Subsidies vs. deposits and cost inefficiency in microfinance

• We evaluate the impact of subsidies and deposits on cost inefficiency in microfinance. • Endogeneity concerns are addressed using two alternative approaches. • The results show that subsidies worsen cost inefficiency while deposits reduce it. • However, combining subsidies and deposits together aggravates cost inefficiency. • The results imply clear policy recommendations on the use of subsidies and deposits. Lending tiny loans to poor clients lacking credit history and enough collateral is an expensive business for microfinance institutions (MFIs). Minimizing cost inefficiency is important if MFIs are to meet their dual mission – outreach and sustainability. This paper evaluates how subsidies and deposit mobilization affect the cost inefficiency of MFIs. We use a rich data set from the Microfinance Information Exchange (MIX) Market consisting of information on 1,582 MFIs in 92 countries for the period 2003 – 2018 and employ a baseline cost stochastic frontier approach, two-step system GMM, and a recently developed test to address endogeneity concerns. The results of our study suggest that subsidies worsen cost inefficiency while deposit-taking reduce it. Deposit-taking, however, may worsen cost inefficiency if an MFI welcomes subsidies and deposits together. Our findings draw a clear policy recommendation for governments and donors regarding the sources of funds and cost inefficiency in microfinance. In light of these results, governments’ adjustments of regulatory framework that allow MFIs to mobilize deposits and donors’ awareness that subsidizing MFIs can be counterproductive seem necessary for the sustainability of the microfinance industry.