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.