1. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom Analysis of Sustainability for European Microfinance Institutions. An Empirical Study Lead Author: Ana Irimia e-mail: anairimia@us.es Co-Author(s): Antonio Blanco and María Dolores Oliver Research group: New Developments in Finance. University of Seville (Spain)

2. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom Analysis of Sustainability for European Microfinance Institutions. An Empirical Study 1.Introduction 2.Literature review 3.Objective and Methodology 4.Empirical study: data and variables 5.Results of empirical study 5.1. Latin-American MFIs 5.2. European MFIs 6.Conclusions and future lines of research

3. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom Future goals of European MFIs are:  Sustainability  Social Performance  Outreach to the most excluded  Scale  Other One of the main goals of European Microfinance Institutions (MFIs) is to be sustainable over the long term, and is widely regarded as a best practice in the microfinance industry. This paper analyses which factors influence the sustainability of European MFIs. The better understanding of these key factors will enable MFIs to improve their performance. 1.Introduction

4. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom Pollinger et al. (2007) suggest that MFIs generally operate in one of three different modes: survival, sustainability, or self-sufficiency.  In survival mode, organizations barely cover their monthly expenses and many programs have faced a lingering decay as capital that was lent out in earlier years did not return as expected to cover future operations. Many of these organizations and programs eventually begin the process of dissolution and explain the high mortality rate of organizations and programs in the sector.  Most organizations seem to operate between survival and sustainability, which can be defined as the ability of organizations to cover their annual budget through donations and other grants in addition to earned income from their lending operations.  Self-sufficiency refers to organizations that can survive and add to their asset base wholly on the basis of income derived from their lending and related operations. 1.Introduction

5. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom The European microfinance market presents a dichotomy between Western Europe and Central Eastern Europe in terms of characteristics of intermediaries.  The Eastern European microfinance sector has generally followed the current microfinance orthodoxy in focusing on sustainability, profitability and scale (Hartarska et al, 2006).  Western European microfinance has a strong focus on social inclusion and pays less or almost no attention to its profitability (Evers&Jung, 2007). Kramer-Eis et al. (2009), argue that a main challenge for MFIs in the EU is to develop and maintain a flexible and sustainable funding model for microfinance operations that allows them to realise their individual approach. Jung et al. (2009) point out that the benchmarks in terms of the degree of self-sustainability set for MFIs in the EU should be individually adjusted according to the target groups they are serving. 1.Introduction

6. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom  Dayson et al. (2009) conducted a benchmarking study of five UK MFIs, as part of which they analysed and modelled the past and future performance of their loan portfolios, their partnerships, and the way in which their staff members spent their time and the processes and structures driving this time- use.  Pollinger et al. (2007) discuss relationship-based financing as practiced by MFIs in the United States, by analyzing their lending process, and present a model for determining the break-even price of a microcredit product. Comparing the model’s results with actual prices offered by existing institutions, reveals that credit is generally being offered at a range of subsidized rates to microentrepreneurs.  Vinelli (2002) explores the statistical relationship between financial sustainability and outreach indicators by using firm-level data from 24 MFIs. Several linear regressions are performed to assess the influence of different variables on financial self-sufficiency. The explanatory variables include percentage of women, percentage of rural clients, average loan size per gross national product (GNP) per capita, real interest rate, and number of borrowers. 2.Literature review

7. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom There is no clear sustainability model to serve as a benchmark and guide for all MFIs. The main reasons are, first, that sustainability can be defined in various ways and, second, that empirical studies fail to attain a unique and conclusive model. According to CGAP (2003) and CDFA (2006), financial sustainability refers to the ability to cover its costs if it had to raise all its loan portfolio through recycling existing funds and through borrowing funds at the market rate. Financial Sustainability = Financial Revenue Financial Expense + Impairment Losses on Loans + Operating Expense 3. Objective and Methodology A factor analysis Methodology: A multiple linear regression Benchmark

8. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom  A reliable database of worldwide MFIs with significant financial information is that of Mixmarket (http://www.mixmarket.org).  We selected two samples, one of 244 Latin-American MFIs and the other, from 19 Central and Eastern European entities. The data selected are variations of 30 variables from 2007 to 2008.  Western MFIs are also focused on sustainability but the lack of primary data and the wide heterogeneity of institutions make it impossible to currently carry out empirical research.  The methodology has been previously tested with a database of Latin- American MFIs in order to obtain a benchmark. The same methodology was applied to the European MFI database although the results were not so significant.  Due to the impossibility of carrying out a factor analysis on the East European data set, we consider the results obtained with the Latin-America MFIs as a standard model based on an in-depth data set to apply to a smaller data set (European MFIs). A stepwise linear regression was then made. 4. Empirical study: data and variables

9. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom 5. Results of empirical study 5.1. Latin-American MFIs Six components are obtained by applying the factor analysis: F1.Size. F1.Size. Includes ratios and variables such as total assets, gross loan portfolio, total borrowings, average amount of each microcredit, personnel, operating expenses, and financial revenue and explains 17.3% of total variance. F2. Generating Cash Flow. F2. Generating Cash Flow. Contains four variables, financial revenue/assets, yield on gross portfolio, financial expenses/assets and interest rate for microcredit. This second component explains 16.2% of total variance. F3. Operations and Commercial Policy. F3. Operations and Commercial Policy. Includes five variables: average loan balance per borrower per GNI, borrowers per staff member, number of borrowers with loans outstanding, financial expense, total women borrowers. It explains 10.6% of total variance. F4. Inefficiency in the use of Assets: F4. Inefficiency in the use of Assets: is composed of variables associated to assets and operating expenses (OE): return on assets, OE to assets, OE to loan portfolio. This component explains 9.6% of total variance. F5. Solvency: F5. Solvency: is formed of variables and ratios related to equity: Debt to equity ratio, return on equity. This factor explains 7.6% of the total variance. F6. Default: i F6. Default: is composed of variables such as portfolio at risk, write-off ratio and explains 4.8% of the total variance.

10. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom 5. Results of empirical study 5.1. Latin-American MFIs Coefficients(a) Model Unstandardized Coefficients Standardized CoefficientstSig.Collinearity Statistics B Std. ErrorBetaToleranceVIFBStd. Error 1 (Intercept)-.015.016 -.938.349 F1.042.026.5771.632.105.04323.167 F2.055.0331.0341.690.093.01469.436 F3.009.013.120.715.476.1915.226 F4 -.019.022-.804-.841.402.006169.626 F5.014.007.1711.973.050.7151.398 F6 -.031.010-1.601-2.925.004.01855.583 a Dependent variable: VAR Financial Sustainability 0708 The regression equation obtained is: Financial Sustainability = - 0.015 + 0.014 Solvency – 0.031 Default Results of the multiple linear regression:

11. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom 5. Results of empirical study 5.2. European MFIs Goal: To check if the previous six components explain the European MFIs financial sustainability by using a linear regression. Dependent Variable: Financial Sustainability. Independent Variables: The previous six factors: Size, Generating Cash Flow, Operations and Commercial Policy, Inefficiency in the use of the Asset, Solvency and Default. Coefficients (a) Model Unstandardized Coefficients Standardized CoefficientstSig.Collinearity Statistics B Std. ErrorBetaToleranceVIFBStd. Error 1 (Intercept).147.068 2.151.277 F1.205.0903.1192.271.264.04024.857 F2.349.3382.8731.033.490.010101.892 F3.073.100.313.725.601.4072.459 F4.563.2887.6131.954.301.005199.892 F5.340.1423.8882.395.252.02934.728 F6 -.067.050-1.159-1.335.409.1019.932 a Dependent variable: Variation of Financial Sustainability

12. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom 5. Results of empirical study 5.2. European MFIs Stepwise Linear Regression: Dependent Variable: European MFIs financial sustainability of European MFIs. Independent Variables: The original thirty variables. ANOVA Model Sum of SquaresdfMean SquareFSig. 1 Regression.295339.0328139.17.0001 Residual.006708.00083770 Total.3020317

13. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom 5. Results of empirical study 5.2. European MFIs Stepwise Linear Regression: R 2 = 0.9778 Model Unstandardized Coefficients B Std. ErrorType II SSF-ValuePr > F 1 (Intercept).11683.01472.0527562.97<.0001 Var_Gross_loan_portfolio -.20477.05583.0112713.45.0063 Var_Capital_asset_ratio.49263.06009.0563167.22<.0001 Var_Financial_revenue_assets -.31902.13332.004805.73.0437 Var_Yield_on_gross_portfolio -.38084.08864.0154618.46.0026 Var_Operating_expense_loan_portfolio -148.218.14174.09160109.35<.0001 Var_Borrowers_per_staff_member -.62819.07093.0657178.44<.0001 Var_Portfolio_at_risk_30_days.02173.01042.003644.35.0706 VarG_Fros -.01204.00630.003063.65.0924 VAR_Intereses 116.663.15536.0472456.39<.0001

14. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom 5. Results of empirical study 5.2. European MFIs Stepwise Linear Regression: The regression equation obtained is: Financial Sustainability = 0.11683 - 0.20477 Var Gross loan portfolio + 0.49263 Var Capital asset ratio – 0.31902 Var Financial revenue assets – 0.38084 Var Yield on gross portfolio – 1.48218 Var Operating expense loan portfolio – 0.62819 Var Borrowers per staff member + 0.02173 Var Portfolio at risk 30 days – 0.01204 Var Financial Expenses + 1.16663 Var Interest rates

15. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom 6. Conclusions and future lines of research In order to increase sustainability, it is easier to generate value by lending to individuals with better credit records, due to their increased ability to handle debt and lower associated default rates. However, in doing so, an MFI must be careful not to subvert its mission. Outreach must be considered as a goal related to sustainability. Nevertheless, a better understanding of the actual costs involved in the microfinance process will enable the evaluation of the interest rates that may need to be charged by an MFI to cover its costs of lending and also its needs of private and public subsidies.

16. EMN 7 th Annual Conference 24-25 June 2010, London, United Kingdom 6. Conclusions and future lines of research 1.The empirical study of Latin-American MFIs allows us to conclude on the explanatory power of “Solvency” (in a positive way) and “Default” (in a negative sense) with respect to financial sustainability. Furthermore, considering the wide sample of MFIs used in the study, and the development and maturity of the Latin-American entities of the sample, the analysis of these explanatory factors can be extrapolated and used as a benchmark in the microfinance sector. 2. Results from Latin-American MFIs fail to explain financial Sustainability of the European MFIs of our sample. Here the explanatory power is focused on “Inefficiency” and “Generating Cash Flow” factors. A better management of the most sensitive variables will enable a better performance of the MFIs. The weakness of the empirical study of European MFIs can be found in both the undersized sample used in our research and the actual lower level of development of European MFIs. 3. Future steps in our research may be, first, to replicate the study with a wider European database and, second, to solve the problem of factor analysis where only limited data is available by means of the Bayes approach to factor analysis.