Assessment of Government Intervention in Microfinance Banks of Pakistan

1. INTRODUCTION

Microfinance is a branch of banking service aimed toward the unemployed or low-income earners who are incapable of utilizing financial services and wish to perform business activities. The purpose of microfinance institutes (MFIs) is to provide the underprivileged with the service in a way such that they become self-sufficient and have adequate resources (Micheal, 2012). Researchers suggest that microfinance is vital to poverty alleviation in Pakistan (Khan et al., 2021). Microfinance, defined as "a credit methodology that employs effective collateral substitutes to deliver and recover short-term, working capital loans to micro-entrepreneurs", has proven success as a poverty reduction strategy.

The microfinance sector in Pakistan is an emerging industry and has a vast number of incumbents. By 2013, there were approximately 2.8 million borrowers, and this number has since grown significantly (Rosenberg, 2014). It is also reported that a potential market size of twenty-seven million borrowers for the sector is developing. This shows the strength of the sector and forms an important variable for analysis which is the market response. Recognizing the need to increase the depth and outreach of financial markets, policymakers and regulators along with other stakeholders worked hard for the development of the microfinance in the country. It is evident that without government intervention, there are fewer chances to increase the financial performance of the microfinance sector in Pakistan (Imai et al., 2012). Additionally, recent studies highlight the role of the MBFIs in disaster management and control (Kamran & Omran, 2023).

An important distinction to make is that governmental intervention does not mean that the government will directly be providing financial services. The organizations provide these financial services, which often receive support from the government (Luyirika, 2010). Interference by the government in the management of MFIs affects sustainable development. This interference can compel MFIs to lend loans at lower rates, and to unfit customers leading to the access of loans by poor borrowers (Consultative Group to Assist the Poor [CGAP], 2013). Microfinance banks cannot work without a proper and regular framework that cannot be included in the analysis because this variable cannot be captured easily. The government has an imperative role in developing the framework of the organization, and typically requires intervention of government. The purpose of research is to develop the causality of how these frameworks are developed through government (Chen & Ravallion, 2008).

High default rates in SME lending should be of major concern to policymakers in developing countries, because of their unintended negative impacts on SME financing. According to Von Pischke (1991), some of the impacts associated with default include: the inability to recycle funds to other borrowers, the unwillingness of other financial intermediaries to serve the needs of small borrowers and the creation of distrust. If the government is effective in regulating the credit risks, the default ratios can be reduced. Hence the defaulters' profiles are key to the valuation of the impact of government regulations on the profitability of the microfinance institutes (Bichanga & Aseyo, 2013). It is imperative for microfinance banks, to focus on deposit regulations. However, complying with regulations can be costly. An analysis of data from 245 MFI banks from all over the world through OLS regression revealed that supervision is negatively related to profitability and outreach. The cost of supervision is absorbed by curtailing the outreach to the markets (Cull et al., 2011).

Government intervention plays a positive role in developing the MFBS all over the world. Consequently, these microfinance institutions play an important role in improving the standards of living (Anwaar, 2022), and, thereby the economic development of the countries (Latif et al., 2023). In Pakistan, the people living under the poverty line constitute a huge part of the population and thus MFBS has an active role in alleviating the class gap in the economy.

Compared with the global ranks, the Pakistani MFBS are failing to a larger extent because of the leading corruption and the systematic disturbance in the distribution channel. In Pakistan, these MFBS are underperforming, and to gauge the performance one uses indicators such as profit ratio and market share. The government has set precedence in regulations. To fight the black economic systems of these institutes, governments have hired overt participant supervisors who regulate the proper channelling of funds such as sponsorships or grants. In recent years, the government's overt participation has proven fruitful and so the results have shown that there is a proper channelling of funds. This, however, hinders profitability, because the governmental audits (overt supervisors) take control of most profit-making activities since the government's aim is welfare maximization.

One evident result is that these overt participations (namely audits) have not worked. Drawing on Adam Smith's arguments, it appears that the free-market system is a more workable and efficient measure, leading to equilibria in the most efficient way. Henceforth, the purpose of the study is to assess the role of government in the building of the microfinance sector. The authors build a hypothesis that the government plays a vital role in dictating the performance of a microfinance sector. Despite certain limitations on the collection of data, there is sufficient data to produce generalized results. The paper presents a widespread contrast with the literature available on the topic, and juxtaposes the research results along with methodologies across a multitude of research conducted globally. The study outlines its methodology and presents the key findings of the empirical result, from the data collected. The research objectives of the study are:

1. To determine whether government has an effective role in the performance of microfinance banks.
2. To assess which forms of governmental involvements are effective in enhancing the performance of MFIB.
3. To identify which governmental tools are vital.
4. To gauge policy recommendations based on research findings.

Literature Review

The model under analysis aims to evaluate the effects of government intervention on the performance of the microfinance institutes. Since performance is a subjective and broad term, the paper limits the decision variables to the profitability ratio as the key indicators of performance. The profit ratio reflects the managers' ability to generate profit from sales, illustrating how effective the management is in creating value surplus out of the operations, that is, how well a firm can do (Velnamby & Ajanthan, 2014). Market share, which represents the organization's size in comparison to the competitors, is also used as a performance measure (Bertay et al., 2013). The presented data was taken from over 90 countries and shows the importance of market share in gauging the performance of the banks. In conformity with the literature, the model presents two dependent variables as a proxy for performance dependent on certain variables that may affect them.

The distinction between the microfinance banks and non-banks is that MFI banks are regulated by state bank and non-bank MFIs do not fall under these regulations. There is research suggesting a relationship between the efficiency of MFIs and regulations (Basharat et al., 2014; CGAP, 2013). Subsidies are a vital variable affecting the sustainability and performance of the microfinance banks and organizations in Pakistan, serving as a proxy to the quantifying effect of government intervention. In analysis, the literature indicates that subsidies by the government are a robust government interventional tool and play an effective role in the sustainability of microfinance banks all over the world. "Subsidy is substantial to measure the sustainability of Microfinance institutions. A large number of microfinance programs in the world are subsidized in different ways, sustainability of the programs poses a question in the minds of academics and researchers. Grameen Bank of Bangladesh has to face high repayment rate but also has to depend on subsidies (Morduch, 1999; Mukhtar & Almas, 2015).

It is evident from the literature that subsidies help in lowering the operational costs and cover the administrative expenses. In some of the literature, it is argued that microfinance banks cannot operate and exist in the market without the help of subsidies, which is exactly coincidental with the hypotheses stated. Marek and Traca (2011) worked on the panel data across various microfinance banks and came up with the result that subsidies are vital in distinguishing the performance of these institutions. As subsidies play a vital role in the form of government grants where MFIs get money below the interest rate, the other imperative variable is government regulation. More specifically, governments can encourage the shift toward sustainable, market-based microfinance through three specific roles: (1) eliminating unfair competition from public institutions; (2) undertaking regulatory reform; and (3) improving the business environment (Purkayastha et al., 2014). There is empirical evidence of the impact of subsidies on the efficiency of microfinance institutions. Subsidies are positively related to the efficiency of MFIs (Hudon & Traca, 2011).

The growth rate of microfinance institutions (MFIs) is closely related to regulatory practices. Literature has treated microfinance as a binary variable that in a specific period MFI banks were regulated or not. These are the leading causes of the improvement or deterioration of the profitability ratio. The direct effect was implied on the market share in their research, and they confirmed the result with more than 90 banks across Africa. In another research by Javeed et al. (2020), conducted in three different segments including World Bank, microfinance banks, and commercial banks showed that regulation has a direct positive effect on profitability ratios and the market share. Others find that the regulations have no direct effect on the performance but in terms of outreach and self-sustainability (Hartarska & Nadolnyak, 2011).

Another key variable effective in microfinance institutions' performance is governmental audits. The literature on this topic is relatively sparse (Hartarska, 2005). In the study of 140 banks, Hartarska found out that audit is a significantly important variable that has had an effect on the financial statements of the company. It is vital to notice that this data presents a milestone in the achievement that provides a unique identifier of the institute's performance. The Audit, as an independent variable in our analysis, is supported by a study in Pakistan. "Preparation and audit of accounts based on international standard and best practices resulted in the disclosure of true and fair picture of the organizations" (Isa et al., 2011, p.16). In their rich datum, the results showed that the audit ratings were highly significant in building the institute's image, which in turn influenced its market share. This identifier has also government-influenced audits. The social audit includes the external and internal assessment for self-reported information regarding social information, the quality of the internal process, and the performance of MFIs with a social mission. The objective of a social audit is to achieve financial ratings for internal and external audiences (Woller, 2010).

In addition to the standardized social rating scale, the internal processes to be audited can also be standardized. Five internal processes have been identified that appeared to offer good potential for standardization. Each is also an internal process common to all MFIs and contributes in a significant manner to social performance. The internal audit process can also be standardized in addition to a standardized social rating scale. These processes include (1) mission statement and communication, and management leadership; (2) hiring and training; (3) incentive systems; (4) monitoring systems; and (5) strategic planning (Roy, 2008). Data is gathered quarterly and annually through PMN. Quarterly and yearly data is used to monitor the performance and trends through micro-watch. Ordinary Least Square methods on Panel data were used to measure the relationship between key performance indicators such as efficiency, risk, productivity, and profitability (Haider, 2016).

The final variable for analysis under the hypothesis is market size, which proxies as a percentage of the whole population. In 2012, the reported market share included 2.8 million borrowers, with expectations for significant growth by the current year. The report also presents a potential market size of 27 million borrowers for the sector. in the report has surveyed almost 140 institutes and deduced this figure with the help of Federal census data. It was presented that the market size and active borrowers are imperative in determining the institute's performance (Akyuz, 2017). Another research paper by Mersland and Strom (2009) gave evidence where it was explicitly concluded through his study of 278 microfinance institutes across 60 countries, that larger market size, especially urban market size, yields a higher profit ratio by yielding a higher market share. The fixed-cost quality investments are used for quality investments to capture the demand when the size of the market increases which in turn raises barriers to entry. There is a correlation between the number of firms, concentration, and competition (Dick, 2010). It is important to illustrate that the government has had some negative impacts on the development of microfinance institutes. The paper mentioned how the government became a competitor against the microfinance institutes and created problems for these organizations. The analysis explores how regulations, as an independent variable, can support or hinder the performance of microfinance institutions. Additionally, the paper discusses potential ways in which government actions could be more supportive (Asian Development Bank [ADB], 2010).

Theoretical Framework

A theoretical framework serves as the foundation for the model used to test hypotheses and assess the impact of government intervention on the performance of microfinance banks. According to Almazari (2012), the profit ratio—defined as the net profit after tax—acts as a key dependent variable and proxy to measure the performance of microfinance institutions. This model, however, is not limited to a single performance metric. It incorporates another critical proxy: the market size of the organization. As suggested by Gunsel (2012), market size is an important independent variable that can influence how organizations perform in competitive environments. This framework adopts and extends the proxies introduced by Dick (2010) and Lynn (2011) to capture this aspect of performance.

In contrast to earlier models, this framework specifically uses the ratio of market size to the population of Pakistan to measure performance. In the private sector, various models exist to evaluate business effectiveness, but this framework establishes relationships between dependent and independent variables through a ratio-based approach. The dependent variable is the profit ratio, while the independent variables include market size, government regulations, government grants to the gross portfolio, and the total number of audits within a year. Each variable is defined to capture causal relationships and facilitate the derivation of policy implications aimed at enhancing microfinance bank performance. The proxy for market size—borrowers of bank "i" at time "t" scaled to total borrowers in Pakistan—is consistent with the approaches of Dick (2010) and Lynn (2011). Similarly, audits are measured as the number of total audits per year, ranging from 0 to 4, and include both internal and external audits (Tagkalakis, 2013).

The variable "government regulations" is operationalized through statements in bank reports that mention penalties for regulatory non-compliance. This is used to evaluate the degree of government intervention in microfinance institutions and is coded as a dummy variable: 0 for non-compliance and 1 for compliance (Hubka & Zaidi, 2005). This binary format helps identify whether a bank is under government regulation at any given time. Government grants to the gross portfolio are calculated as the ratio of total grants received by bank "i" at time "t" to the total grants received across all banks at the same time. Grants are an essential variable for determining performance, and substantial evidence supports their positive impact on profitability (Louis & Seret, 2013).

It is also critical to consider that while financial repression tools like interest rate caps may offer short-term economic control, they often lead to unintended consequences. These caps can restrict the growth of the microfinance sector. Although government grants boost the gross portfolio, they can also foster dependency, which undermines long-term sustainability (Čihák et al., 2021). When financial institutions become overly reliant on government intervention, their resilience and profitability potential diminish over time.

Moreover, financial repression can lead to capital misallocation. Regulations that enforce cheap loans or impose interest rate caps might seem beneficial initially but often result in a significant reduction in lending to small and medium enterprises. This can lead to financial exclusion rather than inclusion, as these businesses struggle to access the credit they need, thereby negatively impacting their growth and the broader economy in the long run (Koskei, 2020). On the other hand, frequent and quality audits ensure transparency and accountability and could enhance investor and depositor confidence, potentially leading to more business and higher profitability in the long term for microfinancing banks (Muotolu & Nwadialor, 2023). The theoretical framework has been proposed in Figure 1.

Methodology

This study examines the impact of government intervention in microfinance banks in Pakistan. The research focuses on a sample of eight well-balanced microfinance banks operating in Pakistan. The data taken is panel data, sourced from financial statements of these 8 banks, over a period of 5 years, from 2011 to 2015, constituting total of 40 firm year observations.

The Federal cabinet of Pakistan approved the SME Policy on January 17^th, 2007. The SME Implementation Policy Plan matrix (Government of Pakistan, 2007) shows the start of implementation plan from 2007, ending by 2009 year end. However, "various organizations may be allowed a two-year time frame to align their current SME definition in line with the SME definition proposed in this Policy" (Government of Pakistan, 2007, p. 14), allowing a two-year grace period up to 2011 for some industries. Simultaneously, the Microfinance Institution Ordinance 2001 was amended in October 2007 to allow for some synchronism between the two policies. Therefore, the sample of the study is taken from 2011 to 2015 to study the effects of the SME policies and regulations. By taking this initial sample, the visualization of the direct impacts of government policies on the SME units and microfinance banks has been made possible, without confounding effects.

The panel data methodology uses same cross-sectional banks over the same time period (Wooldridge, 2010). The data is an intersection of both time-series data as well as cross-sectional data, covering the causal influence of both data types. Amongst the widely used statistical tools, fixed effects and random effects models are commonly used. The choice between these models depends on whichever yields better results, and is rated as the best. Key assumptions are important to approximate the exact association among variables. These assumptions consist of normality tests that are checked by histograms, and linearity is checked by normal probability plot, though linearity and normality are not considered serious problem in panel data analysis. Multicollinearity and Heteroskedasticity are checked by Heteroskedasticity and Pearson correlation tests. Summing all the literature evidence in conformity to theoretical framework, the model being presented is to regress profit ratio on audits, regulation, and market size and grant to gross portfolio. Hence, OLS regression analysis is employed for the empirical tests, and the model is shown below:

PA_i,t = β₀ + β₁NA_i,t + β₂RG_i,t + β₃MS_i,t + β₄GP_i,t + μ_i,t

Where:

• PA_i,t = Profit Ratio (Net Profit after tax/Revenue) of Microfinance i at time t
• NA_i,t = Number of audits at Microfinance i at time t
• RG_i,t = Government intervention in regulating microfinancing banks
• MS_i,t = Market Size (Microfinance customers in Pakistan/total microfinance customers of Pakistan) at time t
• GP_i,t = Grant to Gross Portfolio (Govt Grants/Total Grants) of microfinance i at time t
• β_i = Beta Coefficient for i variable
• μ_i = Error term across i observation at time t

Results

This part of the study includes the descriptive statistics, Pearson correlation matrix and results of models. Table 2 contains the descriptive statistics of the panel for all variables. The number of observations in the panel is 40 for all variables as this data contains a strong balance panel of 8 microfinance banks for 5 years from 2011 to 2015. The average value of the dependent variable profit ratio is -0.14%. Standard deviation which is a measure of dispersion shows that the profit ratio of the banks in the panel deviates from its mean of around 45.67%. The lowest value of the banks’ profit ratio is -13.7% while the highest value of the profit ratio of the banks in the panel is 26%. Likewise, the average value, standard deviation, least value, and highest value of each independent variable of the panel are mentioned in Table 2 below: