The Role of Financial Inclusion and Financial Deepening


By Rachit Khaitan, IFMR Finance Foundation

Financial inclusion and financial deepening have an important role to play in promoting economic growth and reducing poverty and inequality, while mitigating systemic risk and maintaining financial stability. Through a survey of the existing landscape of literature, this post highlights some of these linkages and their mechanisms.

Economic Growth

A growing body of empirical research produces a remarkably consistent narrative that the services provided by the financial system exert a first-order impact on long-run economic growth. Building on the foundations laid by Walter Bagehot in the late 19th century1 and Joseph Schumpeter in the early 20th century2, among others3 4, recent research has produced a key result that countries with better-developed financial systems tend to grow faster.

Finance has a well-established “supply-leading” character i.e. the level of financial development and stock market liquidity each exerts an independent, positive influence on economic growth5. Financial services and financial development (as measured by the size of the intermediary sector) stimulates economic growth by increasing the rate of capital accumulation and by improving the efficiency with which economies use that capital in the current period as well as in the future6. The relative importance of improved efficiency of investments is higher in low- and middle-income countries than in high-income countries7. Financial deepening, as a measure of financial development, contributes more to the causal relationship of economic growth in developing countries than in industrial countries, especially to total factor productivity (TFP) growth8. Furthermore, a greater ability to trade ownership of an economy’s productive technologies (through a liquid stock market) facilitates efficient resource allocation, physical capital formation, and faster economic growth9.

At the industry level, better-developed financial systems ameliorate market frictions that make it difficult for firms to obtain external finance. Financial development may also play a beneficial role in the rise of new firms, which as the disproportionate source of ideas, can enhance innovation, and thus enhance growth in indirect ways10. Countries with high turnover and high bank assets/GDP have a larger proportion of firms growing at a level that requires access to external sources of long-term capital11.

Local financial development enhances the probability that an individual starts a business, increases industrial competition, and promotes growth of firms12. The relaxation of bank branch restrictions boosts bank-lending quality and accelerates real per capita growth rates13. For a household, financial development offers better and cheaper services for saving money and making payments, by allowing firms and households to avoid the cost of barter or cash transactions, cutting remittance costs, and providing the opportunity for asset accumulation and consumption smoothing14.

Poverty and Inequality

Financial development not only promotes economic growth but can also help divide it more evenly. Certain forms of financial development, particularly those that broaden access to finance, can benefit the poor disproportionately by increasing capital flow and increasing efficiency of capital allocation thereby reducing inequality15 16. By targeting financial market imperfections such as asymmetric information and costs associated with transactions and contract enforcement and creating enabling conditions for financial markets and instruments to develop, governments can not only spur growth and also help to ensure it is distributed more evenly17. Better access to credit by the poor enables them to pull themselves out of poverty by investing in their human capital and microenterprises, thus reducing aggregate poverty18 19 20. Financial depth has a significant impact on poverty reduction through channels such as entrepreneurship and the inter-state migration of workers towards financially more developed states21.

Financial liberalisation can affect the reduction of inequality through indirect channels such as higher labour demand and higher wages for lower income groups22. Bank deregulation, in the form of removal of branching restrictions, tightens the distribution of income by disproportionately raising incomes in the lower half of the income distribution23. Branch expansion into rural unbanked locations can significantly reduce poverty, mediated by increased deposit mobilisation and credit disbursement by banks in rural areas24. Bank branch expansion can also alleviate poverty by decreasing unemployment and enabling existing business owners to continue their operations rather than becoming wage earners or unemployed25.

Systemic Risk and Financial Stability

Promoting financial stability and mitigating systemic risk depends on how broad based the access to financial services is, and how it is managed within the regulatory and supervisory framework, especially in terms of financial integrity and consumer protection26. Greater financial inclusion, by providing individuals, households, and small firms with greater access to financial risk-managing tools can enhance resilience and stability of the real economy and thus also the financial system that serves it27. Greater access to bank deposits can make the deposit funding base of banks more resilient in times of financial stress28.

Monetary policy most efficiently exerts a systematic influence on the economy in the forward-looking sense through interest rate and credit channels, underscoring the vitality of financial inclusion (i.e. participation in credit markets) in mitigating systemic risk29 30. Financial inclusion can also lead to greater efficiency of financial intermediation (e.g. via intermediation of greater amounts of domestic savings and investment cycles) and thereby greater stability)31. The diversified funding base of financial institutions has played a role in cushioning the impact of a global credit (wholesale funding) crunch on domestic financial intermediation32.

On the other hand, “easy credit” policies could prove to be a costly way of redistribution and create a fault line along the financial sector where enormous stresses could build up and lead to an instability in the financial system33. The 2007 subprime lending crisis in the US exemplified the “race to the bottom” in mortgage finance in the US, when underwriting quality deteriorated across the board, setting up the stage for an unprecedented housing boom and subsequent crash. In other extreme cases, informal services (such as pyramid schemes and unorganised chit funds) can increase people’s risk exposure to shocks and be a source of instability themselves, as was demonstrated by the recent Saradha episode34 35.

The role of financial services is to help customers maximise the benefit from the human and other resources they possess while minimising the impacts of adverse shocks on their lives. Financial products do this by a crucial interaction with the “natural” financial flows of the household36. The “wrong” financial tools – or irresponsibly delivered financial services – can have adverse effects, suggesting the importance of effective consumer protection in particular to ensure positive effects on micro stability37.

  1. Bagehot, W. (1873). Lombard Street, 1962 ed. Irwin, Homewood, IL.
  2. Schumpeter, J.A. (1912). Theorie der wirtschaftlichen Entwicklung. Dunker & Humblot, Leipzig. The Theory of Economic Development translated by R. Opie. Harvard University Press, Cambridge, MA, 1934.
  3. Gurley, John G., and Edward S. Shaw. “Financial aspects of economic development.” The American Economic Review (1955): 515-538.
  4. Goldsmith, R.W. (1969). Financial Structure and Development. Yale University Press, New Haven, CT.
  5. McKinnon, R.I. (1973). Money and Capital in Economic Development. Brookings Institution, Washington, DC.
  6. King, R.G., Levine, R. (1993). “Finance and growth: Schumpeter might be right”. Quarterly Journal of Economics 108, 717–738.
  7. De Gregorio, J., & Guidotti, P. E. (1995). Financial development and economic growth. World development, 23(3), 433-448.
  8. Calderón, C., & Liu, L. (2003). The direction of causality between financial development and economic growth. Journal of Development Economics, 72(1), 321-334.
  9. Levine, R., Zervos, S. (1998a). “Stock markets, banks, and economic growth”. American Economic Review 88, 537–558.
  10. Rajan, R.G., Zingales, L. (1998). “Financial dependence and growth”. American Economic Review 88, 559–586.
  11. Demirgüç-Kunt, A., Maksimovic, V. (1998). “Law, finance, and firm growth”. Journal of Finance 53, 2107–2137.
  12. Guiso, L., Sapienza, P., Zingales, L. (2002). “Does local financial development matter?”. National Bureau of Economic Research Working Paper No. 8922.
  13. Jayaratne, J., Strahan, P.E. (1996). “The finance-growth nexus: Evidence from bank branch deregulation”. Quarterly Journal of Economics 111, 639–670.
  14. Balakrishnan, R., Steinberg, C., & Syed, M. M. H. (2013). The Elusive Quest for Inclusive Growth: Growth, Poverty, and Inequality in Asia (No. 13-152). International Monetary Fund.
  15. Clarke, G., Xu, L.C., Zou, H. (2003). “Finance and income inequality, test of alternative theories”. World Bank Policy Research Working Paper, #2984.
  16. Beck, T., Demirgüç-Kunt, A., & Levine, R. (2007). Finance, inequality and the poor. Journal of economic growth, 12(1), 27-49.
  17. Balakrishnan, R., Steinberg, C., & Syed, M. M. H. (2013). The Elusive Quest for Inclusive Growth: Growth, Poverty, and Inequality in Asia (No. 13-152). International Monetary Fund.
  18. Banerjee, A., Newman, A. (1993). “Occupational choice and the process of development”. Journal of Political Economy 101, 274–298.
  19. Galor, O., Zeira, J. (1993). “Income distribution and macroeconomics”. Review of Economic Studies 60,35–52.
  20. Aghion, P., Bolton, P. (1997). “A trickle-down theory of growth and development with debt overhang”. Review of Economic Studies 64, 151–172.
  21. Ayyagari, M., Beck, T., & Hoseini, M. (2013). Finance and Poverty: Evidence from India. Centre for Economic Policy Research.
  22. Giné, X., & Townsend, R. M. (2004). Evaluation of financial liberalization: a general equilibrium model with constrained occupation choice. Journal of Development Economics, 74(2), 269-307.
  23. Beck, T., Levine, R., & Levkov, A. (2010). Big bad banks? The winners and losers from bank deregulation in the United States. The Journal of Finance,65(5), 1637-1667.
  24. Burgess, R., Pande, R., & Wong, G. (2005). Banking for the poor: Evidence from India. Journal of the European Economic Association, 3(2‐3), 268-278.
  25. Bruhn, M., & Love, I. (2013). The Real Impact of Improved Access to Finance: Evidence from Mexico. The Journal of Finance.
  26. Cull, R., Demirgüç-Kunt, A., & Lyman, T. (2012). Financial Inclusion and Stability: What Does Research Show? CGAP Brief.
  27. Ibid.
  28. Han, R., Melecky, M. (2013) Financial Inclusion for Financial Stability. Background Paper to the 2014 World Development Report.
  29. Mohan, R., & Patra, M. (2009). 9. Monetary policy transmission in India.Monetary policy frameworks for emerging markets, 153.
  30. Montiel, P., Spilimbergo, A., & Mishra, P. (2010). Monetary transmission in low income countries. International Monetary Fund.
  31. Prasad, E. S. (2010). Financial sector regulation and reforms in emerging markets: an overview (No. w16428). National Bureau of Economic Research.
  32. Hannig, A., & Jansen, S. (2010). Financial inclusion and financial stability: current policy issues. Asian Development Bank Institute.
  33. Rajan, R. G. (2011). Fault lines: How hidden fractures still threaten the world economy. Princeton University Press.
  34. Collins, D., Morduch, J., Rutherford, S., & Ruthven, O. (2009). Portfolios of the poor: how the world’s poor live on $2 a day. Princeton University Press.
  35. Cull, R., Demirgüç-Kunt, A., & Lyman, T. (2012). Financial Inclusion and Stability: What Does Research Show? CGAP Brief.
  36. Reserve Bank of India (2014). Report of the Committee on Comprehensive Financial Services for Low Income Households and Small Businesses.
  37. Cull, R., Demirgüç-Kunt, A., & Lyman, T. (2012). Financial Inclusion and Stability: What Does Research Show? CGAP Brief.