The countercyclicality of microlending rates: Does the business model of microfinance institutions matter?

Abstract

Microfinance institutions (MFIs) are critical to financial inclusion in developing countries, but face challenges in maintaining profitability while serving low-income populations, particularly during economic downturns. This study examines whether MFIs adjust interest rates in response to the business cycle, hypothesizing an increase during downturns. Analyzing data from 1,711 MFIs over 16 years (2003–2018), we find a negative relationship between interest rates and the business cycle. However, certain MFI characteristics mitigate this countercyclical behavior. Specifically, MFIs in the top tertile of the group lending method, deposit-taking MFIs, and subsidy-based MFIs show less cyclical interest rate behavior, contributing to greater stability. Further analysis sheds light on the mechanisms underlying this countercyclical behavior, leading to two main conclusions. First, shareholder-based MFIs tend to raise interest rates during economic downturns, suggesting that profit maximization drives the countercyclical effect. Second, increases in provisioning and funding costs are passed on to borrowers through higher interest rates during downturns. Using propensity score matching and Lewbel’s (2012) instrumental variable approach to address endogeneity concerns, our findings remain robust and consistent across different econometric specifications and measures of the business cycle.