© The Pakistan Development Review 62:1 (2023) pp. 15–40 DOI: 10.30541/v62i1pp.15-40 Performance of Asian MFIs: The Role of Capital Structure and Macro-Institutional Quality ADNAN HABIB and SHAHRIAR KABIR * We draw on the capital structure theory and examine whether Modigliani & Miller’s capital leveraging ideology improves the performance of microfinance institutions (MFIs) under different macro-institutional quality. We develop and test a framework of the combined effect of capital structure and macro-institutional quality on both financial and social performance, which is a novel contribution. We collect data on 75 MFIs in Asia from 2009 to 2018 and applied Hausman-Taylor test. We find that when operating in countries whose institutions are relatively weak, MFIs can better perform both socially and financially by using equity funding instead of debt or donation. As supported by the Market Failure Solution theory of institutions, MFIs perform better socially in weaker institutional quality as they can fill up the gap in the market left by traditional banks. As this gap narrows down with the improvement of institutional factors, MFIs face stronger competition from traditional banks. Such competition transposes MFI’s focus toward financial performance (profit-seeking behaviour) and drifts away from social performance (objective of poverty alleviation). Furthermore, under any institutional condition, MFIs with debt or donation impose less control over capital utilisation compared to equity funding. Thus, despite initiation with a major goal of social performance, MFIs suffer from mission drift even with the support of debts and donations when operating in countries with relatively stronger institutions. Previous literature, mostly focusing on capital structure theory and often ignoring the institutional factors, appears inconclusive in developing a framework on the issue to explain mission drift for MFIs. We contribute to this endeavor by empirically showing that the Modigliani & Miller capital structure theory (improvement of performance by leveraging the firm through external capital) cannot be applied to MFIs, and the Market Failure Solution theory of institutions is a reasonable explanation to avoid the mission drift problem. Keywords: Microfinance, Capital Structure, Institutional Quality, Social Performance, Financial Sustainability, Mission Drift 1. INTRODUCTION Since the emergence of Microfinance Institutions (MFIs) as the primary tool for achieving the first Sustainable Development Goal (SDG), it has gained a lot of focus in academic research. In the field, it was observed that there are vast differences in performance among MFIs. Hence, development literature primarily focused on finding the determinants of the performance of MFIs (Bogan, 2012; Gul, Podder & Shahriar, 2017). Some of these papers concluded that capital structure is the key determinant of Adnan Habib <adnan.habib@northsouth.edu> is affiliated with the North South University (NSU), Bangladesh. Shahriar Kabir is Associate Professor and Head, Department of Economics, Independent University Bangladesh (IUB), Bangladesh.