprise in terms of its stage of development, hereby termed as life cycle. However, the life cycle of a firm would have to be related to its financial structure in order to finance production. Lastly, the friction which</p> <p>happens within firms, i.e. the choice to use more or less debt to finance production and expansion leads to agency problems. Agency problems arise due to the relationship between ownership and management, as is observed in the contractual arrangements which firms would</p> <p>2 3</p> <p>See Reid (1996). Hence, also, the rate of change of capital assets equals the rate of change of equity plus the rate of change of debt. 6</p> <p>undertake in order to access external financing. These key issues would provide the main areas of literature used in the study.</p> <p>Life Cycle Approach to Analyzing Financial Structure Reid (1996, 2003) explains the maximization problem in a dynamic setting. The</p> <p>maximand is the shareholders' value of the firm, under the assumption of a finite time horizon on the dividend-stream integral. The constraints of this maximization problem have been largely covered in the previous paragraph with the addition of initializing values of variables, and nonnegativity constraints on capital and dividends (i.e. a zero dividend policy is possible). This problem can be solved by the Pontryagin Maximum Principle. The state variables, representing the state of the firm at a point in time, are equity and capital. The control variables are debt, investment and dividend. The results give a trajectory for the life cycle of the firm given a debtequity or financing source choice on the part of the firms owner. Each small firm goes through a stage of growth, consolidation, further growth or expansion, and stationarity. Due to the small scale of the firm, positive marginal returns to capital will stay positive if the firm decides to expand or grow. The stages a firm goes through in the trajectory will depend on the level of debt versus equity which the firm owner chooses as a financing source or instrument. It can either borrow, therefore rely on debt financing, or, rely on its internally generated profits or equity financing. Reid (1996 and 2003) provides a theoretical explanation of the firms trajectory in its life cycle for each choice. Specifically, his model enables the firm to predict the relationship between performance to capital growth and financing source.</p> <p>Pecking Order Framework The empirics provide strong support for a pecking order view of financial structure, explaining well the tendency of small business enterprises to rely heavily on internal funds as proposed by Myers (1984). The pecking order framework (POF) suggests that firms finance their needs in a hierarchical fashion, first using internally available funds, followed by debt, and finally external equity. This preference reflects the relative costs of the various sources of finance. This approach is particularly relevant to small firms since the cost to them of external equity, stock market flotation, may be even higher than for large firms for a number of reasons. As a consequence, small firms avoid the use of external equity. 7</p> <p>According to Myers (1984), contrasting the static tradeoff theory of Modigliani and Miller (1958, 1963) based on a financing pecking order: First, firms prefer internal finance; second, they adapt their target dividend payout ratios to their investment opportunities, although dividends are sticky and target payout ratios are only gradually adjusted to shifts in the extent of valuable investment opportunities; third, sticky dividend policies, plus unpredictable</p> <p>fluctuations in profitability and investment opportunities, mean that internally-generated cash flow may be more or less than investment outlays. If it is less, the firm first draws down its cash balance or marketable securities portfolio; fourth, if external finance is required, firms issue the safest security first. That is, they start with debt, then possibly hybrid securities such as convertible bonds, then perhaps equity as a last resort. In this story, there is no well-defined target debt-equity mix, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom. Each firm's observed debt ratio reflects its cumulative requirements for external finance. Simply, the pecking order framework states that small firms prefer to use internally generated fun...</p>