Panizza, and Yañez 2004 and Messouri 1999, among others). It is unclear whether DFIs’ worse performance stems, at least partially, from the fact that they primarily serve social objectives (which are difficult to quantify), rather than maximize profits—in which case financial performance is bound to suffer. Alternate explanations for DFIs’ poor performance could be that they face lower incentives or indeed have poor governance structure and weak management.

As a consequence, the evaluation of DFIs’ performance cannot rely on traditional measures. Traditional approaches are suitable for commercial banking but fail to capture explicit costs and benefits associated with DFIs’ operations, such as the subsidies that are embedded in most DFIs’ “products” or the fulfillment of social welfare objectives. Seeking to overcome these limitations, Yaron (1992a)<sup>11</sup> developed a performance evaluation framework that uses as its primary assessment criteria the “self–sustainability” of DFIs measured through the SDI. This framework was introduced in the early 1990s for assessing the performance of rural banks, microfinance institutions, and others. It has gained wide acceptance among practitioners and academics. Apart from improvements in the effectiveness of those types of measures, a need remains for developing a methodology to assess the extent to which DFIs (a) are reaching their social goals or (b) are effectively using their subsidies to achieve those goals. As stated earlier, these two aspects are the main subject of this paper and are explored in the next sections.

# **3. Methodology**

Our methodology consists of applying the already-tested SDI, developing and implementing the OI, and integrating both the SDI and OI concepts. This methodology is tested on two case studies: Banadesa in Honduras and Banrural in Guatemala. These two DFIs lie at opposite ends of the spectrum in terms of operational and institutional strength, and they were chosen deliberately to show the usefulness of the methodology by illustrating its effectiveness in institutions with substantial differences in levels of cost-effectiveness.

The SDI reveals the increase in annual yield on the DFI’s loan portfolio that would be necessary if full subsidy independence is to be reached. Specifically, the SDI quantifies the total explicit and implicit subsidies to a DFI, thereby allowing cost comparisons with other social programs. This indicator can be used to track subsidy dependence over time. Thus, it can be used as a planning and monitoring tool, as well as to compare the subsidy dependence of different DFIs, in the same or different countries that serve similar clientele.

The OI is custom-designed depending on the policy objective that the DFI may have (for example, lend to the rural poor, or support fledging micro-enterprises). The OI requires choosing explicitly quantifiable output variables that are related to the subsidized intervention and agreement on the relative weights of each variable. The main advantage of the OI is that it provides policy makers with a metric that addresses their prioritized social objectives, especially for reaching the target customer base of the DFI. The specific parameters of this metric can be adjusted depending on the particular objective a DFI may

> 11 There are other tools to measure the subsidy dependence such as the financial self-sustainability (FSS) that was developed later. The transformation from the SDI to the FSS and vice versa is simple.

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