71305 BRIEF Financial Inclusion and Stability: What Does Research Show? 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. Focus to date: linkages among financial periods. 3 Multiple studies have documented a development and economic growth, reduction of robust negative relationship at the country level income inequality, and poverty alleviation. There is between indicators of financial depth and the limited empirical work exploring the specific linkages level of income inequality as measured by the Gini between financial inclusion and financial stability. coefficient.4 Financial depth is also associated with Studies have focused largely on the impact of financial increases in the income share of the lowest income development on growth, income inequality, and quintile across countries from 1960 to 2005 (Beck, poverty reduction. The evidence strongly indicates Demirgüç-Kunt, and Levine 2007). It comes as little that, when effectively regulated and supervised, surprise, therefore, that countries with higher levels financial development spurs economic growth, of financial development also experienced swifter reduces income inequality, and helps lift households reductions in the share of the population living on out of poverty.1 less than $1 per day in the 1980s and 1990s. The magnitude of the impact is also large. Controlling Most cross-country evidence relates to the benefits for other relevant variables, almost 30 percent of of financial depth rather than to broad financial the variation across countries in rates of poverty inclusion. Deep financial sectors are not necessarily reduction can be attributed to cross-country inclusive ones, if financial access is tilted heavily variation in financial development (Beck, Demirgüç- toward the wealthy. Our lack of knowledge about Kunt, and Levine 2007). the macro-level effects of financial inclusion stems, in part, from the challenges associated with measuring The benefits work not only through direct use of it on a consistent basis both across countries and over financial services, but through the indirect positive time based on surveys of users and potential users effects that financial development has on low- of those services.2 In contrast, the effects of financial income population segments, especially through depth have been studied extensively precisely labor markets. For example, careful empirical studies because data from suppliers of financial services are have shown that the deregulation of bank branching readily available. can not only intensify competition and improve bank performance, it can also boost the incomes of the Macroeconomic evidence indicates that well- poor, tightening income distribution by increasing developed financial systems have a strong positive relative wage rates and working hours of unskilled impact on economic growth over long time workers. 5 Financial development is therefore 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). May 2012 5 For the United States, see Jayaratne and Strahan (1998) and Beck, Levine, and Levkov (2010). 2 pro-poor not only in the sense that economic tools needed by the poor. The “wrong� financial growth lifts households above the poverty line, but tools—or irresponsibly delivered financial services— also in a relative sense because it narrows income have been correlated with adverse effects, such as differentials. Do narrower income differentials lower levels of educational attainment,9 suggesting and improved labor prospects for low-income the importance of effective consumer protection households contribute to a more cohesive, stable in particular to ensure positive effects on micro society and thus to market stability in the broader stability. sense? Likely so, though that link could be explored more explicitly, as could the possible connection to Another link between inclusion and micro stability financial system stability. is through the entry, capitalization, and growth of new nonfinancial firms. At the firm level, the macro- Which broad channels of financial inclusion level evidence shows that financial development is promote income equality and reduce poverty? associated with more efficient allocation of capital While the challenges associated with measuring (Wurgler 2000). The entry rate of new firms and their financial inclusion are now being better met, we still growth are also positively associated with financial lack clear understanding about the specific ways in development (Klapper, Laeven, and Rajan 2006), which financial inclusion promotes income equality and the effects of relieving financial constraints are and reduces poverty6—though recent user studies in especially strong for small firms’ growth rates (Beck, individual developing countries are beginning to offer Demirgüç-Kunt, and Maksimovic 2005). Moreover, important clues.7 For example, field experiments recent evidence, for example with respect to the based on randomized controlled trials are helping portfolios of Chilean banks,10 suggests that losses to identify the causal pathways through which access on small loans pose less systemic risk than the to formal financial services improves the lives of the large, infrequent, but also less predictable, losses poor in developing countries, especially with respect associated with large loans. Thus, greater financial 8 to savings products. Savings bolster stability at the inclusion in terms of access to credit might also individual and household level and, given their very coincide with greater stability at the level of providers large numbers, small savers potentially contribute of financial services. to stability at the financial system level—though stability effects of savings at both levels could be What are the macro-level links between financial explored in greater detail, especially at the level of inclusion and financial stability, and what about the financial system. financial exclusion? At the country level, evidence suggests that financial inclusion can lead to greater What are the micro-level links among financial efficiency of financial intermediation (e.g., via access, improved livelihoods, and financial intermediation of greater amounts of domestic savings, stability? If financial inclusion leads to a healthier leading to the strengthening of sound domestic savings household and small business sector, it could and investment cycles and thereby greater stability) also contribute to enhanced macroeconomic (and (Prasad 2010).11 Greater diversification in clientele financial system) stability, though again we are served associated with financial inclusion might also be unable to point to specific research that supports expected to lead to a more resilient and more stable that conjecture at this point. Also more research economy. The reduction of income inequality through needs to be done to identify the specific financial financial 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 greater educational 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 could In addition to FATF’s recent recognition that financial contribute to greater financial system stability (though exclusion poses risks in combating money-laundering here, too, the links merit further exploration). and terrorist financing, the soon-to-be-completed revision of the Basel Core Principles (BCPs) has If financial inclusion can promote greater stability, offered an opportunity for the Basel Committee on could financial exclusion likely lead to greater Banking Supervision (BCBS) to work the principle instability? Evidence here is not well developed, of proportionality (i.e., the balancing of risks and but it is clear that financial exclusion imposes at benefits against costs of regulation and supervision the very least large opportunity costs. Also, the and allocating supervisory resources accordingly) evidence suggests that underdeveloped financial into all the relevant BCPs, permitting consideration systems have disproportionately negative effects of (1) the changing risks and benefits of increased on small firms and low-income households, which financial inclusion, given the expanding and changing in turn is likely to have adverse effects on societal set of providers and products involved, and (2) the cohesion. Moreover, the Financial Action Task Force adaptability of BCBS standards and guidance to (FATF) has recently explicitly acknowledged financial widely varying country contexts (especially with exclusion as an important risk in its efforts to respect to supervisory capacity). The recently 12 combat money-laundering and terrorist financing, revised Insurance Core Principles of the International underscoring the link between financial integrity Association of Insurance Supervisors offer a similar and pro-stability financial inclusion. Additionally, opportunity in the insurance realm. Finally, the in countries with high levels of financial exclusion, recent financial crisis has further underscored the the informal financial services that households (and importance of promoting consumer protection and small firms) must rely on can be poor substitutes for financial literacy and capability, a role that is relevant formal services (Collins et al. 2009). In the extreme, for multiple SSBs. informal services can themselves be a source of instability. For example, pyramid schemes organized Evidence gaps and the road ahead. Notwithstanding as informal savings and investment opportunities the progress SSBs have made and the substantial have been known to trigger both political and volume of empirical research reviewed above, social unrest and lack of confidence in the banking important gaps remain, including the following: 13 system. • How does financial inclusion contribute to political Standard-setting bodies (SSBs) and the virtuous and social stability, and in turn to financial stability? circle linking financial inclusion, financial consumer What threats to financial stability flow from financial protection, financial integrity, and financial stability. exclusion? Until recently, most of the relevant empirical research • What specific contributions to making financial and evidence on links between financial inclusion and inclusion pro-stability do effective financial financial stability has come from research institutions, consumer protection and financial integrity offer? and not from policy makers, regulators, supervisors, How do we measure responsible financial inclusion or global SSBs. Yet SSBs—and policy makers, (i.e., quality, not just quantity)? regulators, and supervisors attempting to follow • What financial “tools� best suit the needs of the SSBs’ standards and guidance while pursuing excluded households? What consumer protection a financial inclusion agenda—are both among the and financial capability measures will ensure most interested parties and also among the best responsible delivery? positioned to contribute to articulating the research • What channels of financial inclusion work best to questions that will help SSBs consider financial promote income equality and reduce poverty? inclusion in their work while remaining true to their • What specific impact can increased formal savings core mandates. have? 12 See FATF (2011). 13 See CGAP (2011) for discussion. Demirgüç-Kunt, Aslı, and Ross Levine. 2008. “Finance, Bibliography Financial Sector Policies, and Long Run Growth.� M. Spence Growth Commission Background Paper, No. Adasme, Osvaldo, Giovanni Majnoni, and Myriam Uribe. 11. Washington, D.C.: World Bank. May 2012 2006. “Access and Risk: Friends or Foes? Lessons from Dupas, Pascaline, and Jonathan Robinson. 2011. “Savings Chile.� World Bank Policy Research Working Paper 4003. 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Acknowledgments and Timothy Lyman, senior policy adviser, Government and Policy, CGAP. The authors express their gratitude The authors of this Brief are Robert Cull, lead economist, to H.R.H. Princess Máxima of the Netherlands, the UN Finance and Private Sector Development, Development Secretary General’s Special Advocate for Inclusive Finance Economics Research Group, World Bank; Aslı Demirgüç- for Development and Honorary Patron of the G-20 Global Kunt, director, Development Policy, Development Partnership for Financial Inclusion, for suggesting this Economics Vice-Presidency and Chief Economist, Finance literature review, and to Kathryn Imboden and Kate Lauer and Private Sector Development Network, World Bank; for their review of the manuscript. AUTHORS: Robert Cull, Aslı Demirgüç-Kunt, and Timothy Lyman