The Impact of Informal Institutions on Microfinance Performance

Abstract: In recent years, microfinance has evolved as an alternative method of providing credit to poor borrowers in developing countries. Despite high expectations and appraisals, the performance of microfinance institutions has been found to differ significantly between different countries. Previous research has focused mainly on formal institutions and macroeconomic conditions as potential explanations for these differences. Due to the informal characteristics of microfinance, however, this thesis shifts focus by instead analysing the effects of informal institutions on the cross-national variation in microfinance performance. Empirically, this is done in a number of cross-country multiple linear regression models. Average country-level microfinance performance data over the years 2003-2010 is used together with survey data on informal and formal institutions. In its largest sample, this study covers 72 developing countries from all over the world. The results of this study generally support the hypothesis that informal institutions are important determinants of microfinance performance. In particular, the microfinance interest rates are found to be significantly lower in countries with relatively strong collectivist cultural norms. Moreover, microfinance institutions tend to perform better in countries that have higher levels of social trust, a more equal income distribution, and that are more culturally homogeneous. As such, the results also confirm the idea that social collateral can serve as a substitute for physical collateral. All in all, this study concludes that microfinance can work as a viable substitute for formal financial institutions in countries where formal institutions are weak, but cooperative informal institutions are strong.