Financial Inclusion and Stability: A Balancing Act

In emerging markets and developing economies (EMDE), policymakers face the challenge of advancing financial inclusion while also maintaining financial stability. Financial inclusion plays a critical role in enabling broader development outcomes, helping people prosper and cope with various shocks by harnessing economic opportunities, and building resilience. At the same time, financial stability is essential in fostering a resilient economic environment that can absorb shocks, sustain growth, preserve consumer confidence, and provide a foundation for long-term development. 

While financial inclusion and stability are policy objectives that often reinforce each other, they can also present trade-offs. For example, in Kenya the advent of mobile money services like M-Pesa not only provided widespread access to financial services, leading to poverty reduction and economic growth, but it also bolstered the stability and resilience of the financial system by reducing reliance on cash, stabilizing income flows for households through remittances and integrating mobile money into the broader financial system. In a contrasting example, expanded access to credit through microfinance in India, often without adequate risk assessments, led to over-indebtedness among borrowers, high levels of non-performing loans, and financial instability, leading to the Andhra Pradesh crisis of 2010. 

Understanding the relationship between financial inclusion and stability is imperative for policymakers to advance both these goals in ways that maximize synergies and mitigate trade-offs, and to respond to shocks that threaten financial stability in ways that protect inclusion.  To that end, we re-examined this relationship using more recent data and improved indicators – our findings show that more robust evidence and more comprehensive data collection on this relationship are needed to inform policy response in EMDEs.

Theory suggests a complex relationship involving both synergies and trade-offs  

Existing literature on the link between financial inclusion and stability is limited and alludes to complex dynamics. Increased financial inclusion brings more participants into the financial system as both savers and borrowers. This helps diversify lenders’ asset portfolios, lowers their overall risk, and provides them with a more diversified and less volatile deposit base. It also improves the ability of households to manage risks and cope with shocks and limits the presence of a large informal sector. 

On the other hand, increased financial inclusion, especially increased access to credit without proper supervision, can introduce risks in the financial system. These risks emerge from the high transaction costs involved in serving low-income consumers and the information asymmetry they face, insufficient regulation and governance, and geographic concentration of providers serving them. The current view is that these risks are institutional, not systemic and that they can be managed with existing policy tools like prudential regulation, market supervision, and consumer protection. However, the rapid digitization and proliferation of new tech-enabled business models is exacerbating these risks, and challenging the adequacy of available policy tools, posing potential threats to stability. 

Empirical evidence is scarce and offers inconclusive results 

Few studies empirically examine the synergies and trade-offs described above, and available evidence offers mixed and inconclusive results. CGAP and IFC’s earlier analysis found no statistically significant relationship between financial access as measured by deposit account penetration and financial stability indicators developed by the IMF and the World Bank. World Bank Analysis of the IMF’s Financial Access Survey (FAS) data finds that financial access (measured by the number of accounts per 1,000 adults at commercial banks) and financial stability (measured by bank Z-score or the probability of default) are poorly correlated overall, however, the correlation is stronger and negative in low- and lower-middle income countries, where access gaps are larger. 

Analysis of FAS data also finds that an increase in loan penetration increases non-performing loans and raises risk premiums in the market, showing a negative correlation between financial access and stability. More recent work finds that while on average there is a negative correlation or a trade-off between financial inclusion and stability, there is a lot of variation in the data across countries, depending on which indicators are used to measure inclusion and stability, and country context. This implies that there are as many odds for synergies as there are for trade-offs. 

CGAP’s preliminary analysis with limited data finds synergies, not trade-offs 

CGAP revisited this debate with a preliminary analysis using panel data from the World Bank’s Global Financial Development Database (GFDD) and the IMF’s FAS, for 30 countries from 2004-2022. Our analysis introduces two significant changes compared to previous studies. 

First, we constructed a comprehensive Financial Inclusion Index (FII) incorporating several dimensions of inclusion like access, availability, and use through measures of bank penetration, account ownership, credit and deposits as a share of GDP, and level of financial development. 

Second, we used a multidimensional measure of financial stability incorporating both institutional (balance sheet level) and macroeconomic measures such as Z-score index, capital, and non-performing loans to assets, return on equity, and inflation, exchange rate, inflation, current account balance and bank concentration, etc. Our Aggregate Macro-Financial Stability Index (AFSI) aggregated more than 17 sub-indices related to financial soundness and stability into a single score.

We reported AFSI data for country income groups, classified as low-income (LIC), middle-income (MIC), and high-income countries (HIC), and found that average financial stability increases with income levels, in line with the prevailing view that more advanced economies have superior regulatory frameworks, robust institutions, and more diversified economies. 

Overall, our analysis suggests that when examined using more comprehensive indicators, there could be synergies between financial inclusion and financial stability.

Controlling for other factors, we found that financial inclusion is positively correlated with financial stability.  The correlation is weaker but more robust for lower- and upper-middle-income countries, likely because they are at levels of inclusion where even a small increase significantly impacts stability through a broader customer base and diversified portfolios, lowering the effects of individual defaults. However, the overall financial system is still developing, causing the absolute strength of the correlation to be weaker. On the contrary, for high-income countries, the correlation is stronger, but less significant, possibly due to high levels of inclusion already in place. This mutes the additional impact on stability, but the correlation is stronger due to mature financial systems and regulatory frameworks. 

We also find bolstering financial stability could increase inclusion, supporting the idea of synergies rather than trade-offs.

We also tested the reciprocal relationship, measuring the effect of financial stability on inclusion using these same indicators. Controlling for other factors, we found positive and robust correlation in lower- and upper-middle-income countries, but not in high-income countries. It stands to reason, then, that improvements in financial stability build confidence in the financial system and expand access to financial services in middle-income countries, but in high-income countries, where financial systems are already stable and financial access is widespread, the additional impact of stability on inclusion is muted.  

Vast and consequential data gaps prevent more detailed analysis

Annual data for low-income countries is virtually missing or of poor quality for both financial stability and inclusion in traditional sources of data like the Financial Access Survey (IMF) or the Global Financial Development Database (World Bank). Recent data sources like the Global Findex provide important demand-side data on access and use, but their frequency is low, and the data series do not go back far enough in time. Consequently, low-income countries are dropped entirely from all existing analyses, including CGAP’s. 

We also attempted to construct inclusion and stability indicators for low-income financial markets and analyzed available data for the microfinance sector. While we could construct some proxy indicators for inclusion such as gross loan portfolios and number of active borrowers, there is not enough data to develop indicators for stability. Moreover, the overall availability and reliability of data over time is low across countries, constraining analysis. 

Data gaps also hinder analytical efforts using advanced tools like machine learning and microsimulation modeling. Despite initial aspirations to develop an AI model that would analyze global inclusion and stability-related data, how that data influences policy interventions, and eventually inform future policy responses to shocks, our efforts remain stymied. Where there is no data, even AI is helpless. 

CGAP’s quest to promote inclusion-conscious crisis policy response

So where does all this leave policymakers in EMDEs? First, there is little robust empirical evidence for the relationship between financial inclusion and stability to inform their choice of policy response to mitigate trade-offs and respond to shocks. Second, there is a need for improved and more comprehensive data collection on financial inclusion and stability indicators, especially in low-income countries, and for the microfinance sector. In the absence of more comprehensive data, there is a need to explore whether synthetic data and advanced analytical tools can provide heuristics to guide policymakers. CGAP will investigate this further through the lens of specific shocks like stability crises to better understand the stability inclusion dynamics and how they can help shape inclusion-conscious crisis policy response. 

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