Strat.

Change 24: 49–66 (2015)

Published online in Wiley Online Library
(wileyonlinelibrary.com) DOI: 10.1002/jsc.1997 RESEARCH ARTICLE

Does Efficiency Lead to Lower Prices? A New

Perspective from Microfinance Interest Rates1
Benazir Basharat
Western Illinois University, USA
Marek Hudon
CEB (SBS-EM), Université Libre de Bruxelles, Belgium
Ahmad Nawaz
Pakistan Institute of Development Economics, Pakistan

In microfinance, high interest

rates are a topic of intense debate
urging accounting for their
motivation.
This article contributes to the
debate by providing empirical
evidence of the impact that the
efficiency of an MFI has on its
microcredit interest rate.
The data envelopment analysis
framework is used to estimate
financial and social efficiency.
The financial efficiency of MFIs
has helped to reduce microcredit
interest rates. There is, however,
no impact of social efficiency on
interest rates.
P ricing is a central strategic decision for all companies, and is particularly sensitive
for social enterprises with both financial and social objectives. High interest rates
in microfinance are a topic of intense debate. Using an original database of 291 MFIs,
this paper provides empirical evidence of the impact the efficiency of an MFI has on
its microcredit interest rate. We use the non-parametric Data Envelopment Analysis
(DEA) framework to calculate efficiency and differentiate financial and social
efficiency. The results show that financial efficiency has a positive impact on interest
rates, with more financially efficient MFIs having lower interest rates, while social
efficiency has no impact on microcredit interest rates.
Pricing is a key strategic decision for all companies, and is particularly sensitive
for social enterprises with both financial and social objectives, such as microfinance
institutions (MFIs) (Milana and Ashta, 2012). The main objective of MFIs is to
provide affordable financial services to poor and low-income households. There-
fore, MFIs have a ‘double bottom line’ of financial and developmental or social
objectives.
High interest rates have been defended in the name of sustainability (Kar and
Bali Swain, 2014). Interest charged on loans is the main source of income for
these institutions. MFIs face high administrative costs because of the low amount
of the loans and therefore they charge high rates, frequently above 30% per year
(Cull et al., 2009; Armendáriz and Morduch, 2010). These high interest rates have
been criticized since the 1970s, but the criticism has recently intensified (Hudon,
2009, 2011; Rosenberg et al., 2009). Some MFIs have been closed down by local
authorities, partly because of their interest rates. A short while ago, a cap on inter-
est levels was set by the central bank of Bangladesh, the leading country in terms
of microfinance.
1
JEL classification codes: G21, L31, L25.

Copyright © 2015 John Wiley & Sons, Ltd. Strategic Change

Strategic Change: Briefings in Entrepreneurial Finance DOI: 10.1002/jsc.1997
50 Benazir Basharat, Marek Hudon, and Ahmad Nawaz
MFIs have been increasingly pushed by donors to
improve their efficiency and productivity. The importance
of efficiency in management control is well documented
(Yahagi, 1995; Milana and Wu, 2012; Périlleux et al.,
2012; Périlleux, 2013). Recent empirical evidence shows
that MFIs as a whole are becoming more efficient over
time (Caudill et al., 2009). Most donors consider that
higher efficiency should lead to lower interest rates (CGAP,
2004; Fernando, 2006; Hudon, 2007).
Nevertheless, empirical evidence on the impact of
efficiency on interest rates in microfinance is scarce in the
literature. This article incorporates efficiency in the inves-
tigation of the determinants of interest rates. Following
Gutiérrez-Nieto et al. (2009), we differentiate social and
financial efficiency and estimate both types of efficiency.
In order to analyze financial efficiency, we employ the
non-parametric data envelopment analysis (DEA) frame-
work, which calculates the quantity of output produced,
given certain levels of input. This framework is also very
common in the banking literature (Seiford and Zhu,
1999; Camanho and Dyson, 2005). Similarly to Gutiér-
rez-Nieto et al. (2009), we measure social efficiency by
including the number of poor borrowers and the percent-
age of women borrowers as an output in the DEA frame-
work. The financial information used in our database was
generated directly from the MIX Market2 website for 291
MFIs located in 67 countries for four years (2005–2008),
for a total of 1167 observations.
The structure of the article is as follows. In the next
section, we begin by reviewing the literature on efficiency
and interest rates in microfinance. Then, we describe the
theoretical background of non-parametric financial and
2
The audit reports are taken from the MIX Market website
(www.mixmarket.org). The MIX Market is a global, web-
based microfinance information platform. It provides
information to sector actors and the public at large on MFIs
worldwide, public and private funds that invest in
microfinance, MFI networks, raters/external evaluators,
advisory firms, and governmental and regulatory agencies.
Copyright © 2015 John Wiley & Sons, Ltd.
social efficiency analysis. In the following section, we
describe the database and the adopted descriptive statis-
tics. Then, we provide financial and social efficiency
results. The final section concludes.
Efficiency and interest rates in microfinance
Higher interest rates in microfinance have spurred a lot
of controversy recently in public policy issues. According
to the MIX Market database, the annual median lending
interest rate charged by MFIs during the period 2005–
2010 ranged between 27.9% and 30.4% (Hudon and
Ashta, 2013).
The link between microfinance interest rates and effi-
ciency is a largely ignored area of research. As with
conventional financial institutions, the efficiency and pro-
ductivity of MFIs has generally been measured by con-
ventional financial ratios or indicators such as staff
productivity and the operating expense ratio (Balkenhol,
2007). An example is Hudon and Traça (2011), who used
staff productivity. Most new studies on cost efficiency use
more sophisticated indicators of efficiency, such as DEA
or stochastic frontier analysis (SFA), to calculate this fron-
tier. Gutiérrez-Nieto et al. (2007) used DEA on a sample
of 30 Latin American MFIs to test 21 specifications. In line
with the banking literature and similar to the approach of
Gutiérrez-Nieto et al. (2007) in microfinance, ‘financial
efficiency’ will be defined as the DEA efficiency computed
with traditional financial input and output indicators.
However, unlike conventional banking institutions,
MFIs have a social face too, and donors consider the social
aspect very important in addition to the financial aspect
when it comes to disbursing funds (Gutiérrez-Nieto and
Serrano-Cinca, 2010; Bédécarrats and Lapenu, 2013). As
such, MFI performance should not be assessed solely by
financial indicators — i.e., their financial efficiency — but
should also take into account their social performance,
including outreach to the poor or reducing the poverty of
clients (Armendáriz and Szafarz, 2011). As has been
argued by Balkenhol (2007), efficiency should be regarded
Strategic Change
DOI: 10.1002/jsc
 Efficiency and Interest Rates in Microfinance
as a key indicator by donors who should focus not just on
financial but also social performance.
We will start by discussing the impact of financial
efficiency on interest rates. In his empirical study on inter-
est rates, Cotler (2010) analyzed the main determinants
of high interest rates. He found that both operating costs
for small loans and return on assets (ROA) are equally
significant in determining the high rate of interest. The
study shows that as these MFIs mature they become more
capable of controlling their operating costs and thus
decrease their lending rate of interest. Cull et al. (2009)
explain that cost structure and operating costs determine
microcredit interest rates.
Another survey of interest rates was done by Dorfleit-
ner et al. (2013). They found that interest rates depend
mainly on MFI operating expenses. The interest rate
charged to borrowers would increase by 0.41 percentage
points for each 1 percentage point increase in the operat-
ing expense ratio.
Hypothesis 1: Financially efficient MFIs should be
able to decrease their interest rates. Hence, financial
efficiency will decrease microcredit interest rates.
In the microfinance literature, there are studies that
focus on financial efficiency but few that consider social
efficiency. The very first effort in this regard was made by
Gutiérrez-Nieto et al. (2009). Using the DEA approach,
their study aimed to show the relationship between social
and financial efficiency. They found that, with one excep-
tion, all MFIs that are socially efficient are also financially
efficient.
Hermes et al. (2011) found that outreach, one dimen-
sion of social performance, and the efficiency of MFIs is
indeed negatively correlated. Their findings suggest that
there may be a trade-off between efficiency and outreach,
similar to Makame and Murinde’s (2006) analysis of a
balanced panel data set for 33 MFIs in five East African
countries. Using a larger database, Cull et al. (2009) found
that the institutions most focused on social missions and
Copyright © 2015 John Wiley & Sons, Ltd.
51
performance charge higher interest rates. One explanation
may be that these institutions target poorer clientele that
are more costly to serve. For instance, Cull et al. (2007)
provided evidence that increasing interest rates does not
ensure greater profitability and that the benefits of cost-
cutting diminish when serving better-off customers.
Hypothesis 2: Serving poorer clients is more costly for
MFIs. Social efficiency therefore leads to higher interest
rates and is positively related to interest rates.
Efficiency: Theoretical framework
Financial efficiency
A two-stage analysis has been carried out to assess the
efficiency of MFIs. The DEA approach is used to estimate
the technical and pure efficiency scores of MFIs. The
numerous advantages of using the DEA technique to
measure efficiency are well documented in the litera-
ture (Gutiérrez-Nieto et al., 2009; Nadiya and Ramanan,
2012; Singh et al., 2013). DEA can handle multiple
outputs and inputs. When analyzing MFI efficiency, it can
incorporate both the outputs of outreach and sustainabil-
ity along with other inputs into a single framework.
Table 1 summarizes the inputs and outputs selected
for this study. The main objective of estimating a produc-
tion function is to explain the quantity of output pro-
duced, given certain levels of input and other relevant
factors that might explain the quantity of output pro-
duced. In the financial literature, two models — the pro-
duction model and the intermediation model — are
popular depending upon what one believes to be the
function of an institution. The majority of banking effi-
ciency studies are based on an input-oriented constant
returns to scale CCR model (Charnes et al., 1978). In the
production model approach, financial institutions are
treated as firms that use physical input, employees,
and money to obtain deposits, grant loans, and collect
revenues. An output-oriented production model with
variable returns to scale is better suited to microfinance
Strategic Change
DOI: 10.1002/jsc
52 Benazir Basharat, Marek Hudon, and Ahmad Nawaz

Table 1. Inputs and outputs in efficiency specifications

Variable Variable name Notation Definition Unit Papers using this input/output

Input Total assets A Total of all net asset accounts ($) Berger and Humphrey (1997);
Seiford and Zhu (1999); Luo
(2003); Gutiérrez-Nieto et al.
(2009)
Input Operating cost C Expenses related to ($) Athanassopoulos (1997); Berger
operations, including all and Humphrey (1997); Pastor
personnel expenses, rent (1999); Gutiérrez-Nieto et al.
and utilities, transportation, (2007, 2009)
office supplies, and
depreciation
Input Number of E The number of individuals No. Athanassopoulos (1997); Berger
staff actively employed by the and Humphrey (1997);
MFI Sherman and Gold (1985);
Seiford and Zhu (1999); Luo
(2003); Gutiérrez-Nieto et al.
(2009)
Financial efficiency
Output Gross loan L Outstanding principal balance ($) Sherman and Gold (1985);
portfolio of all the MFIs’ outstanding Athanassopoulos (1997);
loans Berger and Humphrey (1997);
Wheelock and Wilson (1999);
Gutiérrez-Nieto et al. (2007,
2009)
Output Financial R Revenue generated from the ($) Pastor (1999); Seiford and Zhu
revenue gross loan portfolio and (1999); Gutiérrez-Nieto et al.
from investments plus other (2009)
operating revenue
Social efficiency
Output Number of W Number of active borrowers No. Hashemi et al. (1996); Gutiérrez-
women who are female Nieto et al. (2009); Makame
borrowers and Murinde (2006); Goetz
and Gupta (1996)
Output Indicator of P Number of poor borrowers No. Gutiérrez-Nieto et al. (2009)
benefit to (see text for the variable
the poorest construction)

institutions than a model with constant returns to scale.
MFIs are indeed interested in increasing outreach — i.e.,
granting loans to poor people that not only correspond
with their social mission but also contribute to sustain-
ability by collecting more revenues from lending. They
also compete in an imperfect economic environment as
the markets for MFIs are not as well developed as those
in the conventional banking sector, even if it has recently
moved closer to the conventional financial sector (Brière
and Szafarz, 2011). In addition, they frequently have a
restricted amount of money and human resources (inputs)
to spend, unlike commercial banks, which can generate
money from shareholders. In the context of an output-
oriented model, Brière and Szafarz ask a specific ques-
tion: ‘By how much can the output quantities be
proportionally expanded without altering the input quan-
tities used?’
The selection of specifications with correct inputs and
outputs in the context of MFIs is very important. Based
on the literature, we have selected a few inputs and

Copyright © 2015 John Wiley & Sons, Ltd. Strategic Change

DOI: 10.1002/jsc
 Efficiency and Interest Rates in Microfinance
outputs. This study uses LR-ACE3 as a general specifica-
tion where gross loan portfolio (L) and financial revenues
(R) are taken as outputs; assets (A), operating costs (C),
and workforce (E) as inputs. We have also used L-ACE
and R-ACE specifications, where the former puts empha-
sis on granting loans as the main objective of MFIs and
the latter signifies revenue collection as the main objective
of MFIs. The other specifications used are basically the
different combinations of treating subsidies as an input
and output with the above general specifications.
Social efficiency
Following Gutiérrez-Nieto et al. (2009), in addition to
the traditional variables used in the DEA specification, we
also include two output variables to calculate the social
efficiency of microfinance: variable P, which indicates
the depth of outreach to the poorest and variable W,
indicating the number of women borrowers. We will
therefore use WP-ACE as a general specification for social
efficiency.
The main purpose of establishing MFIs was to fight
against poverty. But the main problem encountered in
microfinance is how to measure poverty and access by the
poor to microcredit. ‘Average loan balance per borrower’
is an indicator used to measure outreach: the smaller the
average balance of the loan, the deeper the reach of the
microcredit (Cull et al., 2007; Armendáriz et al., 2011).
But the average loan balance per borrower is criticized as
an indicator of outreach as it is measured in monetary
units and may have a different meaning from one country
to the next depending on income per capita (Morduch,
2000). Therefore, it is taken in relative terms by dividing
it by the per capita gross national income4 (GNI p.c.),
inspired directly by the World Development Indicator
3
The left part in all specifications shows outputs and the
right part shows inputs.
4
According to WDI, ‘GNI is the sum of value added by all
resident producers plus taxes (less subsidies) not included in
the valuation of output plus net receipts of primary income
from abroad.’
Copyright © 2015 John Wiley & Sons, Ltd.
53
(WDI). The PPP method has an advantage in that it pro-
vides better information on a country’s international pur-
chasing power and relative economic strength. The method
provides more accurate information on the living standards
of people in developing countries. We will therefore use
the relative indicator of outreach suggested by Gutiérrez-
Nieto et al. (2009), denoting the relative term K:
K = Average loan balance per borrower GNI p.c. (1)
A high K value means a high average loan size in rela-
tive terms. The higher the value of K, the lower the level
of poverty. We assign K a range 0–1, where a value near
0 indicates that the institution lends to the poorest. To
determine the objective on outreach to the poor (pi), we
deduct K − min(K) from 1 as follows:
pi = 1 − ( K i − min ( K ) range ( K )) (2)
where i is an indicator associated with a particular MFI,
min(K) is the minimum value over all i, and range(K) is
the maximum value of Ki minus the minimum value of
Ki. For every MFI, we multiply p by the number of active
borrowers in order to create the poverty indicator (P):
P = pi ∗ number of borrowers (3)
Database and descriptive statistics
The data we used are from the audit reports of MFIs taken
from the Microfinance Information eXchange Inc.
website. Through this information exchange platform,
individual MFIs can provide financial and outreach data,
ranked by the MIX Market on quality using a 5-star
system. Using this system, 5 is the most complete data
available, while 1 is the least complete data available
(usually the number of borrowers and some other out-
reach indicators but little financial information). Only
5-star MFIs, which include MFIs reporting audited finan-
cial statements and a rating on their online profile, have
been incorporated. As most samples are taken from the
databases of rating agencies or MIX Market, our sample
is probably biased in favor of the largest and better
managed MFIs around the world. Given the well-
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DOI: 10.1002/jsc
54 Benazir Basharat, Marek Hudon, and Ahmad Nawaz
established concentration of microfinance clients in the
largest institutions (Honohan, 2004), the sample of 291
MFIs in 67 countries in the underlying study is represen-
tative of the microfinance sector as a whole.
To obtain balanced panel data from the total of 1164
observations (291 for each year) generated, we limit it to
observations with non-missing values for four years
(2005–2008). The rationale for disagreeing with an unbal-
anced panel of data is to minimize the noise in the data
mainly due to outliers. Our sample for this research con-
sists of a total of 340 observations (170 for each year 2005
and 2006), assumed to be representative of the whole
microfinance sector. For example, the 1084 MFIs reported
in the 19th MicroBanking Bulletin [MBB] (MicroBank-
ing Bulletin, 2009) yield a median operational sustain-
ability of 111% compared with our 116.27%. The median
nominal yield is 31% in the MBB and 30.54% in our
database. Table 2 presents a statistical summary of the
variables used as inputs and outputs in the DEA frame-
work, along with other social and organizational variables
used in the regression framework.
Appendix 1 provides a pictorial analysis of our data
set. 50% of our total MFIs are registered as non-
governmental organizations (NGOs), followed by non-
banking financial intermediaries (NBFIs) (29%). MFIs
with ‘bank’ status account for just 9% of the total sample.
More than half of the MFIs (55%) offer both group and
individual lending services, followed by MFIs that lend
exclusively to groups (21%). Geographically, more than
one-third of MFIs are located in Latin America (37%) and
almost one-fifth in Africa (20%). South Asian MFIs
account for only 13% of the total MFIs in the sample.
Table 3 presents the financial and social efficiency
analysis of the MFIs separated into various categories.
Financial and social efficiency scores were calculated using
variable return to scale efficiency (vrs). Average efficiency
scores for specification LR-ACE (financial efficiency) and
WP-ACE (social efficiency) are presented in Table 3. The
table employs what is believed to be the realistic output-
oriented model with variable returns to scale.
Copyright © 2015 John Wiley & Sons, Ltd.
Findings: Efficiency analysis
Financially, MFIs located in East Asia and the Middle East
are on average more efficient than those in other regions,
while African MFIs are generally the least efficient.
Socially, East Asian and South Asian MFIs are the most
socially efficient, while African and Latin American MFIs
are the least efficient. As argued by Gutiérrez-Nieto et al.
(2009), MFIs that operate in different continents adapt
to the environment in which they work. Notwithstanding
MFIs’ status, banks are found to be more financially effi-
cient (Haq et al., 2009; Tchakouté-Tchuigoua, 2010),
while NGOs are more socially efficient, similarly to
Gutiérrez-Nieto et al.’s (2009) conclusion that average
social efficiency is higher for NGOs.
Regarding lending methodology, we find that MFIs
who lend to individuals are more financially efficient, as
the study of Cull et al. (2007) concluded. MFIs that focus
on providing loans to individuals perform better in terms
of profitability. This is because, as individual-based MFIs
grow larger or focus more on commercialization, they
tend to focus more on wealthier clients and the provision
of larger loans. Lending to individuals increases their
financial performance. Additionally, the results of this
study suggest that MFIs who provide loans to groups with
village banking methodology are more socially efficient,
which supports the view that this lending technique helps
reduce information costs and is an effective way of reduc-
ing, screening, and monitoring the costs of MFIs (Hermes
et al., 2011). With respect to different types of MFI, it
has been argued that the regulation of microfinance is
essential (Armendáriz and Morduch, 2010). Using a
sample of MFIs in Eastern Europe and Central Asia,
Hartarska (2009) concluded that the regulatory status of
MFIs has no impact on financial sustainability. Using a
larger database, Hartarksa and Nadolnyak (2007) found
that regulatory status is not related to operational self-
sustainability or outreach. Mersland and Strøm (2009)
examined a larger database and found that regulated and
unregulated institutes are equal in their financial effi-
ciency. However, regulation may divert attention away
Strategic Change
DOI: 10.1002/jsc
 Efficiency and Interest Rates in Microfinance 55

Table 2. Variable description and summary statistics

Inputs and Observations Definition Unit Mean Median Minimum Maximum

outputs

Total assets (A) 1164 Average of current year $(000s) 40,100 7,900 76 1,120,000
(t) and previous year
(t — 1) assets. It
includes all asset
accounts net of all
contra-asset
accounts, such as
the loan-loss
allowance and
accumulated
depreciation
Operational 1164 Expenses related to $(000s) 6,777 1,700 96 77,300
cost (C) operations,
including all
personnel expenses,
rent and utilities,
transportation,
office supplies, and
depreciation
Staff (E) 1164 The number of No. 620 103.5 9 24,457
individuals actively
employed by the
MFI
Outstanding 1164 The outstanding $(000s) 30,000 5,900 94 837,000
loan principal balance of
portfolio all an MFI’s
(LP) outstanding loans
Financial 1164 Revenue generated $(000s) 14,200 2,900 28,525.34 540,000
revenues from the gross loan
portfolio (R) and
from investments
plus other operating
revenue
Total women 1164 Number of active No. 93,045.93 83,865 36 6,500,000
borrowers borrowers who are
female
Organizational variables
Operational 1164 Financial revenue (%) 129.75 116.37 0.9 10,834
self- (total)/(financial
sufficiency expense + loan-loss
(OSS) provision
expense + operating
expense)
Average loan 1164 Gross loan portfolio/ 1,154.71 436.5 20 49,077
size number of active
borrowers
Loan size/GNI 1164 Average loan size/GNI 0.28 0.12575 0.01 7.83
p.c. (PPP) p.c.

Continued

Copyright © 2015 John Wiley & Sons, Ltd. Strategic Change

DOI: 10.1002/jsc
56 Benazir Basharat, Marek Hudon, and Ahmad Nawaz

Table 2. Continued

Inputs and Observations Definition Unit Mean Median Minimum Maximum

outputs
GNI p.c. 1164 Gross national income $ 1404 160 6,070
(current) divided by the
population
MFI age 1164 The years since MFI No. 13.12 11 1 58
has started
operations
Borrowers 1164 The number of No. 110,181 13,775.5 119 6,397,635
individuals who
currently have an
outstanding loan
balance with the
MFI or are
responsible for
repaying any
portion of the gross
loan portfolio
Women 1164 Percentage of % 65.58 64.84 3 100
borrowers borrowers who are
female
Total women 1164 Number of active No. 93,045.93 83,865 36 6,500,000
borrowers borrowers who are
female
Lr (lending 1164 Financial revenue/ (%) 35 30.54 4 208
rate) average loan
portfolio
No. of poor 1164 Number of poor No. 104,058.8 12,131.2 0 6,260,022
borrowers borrowers
Fr (funding 1164 Financial expense/total (%) 14 9.03 0 1,615
rate) debt
Borrowers/staff 1164 Number of borrowers/ No. 147.47 131 3 1,209
personnel

Table 3. Average financial efficiency and social efficiency scores (vrs)

Fin. Soc. Fin. Soc. Fin. Soc. Fin. Soc. Fin. Soc. Fin. Soc.

Africa 0.82 0.57 Bank 0.92 0.59 S 0.89 0.70 No 0.87 0.65 No 0.88 0.65 No 0.89 0.60
EA&PF 0.95 0.76 Coop. 0.85 0.48 I 0.91 0.62 Yes 0.88 0.60 Yes 0.87 0.60 Yes 0.86 0.66
EE&CA 0.91 0.62 NBFI 0.86 0.59 IS 0.86 0.59
LA&C 0.85 0.56 NGO 0.88 0.69 V 0.83 0.70
ME&NA 0.94 0.73 RB 0.86 0.46
SA 0.89 0.77
Source: Own calculations.
Average scores are based on a total of 1164 observations.

Copyright © 2015 John Wiley & Sons, Ltd. Strategic Change

DOI: 10.1002/jsc
 Efficiency and Interest Rates in Microfinance 57

from outreach where regulatory requirements are overly
focused on financial goals such as financial sustainability.
For example, Makame and Murinde (2006) and Barry
and Tacneng (2009) found evidence for a negative rela-
tionship between regulatory status and outreach. This is
in line with the findings of this study, namely that unregu-
lated MFIs are more socially efficient.
Moreover, MFIs providing non-financial services are
more socially efficient (Barry and Tacneng, 2009), while
MFIs not providing other services such as education and
health are more financially efficient. Regarding savings,
and after taking account of regional differences, MFIs
with savings are socially less efficient than MFIs with no
savings features. Financial efficiency remains the same on
average for MFIs with and without savings.
The two main objectives of MFIs are to fulfill their
social mission and become financially sustainable. Some
MFIs focus more on financial aims, while others consider
their social remit more important than their financial
objectives.
This study has focused on an important topic, that of
the interest rates charged by MFIs. The nominal interest
rate charged by most MFIs is in the region of 30–70% a
year. According to the MIX Market database, the annual
lending interest rate charged by microfinance institutions
during the 2000–2008 period was on average 42% in
Africa and Latin America and 35% in Asia. Overall, the
correlation coefficients between the variables used in this
research remain relatively low, as shown in Table 4. They
do not exceed 0.8, the level at which a co-linearity problem
appears (Kennedy, 2008).
Tobit regression approach
Once the financial and social efficiency scores are calcu-
lated, a panel Tobit regression analysis is carried out to
test a series of hypotheses on the relationship between
financial and social efficiency and other indicators in their
respective sections below. The most common approach to
modeling DEA scores against exogenous variables is Tobit
regression, which is suitable when the dependent variables
are either censored or corner solution outcomes. The DEA
scores would fall within the second category. A corner
solution variable is continuous and limited from above
and below or both. It takes on the value of one or both

Table 4. Correlation matrix (Pearson correlation coefficients)

Lending Funding Financial Social ROA Outreach Women Age

rate rate efficiency efficiency

Lending rate 1
Funding rate 0.0613* 1
0.0366
Financial efficiency 0.0121 0.1270* 1
0.6795 0
Social efficiency 0.0583* −0.0031 0.2274 1
0.0466 0.9165 0
ROA 0.3155* −0.0298 0.1207 0.0383* 1
0 0.3099 0 0.1911
Outreach −0.3717* 0.032 −0.0312 −0.6202* −0.1160* 1
0 0.2758 0.2881 0 0.0001
Women 0.3204* −0.0315 −0.0213 0.4051* 0.0848* −0.5373 1
0 0.2831 0.4687 0 0.0038 0
Age −0.0985* 0.1774* −0.0084 −0.0101 −0.0689* −0.0198 0.0679* 1
0.0008 0 0.7746 0.7314 0.0187 0.4998 0.0204
* Refers to significance at 10%, 5%, and 1% level of confidence.

Copyright © 2015 John Wiley & Sons, Ltd. Strategic Change

DOI: 10.1002/jsc
58 Benazir Basharat, Marek Hudon, and Ahmad Nawaz
of the boundaries with a positive probability. As DEA
efficiency scores are continuous on the interval [0; 1], it
takes on the value 1 with positive probability. It seems
obvious to use a two-limit Tobit technique for modeling the
scores as a function of the exogenous variables. Tobit has
therefore been adopted as the natural ‘choice’ for modeling
DEA scores in second-stage evaluations. A random-effect
Tobit model was used to analyze the panel data.
Relationship between lending interest rate and
social efficiency
The following regression equation (4a) aims to investigate
the causes of high interest rates. Does the interest rate
follow the same rates which financial institutions pay for
their funding? Or are the small loan sizes the main cause?
Do profit motives determine high interest rates? Four key
factors stand out when determining these rates: the cost
of funds, the MFI’s operating expenses, loan losses, and
the profits needed to expand their capital base and fund
expected future growth (see, for instance, Fernando
(2006), Rosenberg et al. (2009), and Cotler (2010)).
log IL i = α + β1 log IFi + β2 log SocEff i + β3 log ROA i
+ β4 log Outreachi + β5 log Agei
+ β6 log womeni + μci + εi
(4a)
where log ILi is the logarithm of lending interest rates, log
IFi is the logarithm of funding interest rates, log SocEffi is
the logarithm of social efficiency, log ROAi is the loga-
rithm of return on assets, log Outreachi is an outreach
indicator (loan size divided by GNI per capita in purchas-
ing power parity), log Agei is the logarithm of the number
of years since the MFI has been operating, and β5 log
womeni is the logarithm of the percentage of female bor-
rowers, for MFI i.
Ci are the controls for region, status, lending method-
ology, saving, regulated, and other services such as health
and education in addition to providing financial services
or not. Geographic regions in which the MFI operates are
Copyright © 2015 John Wiley & Sons, Ltd.
classified into six regions: Africa (A); East Asia and the
Pacific (EA&P); Eastern Europe and Central Asia
(EE&CA); the Middle East and North Africa (MENA);
Latin America and the Caribbean (LAC); and South Asia
(SA). Lending methodology is classified into four catego-
ries: individual (I); individual and solidarity/group (IS);
group/solidarity (S); and village banking (V). MFIs are
classified into five categories of ownership structure:
NGO; bank (B); NBFI; rural bank (RB); and cooperative
(Coop.).
The omitted variable categories are: for region, Africa;
for status, banks; for lending methodology, group lending;
and MFIs with no savings feature, not regulated, and no
other services.
Table 5 consists of a total of four equations, each one
split into two regressions (with social and financial effi-
ciency, respectively, as the left-hand-side variable). Equa-
tion 1 includes all interest-rate determinants, whereas in
equation 2 we control for outreach and in equation 3
gender has been controlled. Last but not least, in equation
4 we control for ROA.
The empirical results of equation 4(a) with social effi-
ciency as independent variable above are presented in
columns 1(i), 2(i), 3(i), and 4(i) in Table 5. In 1(i), the
social efficiency of MFIs is found to be inversely related
to the interest rate. This relationship is significant. It sug-
gests that institutions that charge higher interest rates are
less efficient socially. However, after controlling for loan
size and gender in equations 2(i) and 3(i), respectively, the
relationship becomes positive though insignificant. This
confirms that an increase in the depth of outreach (lower
loan size) causes the lending interest to rise, something
also found by Cull et al. (2009). Interest rates are driven
upward by operating costs rather than capital costs or loan
loss provisions related to bad repayment (Cull et al., 2009).
ROA has a significant positive impact on interest rates, in
line with the findings of Rosenberg et al. (2009) and Cotler
(2010). As such, MFIs increase their profits and hence
ROA will increase their lending rate. In line with the find-
ings of Cotler (2010), the funding interest rate is found
Strategic Change
DOI: 10.1002/jsc
 Table 5. Interest rates and efficiency — random effect Tobit regressions (dependent variable: lending interest rate)

1 2 3 4

(i) (ii) (i) (ii) (i) (ii) (i) (ii)

Social efficiency −0.1515*** 0.2131*** −0.000 0.2029*** 0.01743 0.2000*** −0.1524*** 0.2264***
Financial efficiency

Copyright © 2015 John Wiley & Sons, Ltd.

(−6.79) (3.89) (−0.31) (3.59) (0.90) (3.51) (−6.75) (4.11)
Funding rate of 0.01226** 0.0101* 0.0062 0.0066 0.00426 0.0045 0.0119** 0.0109**
interest (2.05) (1.84) (1.10) (1.17) (0.75) (0.79) (2.15) (1.97)
Return on asset 0.0329*** 0.0314*** 0.0329*** 0.0315*** 0.0329*** 0.0316***
(4.93) (4.70) (4.74) (4.58) (4.73) (4.57)
Loan size/GNI p.c. −0.2508*** −0.1726*** −0.2526*** −0.1736***
(−11.78) (−9.39) (−11.68) (−9.33)
Gender 0.1136*** 0.0927*** 0.1501*** 0.1487*** 0.1166*** 0.0940***
(4.40) (3.58) (5.52) (5.64) (4.39) (3.59)
Age −0.0268 −0.0525** −0.0916*** −0.0919*** −0.093*** −0.0917*** −0.0377 −0.0642**
(−1.04) (−2.00) (−3.35) (−3.31) (−3.33) (−3.29) (−1.45) (−2.42)
Cooperative −0.3896*** −0.3768*** −0.4280*** −0.4158*** −0.4616*** −0.4537*** −0.3991*** −0.3859***
(−4.42) (−3.99) (−4.28) (−4.13) (−4.40) (−4.30) (−4.43) (−4.00)
NBFI −0.1876** −0.1574* −0.0930 −0.0820 −0.0980 −0.0847 −0.1879** −0.1570*
(−2.34) (−1.83) (−1.03) (−0.90) (−1.03) (−0.88) (−2.29) (−1.79)
NGO −0.2137** −0.1977** 0.0593 0.0570 0.0525 0.0414 −0.2052** −0.1894*
(−2.39) (−2.06) (−0.59) (−0.56) (−0.50) (−0.39) (−2.24) (−1.93)
Rural banks −0.2566* −0.1459 −0.1727 −0.1446 −0.1803 −0.1664 −0.2927* −0.1781
(−1.66) (−0.88) (−0.98) (−0.82) (−0.98) (−0.90) (−1.85) (−1.05)
Individual 0.9978* 0.1105* 0.0731 0.0731 0.0495 0.0460 0.1049* 0.1153*
(1.67) (1.72) (1.08) (1.09) (0.70) (0.64) (1.71) (1.76)
Individual & group −0.0398 0.0442 −0.0243 −0.0140 −0.0372 −0.0309 0.0493 0.5264
(−0.77) (0.80) (−0.42) (−0.24) (−0.61) (−0.50) (0.94) (0.95)
Village banking −0.0256 −0.0135 −0.0209 −0.0031 −0.0231 −0.0035 −0.0169 −0.0041
(−0.26) (−0.13) (−0.19) (−0.03) (−0.20) (−0.03) (−0.17) (−0.04)
Efficiency and Interest Rates in Microfinance

DOI: 10.1002/jsc
Strategic Change
59
 60

Table 5. Continued
1 2 3 4

(i) (ii) (i) (ii) (i) (ii) (i) (ii)

Regulated −0.0394 −0.0819 −0.0716 −0.0824 −0.0833 −0.0894 −0.0373 −0.0807

(−0.77) (−1.49) (−1.23) (−1.41) (−1.36) (−1.45) (−0.71) (−1.44)

Copyright © 2015 John Wiley & Sons, Ltd.

Savings −0.01146 −0.0092 −0.01862 −0.0132 −0.0270 −0.0221 −0.0098 −0.0077
(−0.23) (−0.18) (−0.33) (−0.24) (−0.47) (−0.38) (−0.20) (−0.15)
Other services −0.01704 −0.0171 0.0007 0.0058 0.0095 0.0174 −0.0148 −0.0143
(−0.45) (−0.42) (0.02) (0.13) (0.21) (0.38) (−0.38) (−0.34)
EA&P −0.2667*** −0.2498** 0.0020 −0.0329 0.0424 0.0171 −0.2581*** −0.2441**
(−2.73) (−2.39) (0.02) (−0.30) (0.37) (0.15) (−2.58) (−2.28)
EE&CA 0.0334 −0.0622 −0.0921 −0.1172 −0.1362 −0.1547* 0.0268 −0.0721
(0.47) (−0.84) (−1.16) (−1.46) (−1.64) (−1.84) (0.37) (−0.94)
LA&C −0.1153* −0.0839 0.0219 0.0092 0.0142 0.0009 −0.1103* −0.0795
(−1.89) (−1.29) (0.32) (0.13) (0.20) (0.01) (−1.77) (−1.20)
ME&NA −0.2966*** −0.3109*** −0.1429 −0.1749* −0.1607 −0.1860* −0.2922*** −0.3086***
(−3.41) (−3.32) (−1.47) (−1.78) (−1.57) (−1.80) (−3.29) (−3.24)
SA −0.5698*** −0.5681*** −0.4143*** −0.4359*** −0.3997*** −0.4146*** −0.5867*** −0.5854***
Benazir Basharat, Marek Hudon, and Ahmad Nawaz

(−7.99) (−7.41) (−5.21) (−5.44) (−4.78) (−4.92) (−8.05) (−7.50)

Constant −1.1587*** −0.8272*** −0.5271*** −0.4927*** −0.5657*** −0.5588*** −1.2587*** −0.9158***
(−7.66) (−5.40) (−3.33) (−3.12) (−3.43) (−3.40) (−8.23) (−5.92)
No. of observations 1164 1164 1164 1164 1164 1164 1164 1164
No. of groups 291 291 291 291 291 291 291 291
Log likelihood −75.63 −90.65 −139.278 −132.95 −154.34 −148.63 −87.73 −101.68
Wald Chi2 356.73 297.01 173.73 185.66 132.50 143.00 321.20 266.41
Prob>Chi2 0 0 0 0 0 0 0 0
* Significant at 10%.
** Significant at 5%.
*** Significant at 1%. z-Values in parentheses.
Source: Based on authors’ own calculations.

DOI: 10.1002/jsc
Strategic Change
 Efficiency and Interest Rates in Microfinance
to have a significant and positive relationship with the
lending interest rate. In contrast, our outreach variable as
proxy for average loan size has a significant inverse rela-
tionship with the lending interest rate, even after control-
ling for ROA in equation 4(i). This suggests that the smaller
the loan size, the higher the rate of interest charged to
clients. This result is also in line with the findings of
Rosenberg et al. (2009) and Cotler (2010). The reason for
high interest rates for small loans is high administrative
costs, chief among them rent, utility charges, transport,
the depreciation of fixed assets, and small loan recovery.
Loan recovery is often the task of staff who visit clients.
Poor physical infrastructure and transportation in many
countries in which microlenders operate also increases
administrative costs (Fernando, 2006). Similarly, the
gender variable as measured by the percentage of women
borrowers has a positive significant relationship with the
interest rate, even after controlling for loan size in equation
2(i). This confirms the fact that MFIs predominantly
lending to women charge higher interest rates to their
clients because of the small loan size. Age has an insignifi-
cant inverse effect on interest rate in the first equation but
does become significant in all four equations.
Lending interest rate and financial efficiency
From this regression, we sought to find what role financial
efficiency plays in the determination of MFIs’ lending
interest rates.
log IL i = α + β1 log IFi + β2 log FinEff i + β3 log ROA i
+ β4 log Outreachi + β5 log Agei
+ β6 log womeni + μci + εi
(4b)
In Table 5, the results in regression equation 1(ii) suggest
that the financial efficiency of MFIs has a significantly
positive impact on the interest rate, unlike social effi-
ciency. Even after controlling for outreach, gender, and
ROA (in equations 2(ii), 3(ii), and 4(ii), respectively), the
significantly positive relationship holds. Thus, unlike
social efficiency regression equations, outreach and gender
Copyright © 2015 John Wiley & Sons, Ltd.
61
do not seem to have an impact on interest rates where
financial efficiency is concerned. As in social efficiency
regression equations, variable ROA has a significant posi-
tive impact on interest rate. And similar to social efficiency
regressions, average loan size has a significant inverse rela-
tion with the interest rate even after controlling for ROA
in equation 4(ii), showing that the smaller the loan size,
the higher the rate of interest. Similarly, serving women
is positively related to the lending rate. MFI age has a
significant inverse relation with the lending interest rate,
suggesting that with the passage of time MFIs tend to
charge lower interest rates. Notwithstanding the dummy
variables, our results are the same as the findings of the
social efficiency regression equations.
From the above results, it can be concluded that finan-
cial efficiency — as well as the funding interest rate, ROA,
outreach, gender, and age — all play a significant role in
determining the lending interest rate in microfinance.
Results for our control variables are in line with the find-
ings of Cull et al. (2009) and Cotler (2010).
Results also suggest that on average banks are finan-
cially efficient while NGOs are socially efficient. Similarly,
MFIs with an individual lending methodology are finan-
cially efficient whereas those with a group and village
banking methodology are more socially efficient. Regu-
lated MFIs are on average more financially efficient and
unregulated ones more socially efficient. MFIs without
savings are financially and socially efficient, while MFIs
without non-financial services are financially inefficient
and those with these services are socially efficient.
Conclusion
This article contributes some empirical evidence to the
debate on pricing issues in microcredit. We used a data-
base of 291 MFIs to provide new empirical evidence on the
role of efficiency in the determination of microcredit in-
terest rates. The DEA framework was employed to calculate
efficiency and differentiate financial and social efficiency.
Globally, our findings suggest that microfinance insti-
tutions are on average more financially efficient than
Strategic Change
DOI: 10.1002/jsc
62 Benazir Basharat, Marek Hudon, and Ahmad Nawaz
socially efficient. The issue of the determinants of interest
rates in microfinance, and the impact of efficiency in
particular, was addressed by employing a random-effect
Tobit model. The results suggest that the financial effi-
ciency of MFIs has a significant positive relation with the
interest rate even after controlling for outreach, gender,
and ROA, therefore confirming our first hypothesis. In
line with the findings of Rosenberg et al. (2009) and
Cotler (2010), ROA has a significant positive impact on
the interest rate. This shows that profit increases lead MFIs
to introduce higher interest rates. One key policy recom-
mendation is, therefore, to help MFIs become more effi-
cient so that they can decrease their interest rates more
rapidly. Donors could, for instance, finance technological
innovations that reduce MFIs’ transaction costs.
However, contrary to our second hypothesis, the
social efficiency of MFIs is not related to interest rates.
While social efficiency is negatively related to interest
rates, after controlling for the poverty (loan size) and
gender of the clientele, it has a positive but insignificant
impact on the interest rate. It shows that, as depth of
outreach (or the poverty of the clientele) increases, it
Appendix 1. Pictorial analysis of the data set used
Regions
MFIs
13.06%
7.904%
36.77%
AFRICA
EE & CA
M.E & NA
Copyright © 2015 John Wiley & Sons, Ltd.
causes rises in the lending interest. Interest rates are high
for small loans owing to high administrative costs, consist-
ing mainly of rent, utility charges, transport, fixed-asset
depreciation, and small-loan recovery.
Furthermore, evidence has found that gender has a
positive significant relation with interest rates even after
controlling for loan size. This confirms the fact that MFIs
with predominantly women borrowers charge higher
interest rates to their clients because of the small loan
size.
Our results provide some new insights on the differ-
ential impact of social and financial efficiency. Neverthe-
less, we acknowledge some limitations related to the
database. Our data set suffers from limitations due to the
fact that, for most MFIs, our information is limited to a
two-year period because of the constraints involved in
establishing a long series of reliable data. Moreover, DEA
models bear some limitations in capturing input–output
parameters external to MFIs. Similarly to other studies at
cross-institutional level, data aggregation involves losing a
lot of information on contextual elements that explain
high or low efficiency levels.
19.59%
6.186%
16.49%
EA & PF
LA & C
S.A
Strategic Change
DOI: 10.1002/jsc
 Efficiency and Interest Rates in Microfinance 63

Lending Methodology

4.483%
21.38%

18.97%
55.17%

G I
IG VB

Status
2.062%

8.247%

10.65%

49.83%

29.21%

BANK Cooperative
NBFI NGO
RURAL BANK

Copyright © 2015 John Wiley & Sons, Ltd. Strategic Change

DOI: 10.1002/jsc
64 Benazir Basharat, Marek Hudon, and Ahmad Nawaz
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Strategic Change
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66 Benazir Basharat, Marek Hudon, and Ahmad Nawaz
BIOGRAPHICAL NOTES
Benazir Basharat is a student of economics and is
currently studying for a PhD in Economics at
Kansas State University (KSU), USA. She obtained
a Master’s in Mathematics from Western Illinois
University (WIU), USA and an MPhil in
Economics from International Islamic University
Islamabad (IIUI), Pakistan. Her thesis was on
microfinance and her focus of research is
development economics. She taught economics for
six years at the University of Lahore, Pakistan.
Marek Hudon holds a PhD in Economics and
Management Sciences and a Master in Philosophy.
He is currently Professor at the Solvay Brussels
School of Economics and Management (ULB).
Professor Hudon was a visiting fellow at Harvard
University, where he worked on ethical issues in
microfinance under the supervision of Professor
Amartya Sen. Current research interests also include
public policy issues in microfinance, social
entrepreneurship, and complementary currencies.
He has published or has forthcoming articles in
journals such as World Development, Journal of
Business Ethics, Nonprofit and Voluntary Sector
Copyright © 2015 John Wiley & Sons, Ltd.
Quarterly, Journal of International Development,
Annals of Public and Cooperative Economics.
Correspondence to:
Marek Hudon
CEB (SBS-EM), Université Libre de Bruxelles (ULB)
50 avenue Roosevelt
1050 Brussels, Belgium
e-mail: mhudon@ulb.ac.be
Ahmad Nawaz teaches economics and also runs the
graduate program in the Management Sciences
Department of Comsats Institute of Information
Technology, Lahore, Pakistan. His past affiliations
are with the Pakistan Institute of Development
Economics (PIDE), Government College University
(GCU) Lahore, and the Government of Punjab,
Pakistan. Dr Nawaz has studied economics at
Quaid-i-Azam University, Islamabad, the University
of Manchester, and obtained a doctorate in
economics from the Goerg-August University,
Goettingen, Germany. His research work focuses in
general on issues related to development economics
and in particular to the ethics, governance, and
management of microfinance.
Strategic Change
DOI: 10.1002/jsc