Determinants of capital adequacy and voluntary capital buffer among microfinance institutions in an emerging market

Abstract

This study examines the determinants of capital adequacy and voluntary capital buffers among microfinance institutions (MFIs). We apply the two-stage least squares (2SLS) with instrumental variables to account for endogeneity. Using quarterly panel data of 439 MFIs in Ghana covering the period 2015–2018, the study found that credit risk, income diversification, size, profitability, lending channel, and equity-to-asset ratio significantly affect capital adequacy. Also, the factors that drive voluntary capital buffers are income diversification, size and equity-to-asset ratio, but size and economic growth are insignificant when the upper limits of Basel III requirements are applied. Generally, the results are insignificant among non-deposit-taking (i.e. Tier 3 like Financial NGOs) MFIs. The findings show that non-performing loans negatively affect capital adequacy. Income diversification increases capital adequacy, especially among deposit-taking MFIs which have the regulatory liberty to engage in additional financial intermediation activities. Size has an inverted U-shape nexus with capital adequacy and there is evidence to suggest that for non-deposit-taking MFIs, size may not matter. Profitability increases capital adequacy while equity-to-asset ratio decreases capital adequacy, especially among deposit-taking MFIs. Additionally, lending channels negatively affect capital adequacy, especially among deposit-taking MFIs. Economic growth reduces capital adequacy but results are insignificant when we control for quarter fixed-effects. These results throw light on the application of the capital buffer theory in the context of MFIs which provides useful insights for practitioners, regulators, policymakers and academia.

Keywords:

• microfinance institutions
• capital adequacy
• Basel accord
• financial risk regulation
• pro-poor population
• emerging markets
• non-performing loans

JEL Classification:

• G21
• G23
• G32
• L25
• N27
• P46

Public Interest Statement

The study explored the factors that determine the capital adequacy and voluntary capital buffer of microfinance institutions (MFIs). We found that capital adequacy is determined by credit risk exposure, income diversification, firm size, profitability, equity contributions, lending channels and to some extent economic growth. Only income diversification, size, and profitability increase capital adequacy, the others lead to its reduction. We found that all these factors determine whether or not an MFI keeps capital adequacy levels above the Bank of Ghana level or the rates fixed by Basel II and III. We also found that firms keeping voluntary capital above 13% (which is the maximum cut-off under Basel III) are doing so not because of their size or the economic conditions. We find some differences in the determinants for deposit-taking and non-deposit-taking MFI like the Financial Non-Governmental Organizations. Financial NGOs have more tendency to support social causes and increase capital even in the event of poor financial performance.

Disclosure statement

No potential conflict of interest was reported by the author.

Data availability statement

Data is available upon reasonable request.

Acknowledgments

The author acknowledges the constructive feedback of three anonymous reviewers in improving the article. The author also thanks Rhoda Ladjer Akuaku for proofreading the manuscript. This article benefited from comments from the members of the Dataking Research Lab and the AuthorAID Ghana Hub.

Supplemental material

Supplemental data for this article can be accessed online at https://doi.org/10.1080/23322039.2023.2285142

Notes

1. We observe that although the quarterly data was tagged with pseudo-names, a critical look at the equity trajectories show that organising it in a full panel format may be problematic, as different MFIs could possibly be linked to others. We inculcated this in our regression analysis to ensure our results present the reality.

2. Additional analysis where we included both ROA and LOTA in the same model yielded results of the same power except for change in the direction of impact of LOTA from negative to positive.

3. Bank of Ghana adjusted its capital adequacy requirements from 10 percent to 13 percent, effective April 1, 2022.

4. In some situations, for the 2SLS, we found negative R squared so we did not report them. Negative R squared does not undermine the results in any way. At any rate, the R squared does not have any statistical meaning in the context of 2SLS or instrumental variable.

5. As per classification, Tier 3 institutions also include Money Lending Companies (similar to Finance Houses) but because they also are allowed to often mobilize funds with the aim to pay interests on investments, the Bank of Ghana has been making efforts to raise its minimum capital requirements. It is also worth noting that, Bank of Ghana tend to have a tighter regulatory attention on the FNGOs even more than the other mainstream MFIs (like the Microfinance Companies in Tier 2).

6. These results are consistent whether we use the OLS model or the 2SLS in a simple model where we regress capital adequacy on the interaction of profitability and equity to asset while the latter is additionally treated as endogenous.

Additional information

Funding

The author received no direct funding for this research.

Notes on contributors

King Carl Tornam Duho

King Carl Tornam Duho (ACMA CGMA CA) is an IMF Youth Fellow with 10+ years of experience in the private sector, academia and public policy. He is now a Research Professional with the University of Chicago Booth School of Business. He is the Founder of the Dataking Research Lab, Dataking Consulting (https://datakingconsulting.com/). King holds a Master of Philosophy in Accounting. He has presented at over 30 conferences in Europe, North America, Asia and Africa. King has spoken at the 2022 spring and annual meetings of the IMF/WBG and led various national-level projects as a policy expert. He was the VP of R&D of Ghana’s Fintech and Payments Association. His research focus is on the modern view of accounting with a strong link with economics and public policy. His over 25 peer-reviewed articles appeared in the Journal of Economic Studies, and the International Journal of Managerial Finance, among others.