In this paper we undertake multiple empirical analyses to (a) test whether the links between the Microscope and MFI outcomes are robust to controlling simultaneously for other relevant variables, (b) identify which components of the index best explain variation in which outcomes, and (c) examine where microfinance fits into the broader formal financial sector across developing countries, and how the interplay between microfinance institutions and formal providers of financial services is related to the Microscope and its components.

In addition, the direction of causation is sometimes difficult to infer from simple correlations. For example, it could well be that supervisory capacity improves as a result of widespread microfinance penetration rather than the reverse. We therefore provide instrumental variables regressions to address the potential endogeneity of the Microscope. As instruments we rely on measures of the strictness of commercial banking regulation and supervision in a country reasoning that those variables reveal a general approach to financial regulation that could be tied to underlying exogenous factors such as culture, ethnic fractionalization, religion, and geography. Importantly, because the microfinance sector is quite small relative to the formal banking sector in almost every country, it is plausible to argue that a country’s approach to banking sector regulation and supervision is much more likely to influence microfinance regulation and supervision than the reverse. In essence, we use the broader financial regulatory variables to identify an exogenous component of the microfinance business environment and we link it to microfinance financial performance and outreach.

Microfinance institutions occupy unique places within the financial sectors of developing countries, niches that vary by country. The interplay between the microfinance and banking sectors is therefore likely to shape both the business environment for microfinance and resulting outcomes in terms of their financial performance and outreach to underserved market segments, and thus we account for the development of the formal financial sector in the analyses that follow.<sup>5</sup> We also hypothesize and test whether responses to the competitive and business environment vary across types of MFIs, as has been suggested by recent studies. Baquero, Hamadi, and Heinen (2012) use combined data from three rating agencies to construct measures of concentration and competition within the microfinance sector. They find that non-profit institutions are relatively insensitive to competitive pressures, while for-profit institutions are sensitive. Competition pushes the for-profit microfinance institutions to reduce interest rates charged to borrowers, creating greater consumer surplus. Similarly, Cull, Demirguc-Kunt, and

> 5 In that sense, our work is related to a growing body of research on competition between banks and microfinance institutions (and within the microfinance sector itself). For example, Vanroose and D’Espallier (2013) find that microfinance institutions reach more clients and are more profitable in countries where the formal banking sector is less developed. This suggests that microfinance institutions fill niches left uncovered by lagging bank development. However, another interpretation consistent with those results is that as the formal banking sector develops, it puts competitive pressure on microfinance providers resulting in lower profitability and competition for the most attractive customers. This interpretation is consistent with Hermes, Lensink, and Meesters (2009) who use a stochastic frontier analysis to show that MFIs are more efficient where the formal financial system is better developed.

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