The efficiency of microfinance institutions with problem loans: A directional distance function approach

Abstract

This article examines the question of whether the inclusion of problem loans leads to any variation in the technical efficiency of microfinance institutions (MFIs). This question has become pertinent as MFIs, which are well known for their excellent asset quality, have been vulnerable to a delinquency crisis worldwide. Traditionally, the efficiency of MFIs has been measured through non-parametric data envelopment analysis (DEA) or parametric stochastic frontier analysis. As both methods are not flexible enough to cover undesirable outputs, we have instead used the method of directional distance function (DDF) that accounts for the joint production of both desirable and undesirable outputs. Using data from 64 large MFIs, this study reveals corroborative evidence that, with the inclusion of at-risk portfolios as undesirable outputs in the efficiency analysis, the scores and rankings of sample MFIs differ significantly from the results of conventional DEA after the use of DDF. MFIs whose numbers of at-risk portfolios are comparatively high have exhibited lower efficiency scores and vice versa. It is therefore critical that MFIs also include problem loans in their efficiency assessment. This would help MFIs get a more accurate picture of their performance as compared to their peers.