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Financial Inclusion and Stability: What Does Research Show?

Financial Inclusion and Stability: What Does Research Show?

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Published by CGAP Publications
A growing body of research suggests that whether broad-based access to formal financial services promotes financial stability depends on how that access is managed within the regulatory and supervisory framework, especially in terms of financial integrity and consumer protection. Four factors come into play: financial inclusion, financial consumer protection, financial integrity, and financial stability. These factors are inter-related and, under the right conditions, positively related. Yet failings on one dimension are likely to lead to problems on others. This Brief explores what research to date shows about the linkages and potential beneficial relationships among these factors, and it identifies gaps that remain to be explored.
A growing body of research suggests that whether broad-based access to formal financial services promotes financial stability depends on how that access is managed within the regulatory and supervisory framework, especially in terms of financial integrity and consumer protection. Four factors come into play: financial inclusion, financial consumer protection, financial integrity, and financial stability. These factors are inter-related and, under the right conditions, positively related. Yet failings on one dimension are likely to lead to problems on others. This Brief explores what research to date shows about the linkages and potential beneficial relationships among these factors, and it identifies gaps that remain to be explored.

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Published by: CGAP Publications on May 31, 2012
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Financial Inclusion and Stability:What Does Research Show?
      B       R      I       E      F
Focus to date: linkages among financialdevelopment and economic growth, reduction of income inequality, and poverty alleviation.
There islimited empirical work exploring the specific linkagesbetween financial inclusion and financial stability.Studies have focused largely on the impact of financialdevelopment on growth, income inequality, andpoverty reduction. The evidence strongly indicatesthat, when effectively regulated and supervised,financial development spurs economic growth,reduces income inequality, and helps lift householdsout of poverty.
1
Most cross-country evidence relates to the benefitsof financial depth rather than to broad financialinclusion. Deep financial sectors are not necessarilyinclusive ones, if financial access is tilted heavilytoward the wealthy. Our lack of knowledge aboutthe macro-level effects of financial inclusion stems, inpart, from the challenges associated with measuringit on a consistent basis both across countries and overtime based on surveys of users and potential usersof those services.
2
In contrast, the effects of financialdepth have been studied extensively preciselybecause data from suppliers of financial services arereadily available.Macroeconomic evidence indicates that well-developed financial systems have a strong positiveimpact on economic growth over long timeperiods.
3
Multiple studies have documented arobust negative relationship at the country levelbetween indicators of financial depth and thelevel of income inequality as measured by the Ginicoefficient.
4
Financial depth is also associated withincreases in the income share of the lowest incomequintile across countries from 1960 to 2005 (Beck,Demirgüç-Kunt, and Levine 2007). It comes as littlesurprise, therefore, that countries with higher levelsof financial development also experienced swifterreductions in the share of the population living onless than $1 per day in the 1980s and 1990s. Themagnitude of the impact is also large. Controllingfor other relevant variables, almost 30 percent of the variation across countries in rates of povertyreduction can be attributed to cross-countryvariation in financial development (Beck, Demirgüç-Kunt, and Levine 2007).The benefits work not only through direct use of financial services, but through the indirect positiveeffects that financial development has on low-income population segments, especially throughlabor markets. For example, careful empirical studieshave shown that the deregulation of bank branchingcan not only intensify competition and improve bankperformance, it can also boost the incomes of thepoor, tightening income distribution by increasingrelative wage rates and working hours of unskilledworkers.
5
Financial development is therefore
A growing body of research suggests that whether broad-based access to formal financialservices promotes financial stability depends on how that access is managed withinthe regulatory and supervisory framework, especially in terms of financial integrity andconsumer protection. Four factors come into play:
financial inclusion
,
financial consumerprotection
,
financial integrity
, and
financial stability
. These factors are inter-related and,under the right conditions, positively related. Yet failings on one dimension are likely tolead to problems on others. This Brief explores what research to date shows about thelinkages and potential beneficial relationships among these factors, and it identifies gapsthat remain to be explored.
1 See World Bank (2008) for an overview.2 See Cull, Demirgüç-Kunt, and Morduch (2012), especially chapter 1, for discussion.3 See Levine (2005) and Demirgüç-Kunt and Levine (2008) for reviews of the literature on the causal effect of financial development on growth.4 See Clarke, Xu, and Zhou (2006); Li, Xu, and Zou (2000); and Li, Squire, and Zou (1998).5 For the United States, see Jayaratne and Strahan (1998) and Beck, Levine, and Levkov (2010).
May 2012
 
2
pro-poor not only in the sense that economicgrowth lifts households above the poverty line, butalso in a relative sense because it narrows incomedifferentials. Do narrower income differentialsand improved labor prospects for low-incomehouseholds contribute to a more cohesive, stablesociety and thus to market stability in the broadersense? Likely so, though that link could be exploredmore explicitly, as could the possible connection tofinancial system stability.
Which broad channels of financial inclusionpromote income equality and reduce poverty?
 While the challenges associated with measuringfinancial inclusion are now being better met, we stilllack clear understanding about the specific ways inwhich financial inclusion promotes income equalityand reduces poverty
6
—though recent user studies inindividual developing countries are beginning to offerimportant clues.
7
For example, field experimentsbased on randomized controlled trials are helpingto identify the causal pathways through which accessto formal financial services improves the lives of thepoor in developing countries, especially with respectto savings products.
8
Savings bolster stability at theindividual and household level and, given their verylarge numbers, small savers potentially contributeto stability at the financial system level—thoughstability effects of savings at both levels could beexplored in greater detail, especially at the level of the financial system.
What are the micro-level links among financialaccess, improved livelihoods, and financialstability?
If financial inclusion leads to a healthierhousehold and small business sector, it couldalso contribute to enhanced macroeconomic (andfinancial system) stability, though again we areunable to point to specific research that supportsthat conjecture at this point. Also more researchneeds to be done to identify the specific financialtools needed by the poor. The “wrong” financialtools—or irresponsibly delivered financial services—have been correlated with adverse effects, such aslower levels of educational attainment,
9
suggestingthe importance of effective consumer protectionin particular to ensure positive effects on microstability.Another link between inclusion and micro stabilityis through the entry, capitalization, and growth of new nonfinancial firms. At the firm level, the macro-level evidence shows that financial development isassociated with more efficient allocation of capital(Wurgler 2000). The entry rate of new firms and theirgrowth are also positively associated with financialdevelopment (Klapper, Laeven, and Rajan 2006),and the effects of relieving financial constraints areespecially strong for small firms’ growth rates (Beck,Demirgüç-Kunt, and Maksimovic 2005). Moreover,recent evidence, for example with respect to theportfolios of Chilean banks,
10
suggests that losseson small loans pose less systemic risk than thelarge, infrequent, but also less predictable, lossesassociated with large loans. Thus, greater financialinclusion in terms of access to credit might alsocoincide with greater stability at the level of providersof financial services.
What are the macro-level links between financialinclusion and financial stability, and what aboutfinancial exclusion?
At the country level, evidencesuggests that financial inclusion can lead to greaterefficiency of financial intermediation (e.g., viaintermediation of greater amounts of domestic savings,leading to the strengthening of sound domestic savingsand investment cycles and thereby greater stability)(Prasad 2010).
11
Greater diversification in clienteleserved associated with financial inclusion might also beexpected to lead to a more resilient and more stableeconomy. The reduction of income inequality throughfinancial development and inclusion could lead to
6 On improved measurement of financial inclusion, see Demirgüç-Kunt and Klapper (2012).7 On the effects of bank branch expansion, see Burgess and Pande (2005) for India and Bruhn and Love (2009, 2012) for Mexico.8 On the effects of commitment savings devices in Africa see Dupas and Robinson (2011) and Brune et al. (2011). See also Citi Foundation (2007).9 Zhan and Sherraden (2011) find that the accumulation of nonfinancial and financial assets by parents is generally associated with greatereducational attainment by children, but their unsecured debt is negatively related to children’s college completion.10 See Adasme, Majnoni, and Uribe (2006).11 We acknowledge that savings accumulation associated with greater financial inclusion does not always lead to more efficient intermediation.Whether it does so depends crucially on the quality of financial infrastructure, regulation, and supervision.
 
3
greater social and political stability, which in turn couldcontribute to greater financial system stability (thoughhere, too, the links merit further exploration).If financial inclusion can promote greater stability,could
financial exclusion
likely lead to greaterinstability? Evidence here is not well developed,but it is clear that financial exclusion imposes atthe very least large opportunity costs. Also, theevidence suggests that underdeveloped financialsystems have disproportionately negative effectson small firms and low-income households, whichin turn is likely to have adverse effects on societalcohesion. Moreover, the Financial Action Task Force(FATF) has recently explicitly acknowledged financialexclusion as an important risk in its efforts tocombat money-laundering and terrorist financing,
12
 underscoring the link between financial integrityand pro-stability financial inclusion. Additionally,in countries with high levels of financial exclusion,the informal financial services that households (andsmall firms) must rely on can be poor substitutes forformal services (Collins et al. 2009). In the extreme,informal services can themselves be a source of instability. For example, pyramid schemes organizedas informal savings and investment opportunitieshave been known to trigger both political andsocial unrest and lack of confidence in the bankingsystem.
13
Standard-setting bodies (SSBs) and the virtuouscircle linking financial inclusion, financial consumerprotection, financial integrity, and financial stability.
 Until recently, most of the relevant empirical researchand evidence on links between financial inclusion andfinancial stability has come from research institutions,and not from policy makers, regulators, supervisors,or global SSBs. Yet SSBs—and policy makers,regulators, and supervisors attempting to followthe SSBs’ standards and guidance while pursuinga financial inclusion agenda—are both among themost interested parties and also among the bestpositioned to contribute to articulating the researchquestions that will help SSBs consider financialinclusion in their work while remaining true to theircore mandates.In addition to FATF’s recent recognition that financialexclusion poses risks in combating money-launderingand terrorist financing, the soon-to-be-completedrevision of the Basel Core Principles (BCPs) hasoffered an opportunity for the Basel Committee onBanking Supervision (BCBS) to work the principleof proportionality (i.e., the balancing of risks andbenefits against costs of regulation and supervisionand allocating supervisory resources accordingly)into all the relevant BCPs, permitting considerationof (1) the changing risks and benefits of increasedfinancial inclusion, given the expanding and changingset of providers and products involved, and (2) theadaptability of BCBS standards and guidance towidely varying country contexts (especially withrespect to supervisory capacity). The recentlyrevised Insurance Core Principles of the InternationalAssociation of Insurance Supervisors offer a similaropportunity in the insurance realm. Finally, therecent financial crisis has further underscored theimportance of promoting consumer protection andfinancial literacy and capability, a role that is relevantfor multiple SSBs.
Evidence gaps and the road ahead.
Notwithstandingthe progress SSBs have made and the substantialvolume of empirical research reviewed above,important gaps remain, including the following:
•
How does financial inclusion contribute to politicaland social stability, and in turn to financial stability?What threats to financial stability flow from financialexclusion?
•
What specific contributions to making financialinclusion pro-stability do effective financialconsumer protection and financial integrity offer?How do we measure
responsible
financial inclusion(i.e., quality, not just quantity)?
•
What financial “tools” best suit the needs of excluded households? What consumer protectionand financial capability measures will ensureresponsible delivery?
•
What channels of financial inclusion work best topromote income equality and reduce poverty?
•
What specific impact can increased formal savingshave?
12 See FATF (2011).13 See CGAP (2011) for discussion.

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