Capital adjustment process and credit growth of microfinance institutions: Evidence from Sub-Saharan Africa

The purpose of this study is twofold: First, we examine the capital adjustment process using a partial adjustment framework and second, we test whether capitalization impacts the credit growth of microfinance institutions (MFIs) through the deviation (i.e. the divergence between the actual capital ratio and the implicit long-run target capital). To this end, we use an unbalanced panel dataset of 127 MFIs across 31 countries in Sub-Saharan Africa (SSA) during 2004–2014. We apply the Arellano-Bover/Blundell-Bond two-step Generalized Method of Moments (GMM) Windmeijer bias-corrected standard errors for estimating both the capital and lending models. Standard errors for the long-run effects in the capital equation are approximated with the Delta method. Our findings reveal that profitability contributes to the capitalization of MFIs, whereas portfolio risk and liquidity are negatively associated with MFI capital. We also find that large-scale MFIs have lower capitalization, while small-scale MFIs have higher capitalization relative to medium scale MFIs consistent with the “too big to fail” hypothesis. Nevertheless, we uncover that the legal status of MFIs, deposit growth and economic growth have no direct effects on capitalization. The findings also confirm that there is a capital adjustment difficulty in the microfinance industry in SSA. The constant of the model is also statistically significant and has the highest economic significance suggesting that the capital ratio fluctuates mainly around a firm-specific unobserved time-invariant component. The findings, however, fail to support the hypothesis that capitalization impacts MFI lending behavior through the deviation.