The nexus between institutional quality and the financial sustainability of microfinance institutions

Abstract

Purpose

In recent years, researchers have shown an increased interest in studying the institutional environment–financial institutions’ performance nexus. However, little attention is paid to investigating the role of institutional quality in the financial sustainability of microfinance institutions (MFIs). Consequently, this study explores whether investments in strengthening institutional environment enhance MFIs’ financial sustainability.

Design/methodology/approach

The study relies on an unbalanced panel dataset of 136/138 MFIs in Sub-Saharan Africa (SSA) spanning from 2004 to 2018, which was obtained from the Microfinance Information Exchange (MIX) Market database under the World Bank catalog. Data for institutional factors are accessed from the World Bank database for World Governance Indicators (WGI). The study applies the two-step system generalized method of moments (GMM) to analyze the data.

Findings

The research uncovers that institutional environment matters in the financial sustainability of MFIs. The study shows that institutional quality is, in the aggregate, positively associated with financial sustainability. Different institutional factors also have distinct impacts on financial sustainability. While contemporaneous relationships are discovered between government effectiveness (GOVE), rule of law (RUL) and sustainability, the relationship between control of corruption (CCOR) and sustainability is an intertemporal one. Unlike the others, CCOR impacts sustainability with a one-year lag and not instantaneously. Nevertheless, the effects of the aforementioned institutional factors on financial sustainability are all positive and consistent with the result for the aggregate measure.

Practical implications

The practical implication of our findings to MFI managers is that strategies should be developed and instituted to manage MFI-specific factors appropriately and counterbalance the negative effect of a weak institutional environment (in SSA) on financial sustainability, as MFIs have no or less control over the institutional quality. For policymakers, our findings underscore the significance of policy documents that assist developing economies in improving their institutional environment, as strong institutions are vital for MFIs in the attainment of financial sustainability, which is crucial for sustainable poverty reduction.

Originality/value

While the extant literature provides valuable insights that different MFI-specific factors drive the financial sustainability of MFIs, the previous studies fail to address the role of institutional quality in the financial sustainability of MFIs. This study examines the nexus between institutional quality and financial sustainability, which has been ignored in the previous literature.

Citation

Tehulu, T.A., Muhammed, S.W. and Melesse, M.T. (2024), "The nexus between institutional quality and the financial sustainability of microfinance institutions", African Journal of Economic and Management Studies, Vol. ahead-of-print No. ahead-of-print. https://doi.org/10.1108/AJEMS-01-2024-0006