This paper analyzes the relationship between performance of microfinance institutions (MFIs) and the development of the formal financial sector of the country in which the MFI is active. We find that MFIs reach more clients and are more profitable where access to the formal financial system is low. This finding is in line with the market-failure hypothesis: MFIs respond to a need that banks do not fulfill and flourish where the formal banking sector fails. However, we also find indications of interdependencies between MFI-performance and formal financial sector development. First, MFIs are less profitable where interest rates are higher reflecting the fact that MFIs depend upon the domestic banking system for additional funding. Secondly, MFIs are less profitable where inflation is high, suggesting that MFIs benefit from stability of the formal financial system. Overall, the results show that the macro-economic environment is crucial to fully understand MFI-performance and that outreach and accordingly impact of MFIs are contingent on financial sector development.
