MADDA WALABU UNIVERSITY

SCHOOL OF POSTGRADUATE PROGRAMME

DEPARTMENT OF ECONOMICS

COURSE TITLE: DEVELOPMENT ECONOMICS II

ARTICLE REVIEW ON: THE LINKAGE BETWEEN POVERTY, CREDIT
AND INSURANCE MARKETS IN DEVELOPING COUNTRIES
By:
i. Habte Yohannes (ID No: PGE/19669/12)
ii. Geda Wako (ID No: GE/19666/12) and
iii. Dini Dermo (ID No: PGE/19662/12)

Submitted to: Dejene Nigusie (Ph.D.)

February ,2021
SHASHEMENE, OROMIA.
Abstract
Developing countries are nations with low, lower middle, or middle incomes relative to
other countries. Common characteristics of developing countries are low levels of living
characterized by low income, inequality, poor health and inadequate education. Also,
they are countries with low Human Development Index.

Low levels of living are not only in relation to their counterparts in rich nations, but also
in relation to the small elite class within their own countries. These low levels of living
are manifested quantitatively and qualitatively

Economic development is believed to be the key to overcome these problems, and is seen
as the main objective of the world’s economies. It is a complex issue that can be defined
as improvement of welfare, and the focuses have developed as the views of development
have done so.

Numerous studies have considered linkage between financial development and economic
growth, including the direction of causality between the two. Accordingly, these studies
consider how financial development affects economic growth and then examine to what
extent growth reduces poverty. A common element of these studies is that they have
considered economy wide measures of financial development, such as money and quasi
money, market capitalization, or private credit in their empirical work. Such indicators
fail to capture how different institutions within the financial sector influence poverty.

Therefore, this paper reviews the theoretical literature on the linkage between Poverty,
credit and insurance markets in developing countries.

Keywords: Poverty, credit and insurance markets

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Contents
Abstract...............................................................................................................................II
Introduction.....................................................................................................................- 5 -
Background.....................................................................................................................- 5 -
Objectives of the paper...................................................................................................- 6 -
Specific Objectives.........................................................................................................- 6 -
Significance of the paper.................................................................................................- 6 -
Methodology...................................................................................................................- 6 -
1. Definitions of key words.........................................................................................- 6 -
Poverty........................................................................................................................- 6 -
Credit markets.............................................................................................................- 7 -
Private Credit markets.................................................................................................- 8 -
Insurance markets.......................................................................................................- 8 -
2. Linkage between poverty, credit and insurance markets in developing countries:. - 9 -
2.1. Conceptual and theoretical context......................................................................- 9 -
2.1.1. Poverty and credit markets...........................................................................- 9 -
2.1.2. Insurance market and poverty.....................................................................- 12 -
2.2. Reviews on Empirical basis...............................................................................- 15 -
2.2.1. Financial Sector Development, Growth and Poverty Reduction................- 15 -
3. Conclusion.............................................................................................................- 19 -
4. Recommendation...................................................................................................- 22 -
References.....................................................................................................................- 23 -
Introduction
Background
Developing nations feature great importance to financial sector development and
deepening in the pursuit of their poverty reduction goal. By mobilizing savings,
facilitating payments and trade of goods and services, introducing insurance markets and
promoting efficient allocation of resources, the financial sector is seen as playing a
critical role in facilitating economic growth and, directly through broadening access to
finance and indirectly through growth, contributing to poverty reduction. Supporting
financial sector development has also been a key priority of development assistance in
the past several decades. For example, the Asian Development Bank (ADB) provided
assistance (technical assistance, lending, equity investment, or credit guarantees) to the
financial sectors of its developing member countries amounting to over US$19 billion
since the 1970s. In its recently adopted Strategy 2020, ADB reaffirms financial sector
development as one of its core areas of operations in the next years in support of
inclusive and environmentally sustainable growth, regional integration, and poverty
eradication in Asia and the Pacific.

However, economists’ views on the role of financial sector in economic development

have not always been unanimous. In previous literatures, there were significant
disagreements on the finance-growth nexus. For instance, questions were often raised
over the nature of causality: whether financial sector development causes economic
growth or economic growth generates a need for financial sector development.

Economists have also debated on the nature of the growth-poverty nexus: whether and to
what extent economic growth leads to poverty reduction. Further, there were questions
over whether financial sector development can bring direct benefits to the poor. The last
2 decades, however, have seen the emergence of a consensus on the vital importance of
financial sector development in facilitating growth and supporting poverty reduction, and
this has been backed up by a large body of empirical studies providing evidence of the
causal linkages from financial sector development to economic growth and poverty
reduction.

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One of the important lessons learned from the recent global financial crisis and indeed
from many crisis episodes (in both developed and emerging markets) in the past is that
the financial sector needs to be adequately regulated and cannot be left entirely to the
hands of market forces. While the lessons learned from the recent crisis are likely to have
significant implications for economists’ thinking on how banks and financial institutions
should be regulated and financial innovations should be managed.

Objectives of the paper

The general objective of this study is to examine the linkage between poverty, credit and
insurance markets and their impact on economic growth in developing countries.

Specific Objectives

 To review empirical and theoretical investigations about the effect of financial

market (credit and insurance) on economic development.
 To examine the causalities between credit and insurance market in poverty
reduction.
Significance of the paper

The results of this paper will have a great importance to students, researchers and
financial analyst who have interest in understanding the importance of insurance and
credit market contribution and the extent of degree of the sector development on
economic growth and poverty reduction.

Methodology

For the purpose of this paper work, different accredited articles, books, working papers,
published and unpublished reports were collected and reviewed using detailed empirical
and theoretical review of related studies and findings.

1. Definitions of key words

Poverty
Poverty is a state or condition in which a person or community lacks the financial
resources and essentials for a minimum standard of living. Poverty means that the income
level from employment is so low that basic human needs can't be met. Poverty-stricken

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people and families might go without proper housing, clean water, healthy food, and
medical attention. Each nation may have its own threshold that determines how many of
its people are living in poverty.

Poverty has decreased in developed countries since the industrial revolution. Increased
production reduced the cost of goods, making them more affordable. Advancements in
agriculture increased crop yields as well as food production. Since the mid-1990s, there
are more than one billion fewer people in extreme poverty or less than $1.90 per day,
according to the World Bank. However, over half of the world's population in extreme
poverty live in the Sub-Saharan Africa region.

Credit markets
Credit market refers to the market through which companies and governments issue debt
to investors, such as investment-grade bonds, junk bonds, and short-term commercial
paper. Sometimes called the debt market, the credit market also includes debt offerings,
such as notes and securitized obligations, including collateralized debt obligations
(CDOs), mortgage-backed securities, and credit default swaps (CDS).

The credit market dwarfs the equity market in terms of dollar value. As such, the state of
the credit market acts as an indicator of the relative health of the markets and economy as
a whole. Some analysts refer to the credit market as the canary in the mine, because the
credit market typically shows signs of distress before the equity market.

The government is the largest issuer of debt, issuing Treasury bills, notes and bonds,
which have durations to maturity of anywhere from one month to 30 years. Corporations
also issue corporate bonds, which make up the second-largest portion of the credit
market.

Through corporate bonds, investors lend corporations money they can use to expand their
business. In return, the company pays the holder an interest fee and repays the principal
at the end of the term. Municipalities and government agencies may issue bonds. These
may help fund a city housing project, for example.

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 Private Credit markets
Private credit is an asset defined by non-bank lending where the debt is not issued or
traded on the public markets. Private credit can also be referred to as "direct lending" or
"private lending". It is a subset of "alternative credit".

More generally, Private credit refers to the extension of loans directly to firms by
nonbank actors. Typically, these are institutional investors, including insurance
companies, pension funds, hedge funds, foundations and endowments, sovereign wealth
funds, and other fund managers. In the asset management world, private credit is a
catchall label for a smorgasbord of investment strategies aimed at the debt component of
the capital structure of corporate borrowers. Thus, it includes all debt obligations in
various formats issued by firms in private markets (as opposed to public markets). Private
credit is an information-intensive area, and investors can gain access either directly if
they have the in-house skills, or more commonly, through asset managers.

Private credit investment strategies usually encompass a number of specialized strategies,

with products ranging from collateralized senior lending at one end of the scale to special
situations and distressed debt at the other end, and with a gamut of products such as
mezzanine loan funds, opportunistic credit funds, and collateralized loan obligations
(CLOs) in between.

Insurance markets
The insurance market is simply the "buying and selling of insurance." Consumers or
groups buy insurance for risk management from insurers offering coverage for specific
risks.

Individual consumers purchase insurance coverage to protect against risk. Common

insurance market products including homeowner's, auto, life and health insurance.
Monthly or annual premiums are paid to the insurer in exchange for a commitment of
coverage according to the policy.

On the other hand, Group insurance buyers are typically businesses or organizations that
buy group policies to cover all members of an organization. Some companies pay all

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premiums for employees while others pay partial premiums and employees cover the
remainder. Group members benefit from broader protection and more affordable rates,
and higher-risk members usually get coverage that otherwise might not be affordable or
available. Health insurance is a common example of a group product.

Premium costs are a primary driver of revenue for insurance providers. Insurers collect
monthly premiums from a large number of customers to help offset the cost of payouts on
insurance claims. Customers who rarely use their insurance benefits are profitable to
insurers and help cover the losses created by higher-risk customers.

A less obvious form of income derived by most insurance companies is investment

income. Insurance companies invest the revenue they receive from policy premiums in
order to increase profits and hedge against high payouts and claims. In essence, they
borrow your premiums to invest in exchange for the possibility of paying a significant
amount to you in claims.

2. Linkage between poverty, credit and insurance markets in developing

countries:

2.1. Conceptual and theoretical context

2.1.1. Poverty and credit markets

Many believe that financial sector development can directly contribute to poverty
reduction by providing or broadening the poor’s access to financial services. Many
economists are of the view that financial intermediary development will have a
disproportionately beneficial impact on the poor. This is because informational
asymmetries produce credit constraints that are particularly binding on the poor as they
do not have the resources to fund their own projects, nor the collateral to access bank
credit.

These credit constraints restrict the poor from exploiting investment opportunities, thus
slowing aggregate growth by keeping capital from flowing to its highest-value use. A
poorly functioning financial system will produce higher income inequality by

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disproportionately keeping capital from flowing to “wealth-deficient” entrepreneurs.
Financial sector development reduces information and transaction costs and, therefore, (i)
allows more entrepreneurs, especially those less well-off, to obtain external finance, (ii)
improves the allocation of capital, and (iii) exerts a particularly large impact on the poor.

Few economists argue that much would be gained by developing credit and finance
markets since an underdeveloped credit market contributes to continued poverty, higher
income inequality, and slower economic growth. Through better access to credit, the poor
are given the opportunity to participate in more productive endeavors, in turn increasing
their incomes. It has been argued that the most obvious hunting ground for poverty
reduction in less developed countries is the small and medium-sized enterprises (SMEs),
and the sizeable informal sector (household-based small businesses in rural or urban
areas, or the so-called microenterprises). SMEs are employment intensive, and job
creation is the most important pathway to poverty reduction. Thus, allowing greater credit
access by poor households has an especially important impact on poverty reduction.

Access to financial services also enables the poor to better respond to economic or health-
related shocks, reducing the likelihood of falling into poverty when such shocks occur.

There are, however, also skeptical views on whether financial sector development can
lead to a broadening of access to finance by the poor, especially at early stages.

Some argue that it is primarily the rich and politically connected who would benefit from
improvements in the financial system (Haber 2004). As such, greater financial
development may only succeed in channeling more capital to a select few. Hence, it is an
open question whether financial development will narrow or widen income disparities
even if it boosts aggregate growth. Some views support a nonlinear relationship between
finance and income distribution. Greenwood and Jovanovic (1990) show how the
interaction of financial and economic development can give rise to an inverted U-shaped
curve of income inequality and financial intermediary development. At early stages of
financial development, only a few relatively wealthy individuals have access to financial
markets and hence higher return projects. With aggregate economic growth, however,
more people can afford to join the formal financial system, with positive ramifications on

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economic growth. With sufficient economic success, everyone can participate in the
financial system and enjoy the full range of benefits.

That improvements in the financial system may not automatically lead to the poor having
greater access to finance provides justifications for public sector interventions in the
forms of various microfinance schemes and SME credit programs. Theoretically, there
are good reasons why the availability (and cost) of credit may be more adverse for
smaller enterprises and the informal sector. Fixed costs associated with loan appraisal,
supervision, and collection are non-trivial. From the perspective of a lender, it is
preferable to provide larger amounts of credit to a larger enterprise than small amounts of
credit to many smaller enterprises. SMEs and microenterprises are also less able to
provide collateral against their loans, further diminishing lenders’ incentives to lend to
them when considering adverse cost implications associated with possible loan defaults.
Because of these, in practice, governments of both developed and developing countries
often put in place policies that support various forms of MFIs and SME credit programs
to ensure that a widest possible segment of population have access to finance (ADB
2009). The most well-known example of MFIs is the Grameen Bank in Bangladesh
founded by Muhammad Yunus who was awarded the 2006 Nobel Peace Prize for his
contribution to microfinance.

Supporting microfinance schemes and SME credit programs has also been a key focus of
development assistance. Some of the conventional wisdom about the poverty reduction
potential through allowing greater access to finance by microenterprises and SMEs has
come under scrutiny recently. Some have questioned whether access to finance is the
only constraint that microenterprises and SMEs face and hence a panacea for poverty
reduction.

Other constraints and challenges faced by these enterprises often highlighted in the
literature include access to markets, access to know-how and technologies, and other
market failures. A United Nations (UN) report (1998) on the role of microcredit in the
eradication of poverty cites findings of some studies that point to limits to the use of
credit as an instrument for poverty eradication, including difficulties in identifying the

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poor and targeting credit to reach the poorest of the poor; the lack of business skills and
even the motivation for the poor to undertake economic activity; fragile or rudimentary
administrative structures leading to high transaction costs of many MFIs; and the fact that
in many cases, microcredit programs have been stand-alone operations rather than
accompanied by other support services, especially training, information, and access to
land and technology. A recent ADB study (2009) on SMEs argues that (i) access to
finance is often only one of the major constraints to growth of these enterprises, and other
constraints include weak access to new technologies and to dynamic markets; (ii) if
SMEs were to increase productivity and employment, they must innovate, including
adopting new technology and diversifying into new markets; and (iii) governments
should assist SMEs, and such assistance should include providing information services on
technology and markets, vocational training, and technical support services, and fostering
linkages between SMEs and large enterprises, in addition to facilitating access to finance,
that is, following an integrated approach.
2.1.2. Insurance market and poverty

Some economists argue that, the reduction in transaction costs as the main function of
financial intermediaries, have an advantage over direct financing in economics of scale
that result from costs shared. Moreover, a large amount of funds enables financial
intermediaries to be more easily divested than the individual economic units.

Others argued for the existence of financial intermediaries is information asymmetry.

Financial intermeddles are information collectors of borrowers’ financial prospects ex-
ante for solving the problem of adverse selection, it can signal their informal status by
investing their wealth in assets about which they have special knowledge.

Few economists, like Diamond (1984), suggest that financial intermediaries act as
delegated monitors to overcome ex-post asymmetric information between potential
lenders and a risk neutral entrepreneur who needs to raise capital for a risky project and
in that way reduce the problem of moral hazard.

The cause-and-effect relationship of insurance industry growth and economic growth has
been area of debate both in theoretical and empirical literature. One view is on the

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demand-leading and supply-following side the other view stands on the supply side;
Supply-leading and demand-following. Patrick (1966) follows an approach that places
emphasis on the demand side for financial services; as the economy grows it generates
additional and new demand for these services, which brings about a supply response, and
in the growth of the financial system.

As per Patrick (1966), the lack of financial institutions in underdeveloped countries is

simply an indication of the lack of demand for their services, this can be termed as
“demand -following” phenomenon in which the creation of modern institutions, their
financial assets and liabilities, and related financial services is in response to the demand
for these services by investors and savers in the real economy.

This shows that the development of financial system is a continuing result of the
opportunity of the economic environment and by changing the preferences of the
subjective responses such as individual motivation, attitudes, tests and preferences. He
further discussed that the more rapid the growth rate of real national income, the greater
will be the demand by enterprises for external funds (the saving of others) and therefore
financial intermediation, since under most circumstances firms will be less able to
finance expansion from internally generated depreciation allowances and retained profits,
this demand-following approach is that finance is essentially passive and permissive in
the growth process.

The basic functions of financial systems remain constant through time and across the
countries. There are large differences across countries and time, however, in the quality
of financial services and in the type of financial instruments, markets, and institutions
that arise to provide these services. Financial markets and institutions may arise to
ameliorate the problems created by information and transaction frictions. Different types
of combinations of information and transaction costs motivate distinct financial contracts,
markets and institutions. To organize the vast literature on financial and economic
activity, Levine (1997) breaks this primary function into five basic functions, specifically
financial systems: 1) facilitate the trading, hedging, diversifying, and pooling of risk, 2)
allocate resources 3) monitor managers and exert corporate control 4) Mobilize savings

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and 5) facilitate the exchange of goods and services. Levine (1997, p. 690-691)) further
explains how the particular market frictions motivate the emergence of financial markets
and intermediaries that provide these five functions, and explains how they affect
economic growth: capital accumulation and technological innovation.

Linking of financial intermediaries’ functions, and thereby functions of insurance sectors

too, and economic growth was enabled by the development of endogenous theory. This
can be more supported by Solow-swan model applying Cobb-Douglas production
function. The model shows three channels from financial development to economic
growth; the marginal productivity of capital, the proportion of saving funneled to
investment, and the saving rate.

The other view of the theory of the endogenous growth is Schumpeterian growth models
are focused on technological innovation as channel through which the growth could be
affected. Since the insurance sectors act as financial intermediaries, the same channels
connect their functions with economic growth.

Others explained further about the issues and stated that there are likely to be different
effects on economic growth from life and non –life insurance (property/liability)
give that these two types of insurance protect the households and corporations
from different type of risks that affect the economic activity in different ways and
also because life insurance companies facilitate long-term investments rather than short
term investments as it is the case of non- life insurance companies.

Insurance fosters investment and innovation by creating an environment of greater

security so as to economic growth. Availability of funds could result from creating,
pooling and transferring risk through developing kinds of insurance products by which
insurance companies provide protection from credit risk to other financial intermediaries
in that way financial intermediaries are more willing to lend funds for financing real
investments that encourage economic growth. The function of providing insurance
coverage could affect economic growth through saving rate channels in mixed way. By
offering life insurance products that combine risk protection and saving benefits,
insurance companies encourage long term savings and invest in corporate bonds, equities,

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stocks as well as in real estate’s this helps to resource accumulation and allocation
efficiently with managing various financial risks that affect positively on the economic
growth. Further insurance investment explains that insurance companies contribute
to more efficient and allocation of capital on the process of accumulation and allocation
of resources, insurance companies lower transaction costs, achieve diversification and
lower non-systematic risks provide limited liquidity and lower information
asymmetry, by which they contribute to economic growth through channels of marginal
productivity of capital, saving rate and technological innovations Curak, et al. (2009).

2.2. Reviews on Empirical basis

2.2.1. Financial Sector Development, Growth and Poverty Reduction

A substantial body of empirical work assesses whether financial sector development

facilitates economic growth and the magnitude of the impact; whether certain
components of the financial sector (such as banks or stock markets) play a particularly
important role in fostering growth at certain stages of economic development; and
whether and to what extent financial sector development directly benefits the poor. A
large body of literatures also investigates the extent to which economic growth leads to
poverty reduction.

Cross-country studies refer to those using data from several countries, either cross
sectional or a panel (cross-section and time-series analysis combined). Such studies
mostly apply multivariate regressions to investigate how a particular independent (or
explanatory) variable, such as the ratio of private credit to gross domestic product (GDP)
(commonly used as a measure of financial depth), affects the dependent variable, such as
real per capita GDP growth rate, while controlling for other variables (such as regulatory
standards, governance quality, or country-fixed effects) that may also affect the
dependent variable.

As noted by Levine (2004), one of the critical issues for many empirical studies on
finance-growth relationships pertains to the proxies for financial sector development.
While theory suggests that a financial system influences growth by easing information

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and transaction costs through a number of mechanisms, improving or enhancing the
acquisition of information about firms, corporate governance, risk management, resource
mobilization, and exchanges of goods and services, empirical measures of financial
development tend to focus on the depth of the financial sector, rather than directly on
these mechanisms. Honohan (2004a), for instance, points out the importance of legal
structures as well as regulatory and information infrastructures in determining the scale
and efficiency of finance, which should be reflected in the proxies used for financial
development in empirical analyses. Although a growing number of country-specific
studies have been developing financial development indicators more closely tied to
theory, more work is needed on improving cross-country indicators of financial
development (Levine 2004).

Moreover, Resource mobilization, allocation, maximization and capital accumulation by

the method of risk transfer and indemnification through the channel drives from the
function of insurance as the financial intermediary in the national economic growth. The
relationship between insurance development and economic growth is not a new
discovery. However, research debate continues today and marked with mixed results and
conflicting conclusions depends on countries, regions and different time periods. The
different is not due to the differences in theoretical perspectives but rather in Empirical
perspectives.

According to Haise and Sumegi (2008) further discussed and give emphasis on the main
objective of insurance companies is the transfer of risk and to be one of major investors
in the economy, and increasingly so: aggregate investment by insurance companies grew
by 20% relative to GDP in Europe within the time span 1993-2004 while investment by
life insurance companies nearly doubled over the same period. Among the main
recipients of households’ financial asset’s, institutional investors are insurance companies
and pension funds. Life insurers sell traditional life assurance, annuities and disability
insurance contracts while property causality insurers sell insurers contracts that
indemnify the policy holders for property and liability losses. In both cases, the insurer
collects premiums from consumers when selling contracts, and invests the proceeds with
a view to meeting the contractual incurred. For long term institutional investors, liability

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structures are key factors influencing asset allocation decisions. Asset held by a company
usually reflects the maturity of its liability at the same time; the growth of institutional
investors may be accompanied by an increase in the overall level of savings.

Some other economists, attempts to verify whether the insurance-growth market is linked
to economic growth using a cross-country panel data set for the 10 Post-transition
countries over the period 2000-2013 period, applying a fixed effect model to test the
hypothesis that this linkage is demonstrably positive, multiple regression analysis is used
to estimate the insurance-growth relationship.

Haiss and Sumegi (2006) investigate the link between insurance sector development and
economic growth; by adopt endogenous growth model with a modified Cobb-Douglas
production function which is vary from the standard approach (OLS regression or
Granger causality test and mainly test for the determinants of insurance demand) and
adopted a framework mainly used in other financial-growth nexus analysis.

Webb, et al. (2002) uses Solow-Swan model to analyses the roles of Banking and
Insurance to economic growth by facilitating the efficient allocation of capital by apply a
cross-country of 55 countries for the 1980-1996 period, after controlling the exogenous
components, they find that the exogenous variables of banking and life insurance
penetration are robustly predictive of increased productivity across the sampled countries
this leads that the higher level of banking and insurance jointly produce a greater effect
on growth than would be indicated by the sum of their individual contributions.

In relation to developing countries the empirical evidences approach the suggestion as

well by explaining the impact of financial sector development in economic growth and
poverty reduction.

Overwhelming evidence suggests that the depth of the financial sector has a positive and
statistically significant effect on economic growth. The majority of empirical studies
support a positive contribution of financial sector development (measured by financial
depth) to economic growth, even though some studies do not find a strong relationship
(e.g., Favara 2003). Building on a seminal work undertaken by Goldsmith (1969), and

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using data for 80 countries over 1960−1989, King and Levine (1993a, 1993b) empirically
show that the level of financial development measured by various indicators is positively
and strongly associated with economic growth. It is found that increasing the financial
depth (measured by the ratio of liquid liabilities to GDP) from the mean of the slowest
growing quartile of countries to the mean of the fastest growing quartile of countries
would increase a country’s per capita income growth rate by almost one percentage point
per year. Given that the difference in average annual growth rate between these two sets
of countries is about 5 percentage points over this 30-year period, differences in the depth
of the financial sector alone explain about 20% of the growth difference. In addition, the
results suggest that the level of financial depth in 1960 is a good predictor of subsequent
rates of economic growth, capital accumulation, and productivity growth over the next 30
years, even after controlling for income level, education, and measures of monetary,
trade, and fiscal policies (King and Levine 1993a, 1993b).

While the work by King and Levine (1993a, 1993b) is among the earlier studies to
highlight the role of financial sector development in economic growth, one of the
weaknesses of their analysis is that they do not take into account possible reverse
causality. The financial sector-growth relationship found in their study might not
necessarily imply that financial sector development promotes economic growth, but
rather economic growth leads to financial sector development by increasing demand for
financial services which, in turn, induces an expansion of the financial sector. To control
for possible simultaneity bias in the estimation, researchers often use instrumental
variable estimation methods. One of the key challenges associated with this methodology
is to find valid instrumental variables that explain cross-country differences in financial
development, but that are uncorrelated with economic growth beyond their link with
financial development.

The positive effect of financial sector deepening on economic growth appears to be

greater for developing countries than for developed countries (e.g., Calderon and Liu
2003,9 Jalilian and Kirkpatrick 2005, Kumbhakar and Mavrotas 2008, Mavrotas and Son
2006).10 For example, based on various instrument variable estimators using data for 65
countries over 1960 to 1999, Mavrotas and Son (2006) find that the magnitude of the

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positive impact of financial sector development on economic growth varies, depending
on the level of development (industrial vis-à-vis developing countries). The estimation
results show that the effect of financial sector development in developing countries is
more persistent and larger than those in developed countries.

3. Conclusion

This paper reviewed theoretical and empirical literature on the role of the financial sector
in facilitating economic growth and supporting poverty reduction. The review leads to the
following conclusions.

o There is now a consensus that financial sector development plays a vital role in
facilitating economic growth. A sound financial system supports growth through
mobilizing and pooling savings; producing information ex ante about possible
investments and allocating capital; monitoring investments and exerting corporate
governance; facilitating the trading, diversification, and management of risks; and
facilitating the exchange of goods and services. This consensus is supported by a
large body of empirical evidence generated from cross-country and country-
specific studies—although there are methodological problems associated with
many empirical studies, still and all, the evidence is overwhelming. The empirical
studies also find that: (i) the effects of financial sector development on growth in
developing countries are more persistent and larger than those in developed
countries; (ii) industries composed of smaller firms grow faster in countries with a
better-developed financial sector, suggesting that financial development is
particularly important for the growth of industries that are naturally composed of
small firms; and (iii) more financially developed countries are better able to avoid
currency crises.

o There is also a consensus that financial sector development contributes to poverty

reduction, and a major channel is through economic growth. Higher growth
benefits the poor by creating more jobs, enabling the government to allocate more
fiscal resources on social spending; and increasing funds available to the poor for
investment. Cross-country empirical estimates show that the impact of growth on

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 poverty depends on a country’s level of inequality: one percentage point of
growth is likely to lead to a reduction in poverty. These suggest that the
imperative of growth for combating poverty should not be interpreted to mean
that “growth is all that matters”. Growth has to be inclusive, and this requires
reducing inequalities that limit the prospect for the poor to participate in the
opportunities unleashed by growth.

o It is widely agreed that financial sector development also directly supports

poverty reduction by broadening the access to finance of the poor and vulnerable
groups. Finance facilitates transactions; reduces the costs of remitting funds;
provides the opportunity to accumulate assets and smoothen consumption; and
enables poor households to better cope with shocks, thus mitigating the risk of
falling into poverty. Cross-country empirical evidence shows a robust effect of
financial depth on headcount poverty incidence: This is robust to controlling for
the average rate of economic growth, suggesting that financial development
alleviates poverty beyond its effect on aggregate growth. There is also empirical
evidence showing that financial sector development supports the achievement of
the MDG targets by reducing income and gender inequalities and improving
education and health services.

o While the role of financial sector development in facilitating growth and

supporting poverty reduction is largely accepted, there are disagreements over the
relative importance of banks and capital markets in financial sector development
in low-income countries and, in developing the banking sector, the relative
importance of large and small banks. Empirical studies on how the financial
structure is related to a country’s ability to grow, how to sequence financial sector
development in developing countries, and relative importance and/or priorities of
large domestic banks, small local banks, and capital markets are still sparse. This
is an area for more research.

o Microfinance and SME credit programs are considered as effective instruments to

improve poor households’ economic and social welfare and reduce poverty,

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 largely based on earlier case studies. Some of the earlier studies, often using a
non-experimental approach, have been criticized recently on the ground of
methodological weaknesses. A number of more recent studies using the
experimental approach have produced mixed results on the effectiveness of
microfinance programs in poverty reduction. Some have questioned whether
access to finance is the only constraint that microenterprises and SMEs face.
Other constraints faced by these enterprises that are often highlighted in the
literature include access to information and markets; access to skills, technologies,
and land; and other market failures. It is widely believed that to make
microfinance and SME credit programs work better, these nonfinancial
constraints also need to be addressed by the government. It has also been argued
that for microfinance to benefit the ultra-poor, programs should be well targeted
and designed, and should be supplemented with training, social empowerment
programs, and other safety net measures—that is, following an integrated
approach. This is another area for more research.

o Case studies designed to evaluate the effectiveness of development assistance to

the financial sector in developing countries find that in general, such assistance
has been effective in supporting the development of financial regulatory
frameworks and market infrastructures, developing missing or incomplete
markets, and contributing to financial deepening and funding source
diversification, and that many development assistance projects have had
significant catalytic and demonstration effects. Development assistance involving
microcredit programs has often been found to have real development impact and
contribute to poverty reduction by broadening the access to, and reducing the cost
of, finance for SMEs and poor households, especially when the programs are well
targeted and designed.

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 4. Recommendation

To conclude with a recommendation, the vital role of financial sector development in

supporting poverty reduction—directly through broadening the access of the poor to
financial services and indirectly through promoting economic growth—provides a strong
justification for development assistance to target the financial sector as a core area of
intervention. How should such assistance be designed and provided?

o As a general principle, like any public sector intervention, development assistance

to the financial sector should be designed to address market and nonmarket
failures that impede financial sector development.

o Hence there is a need for more efforts to increase transparency and efficiency in
insurance industry through legislation and risk management product innovations
and education in insurance industry.

o Having well developed insurance sector must be one of the crucial primary targets
of policy makers and the Government; it requires financial developmental
strategic focus. This can lead the sector ultimately to occupy its right place in
economics development system in the country. This outcome can be achieved by
providing conducive and competitive environment like adequate investment on
the area of R&D, developing saving and investment element of products, such as
compulsory group life products for communities (professionals, academicians &
students), private, and public & government employees tax incentive for life
premium paid by policy holder. Compulsory market integration within the
financial institutions also very important to promote saving rates through effective
risk management like Banc-assurance and credit life related with real estate and
mortgages loans. Since, the higher levels of banking and insurance jointly
produce greater effect on economic development than would be indicated by the
sum of their individual contribution.

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