Is donation funding a dilemma for microfinance institutions?

Microfinance institutions (MFIs) play critical roles in providing financial access to low-income communities worldwide. Yet, reliance on donation funding in the operations poses fundamental challenges to their long-term sustainability. We argue that this dependence creates an unclear agency relationship between donors (principal) – providing cost-free funds – and the MFI managers (agent), heightening moral hazard concerns. Also, due to the nature of the business model, MFIs’ operating leverage increases as they increasingly expand lending operations with more cost-free donation funds. Based on a global dataset of 2653 MFIs across 119 countries over 20 years, we find that greater reliance on donations weakens MFIs’ financial stability and reduces their likelihood of survival in the long run. The destabilizing effect intensifies over time, confirming the ex-post inefficiency of donation-reliant models. Our findings are robust across multiple empirical techniques and consistent across various dimensions such as profit orientation, legal status, geography, and country characteristics. By jointly examining financial stability and institutional survival, the study provides a comprehensive assessment of the long-term risks of donation dependence. These findings have important implications for donor agencies and policymakers in re-evaluating the effectiveness of the donation-based microfinance and in designing measures to promote sustainable models.