Despite financial inclusion being an important public policy priority, we know very little of how it impacts the soundness of the providers of financial services. Using a large international sample of banks, we find that a higher level of financial inclusion contributes to greater bank stability.

The relationship is particularly pronounced for those banks that have higher customer deposit funding share and lower marginal costs of providing banking services; and also with those that operate in countries with stronger institutional quality.

Financial inclusion, that is, all economic agents have access to formal financial services and can use such services effectively, has become an important public policy priority following the recent global financial crisis.

What are the benefits

Existing literature shows that greater access to finance increases savings, reduces income inequality and poverty, increases employment, and improves overall well-being. Despite positive effects, little is known about the impact of inclusiveness on the soundness of banks. As banks are responsible for providing the bulk of financial services to households/firms in any economy, a clear understanding of this link is of immense managerial and economic importance for inclusive financial development and growth. By exploiting innovative technology, banks can provide financial services to a large number of customers, potentially at a reduced cost, and mobilise large non-wholesale long-term funding.

The existing literature suggests that retail deposits are sluggish, cheap and insensitive to risks compared to wholesale funding. Therefore, in an inclusive financial sector, banks have ample opportunities to garner a large amount of deposit funding from a vast customer base, which should enable them to reduce funding costs and risks, and thus become more stable.

Recent literature also shows that financial institutions get precise signals about a customer’s quality when the distance between them is reduced. Increased banking sector outreach helps reduce distance, enabling financial institutions to build a good relationship. With the competitive advantage of better information, banks can make judicious lending decisions and set prices accordingly, while mitigating moral hazards and adverse selection problems. Therefore, in an inclusive financial sector, banks with lower marginal costs should be able to reduce excessive risk-taking and become more stable.

Given the benefits of financial inclusion, banks operating in an inclusive financial sector along with a stronger institutional quality could experience greater operating efficiency in financial intermediation, and hence their soundness.

Despite having many benefits consequent to greater financial inclusion, we also assume that there may be countervailing effects of an inclusive financial sector. These could be associated with loss of banking stability due to informational asymmetries while dealing with poor households or small firms. It may also occur due to lack of managerial and technical expertise, and agency problems related to complex organisational and product structure required to serve a wide-ranging customer base. We therefore argue that the benefits may outweigh the costs associated with greater financial inclusion.

Impact on bank stability

In the absence of robust evidence on the link between financial inclusion and bank stability, we empirically investigated how financial inclusion affects bank-level stability using an international sample of 2,635 banks across 86 countries over the period 2004-12.

We first used financial outreach and usage dimensions to construct a composite index of financial inclusion at country level, and then employed both the index and its associated dimensions to see the effect on bank-level stability in a cross-country analysis while controlling for an array of bank- and country-specific characteristics.

Main findings : Our results indicate that there is a strong association between financial inclusion and bank stability. In particular, the higher the degree of financial inclusion, the better the bank performance in terms of reducing risks. Taking individual dimensions, we also found a positive and significant relation between financial outreach/usage and bank stability.

Further, we explored the possible channels through which financial inclusion influences bank soundness. We found that in an inclusive financial sector, banks that have higher customer deposit funding share, lower marginal costs of producing financial services, and which operate in countries with stronger institutional quality, are more stable.

Policy implications

Using an international sample, we provide comprehensive empirical evidence that greater financial inclusion is positively associated with individual bank stability. In this study, we have also identified, for the first time, the channels through which financial inclusion impacts bank soundness. These results suggest that banks perceive financial inclusion as a mechanism to garner ample near risk-free and mostly cheap retail deposits, providing a significant leeway to reduce reliance on volatile and often costly money market funding.

Increasing financial inclusion also acts as an instrument to reduce marginal cost of producing outputs, which contributes to the greater pricing power of banks and makes them more stable. As greater financial inclusion promotes stable socio-political environments, banks operating in an inclusive financial sector and in countries with high levels of institutional quality can improve stability as they get to operate efficiently in those settings.

Our results have important policy implications. By broadening banking services to unbanked and/or underbanked people, bank managers can not only take early advantage of exploiting the untapped potential of customers and create a ‘lock-in’ effect but also aid an inclusive development agenda while allocating resources into more productive areas.

Ahmed is with the School of Business, Management and Economics, University of Sussex; Mallick is with the School of Business and Management, Queen Mary University of London