Ario, Ario (2020) Lending methodologies, sustainability and depth of outreach of microfinance institutions in Indonesia. PhD thesis, Victoria University.

Abstract

Microfinance is a term used to describe the provision of small-scale financial services aimed primarily at the poor, and to small scale enterprises. A substantial information gap and lack of collateral cause lending in this market segment to be riskier than in other segments. In the past, policy to eradicate poverty in rural areas in many developing countries involved direct intervention, including the provision of subsidised credit at low interest rates to poor people. However, many subsidised credit programs failed and required continuous and costly funding from government (Al-Azzam, et al., 2012; Morduch, 1999; & Wenner, 1995) such as BIMAS or KUPEDES program in Indonesia (Arsyad, 2005; Baskara, 2014; & Berenbach, 1997). Microfinance emerged as an alternative way of supporting poor people, although often still involving government support. In recent decades there has been growing emphasis on the provision of microfinance on a commercial basis, without government or donor support. This has raised the question of whether, without such support, microfinance can still reach out deeply to the poorer borrowers while maintaining financial sustainability. The potential conflicts between the objectives of depth of outreach and financial sustainability are the central focus of this thesis. Although a trade-off between depth of outreach and sustainability is evident in many empirical studies (Awaworyi Churchill, 2018; Kodongo and Kendi, 2013; & Necesito, 2016), other studies suggest that non-subsidised microfinance can also possibly achieve both sustainability and depth of outreach (Ault, 2016; Gutierrez-Goiria, et al., 2017; & Quayes, 2015). It may reflect differences in lending methodology: lending through groups can help microfinance to reduce credit risk and to be sustainable for a given level of outreach, relative to lending to individuals. To see this possibility, this study specifically examines the link between the depth of outreach, sustainability, and lending methodology. The study was approached by a mixed research methodology, involving both qualitative and quantitative components. For the qualitative approach, the primary data was collected by semi-structured interviews of the managers of the 20 institutions. Information from the interviews was analysed thematically to understand the lending methodology of the institutions. For the quantitative approach, data on more than 2,000 individual loans was collected, from a sample of 20 microfinance institutions. A probit model and a multiple linear regression model were applied to analyse the quantitative data. A key finding of the study is that there is evidence of a trade-off between depth of outreach and sustainability in Indonesian microfinance lending. The trade-off occurred only in individual lending where, although lending to females or smaller scale lending earned higher interest revenues to microfinance, it was exposed to higher risks because of a higher probability of default. On the other hand, this study did not find any evidence of trade-off between depth of outreach and sustainability in group lending. In addition, group lending makes the most of strong and close connectedness of group farmer members to obtain information about the borrowers and enforce loan repayment. The localised operation of the microfinance institutions in the area of a village might also facilitate an information search for borrower screening. The interviews also revealed that although individual lending was frequently secured by collateral, the collateral was rarely taken over in the case of defaulted loans. This situation might lead to a “mission drift” of the institutions, by shifting the target market for individual lending to wealthier borrowers with lower credit risk. These results have implications for both microfinance and government policy. They suggest that, to improve depth of outreach with a given level of sustainability, microfinance institutions should provide more loans with the group lending methodology. Two financial issues constrain the extent to which MFIs can pursue this course: the generation of sufficient operating income to at least cover operating costs, and the availability of capital to support an increase in group lending. For some institutions a possible solution for this issue might be giving a greater allocation of funds for group lending while keeping a substantial proportion in individual lending. Alternatively, the microfinance institutions might be given access to cheaper loanable funds, with some government support, to assist them to cover the operating costs of a higher level of group lending to achieve social objectives. Thus if there is to be pronounced shift to group lending this will probably need to be supported by policy action on the capital front also. Furthermore, it may be useful for the microfinance institutions to optimize the benefits of the joint liability approach by further developing appropriate group lending methodologies including peer selection, peer monitoring, and peer pressure. If group lending is indeed a key way of achieving the goal of increasing the income and welfare of low-income and poor people, the microfinance regulations should be redrafted to address the coverage restrictions for group lending separately from those for lending to individuals, perhaps with a view to requiring more localised operations for the former. Lastly, if the Indonesian Government is interested in expanding group lending as a way of reducing poverty in rural areas it needs to address the two financial issues. First, how a portfolio of small loans to poor men and women can generate sufficient net revenue to cover operating costs in a sustainable way. Second, how capital to expand group lending can be raised from such a low income group. Possible solutions might involve the provision of interest rate subsidies and/or additional capital to microfinance institutions, targeted only to group lending.

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