Financial Market Regulation and Reforms in Emerging Markets

11. Financial Inclusion and Financial Stability: Current Policy Issues

284 Financial Inclusion and Financial Stability: Current Policy Issues alfred hannig and stefan jansen 11 The recent financial crisis has shown that financial innovation can have devastating systemic impacts. International standard setters’ and national regulators ’ response has been a global concerted effort to overhaul and tighten financial regulations. However, at a time of designing stricter regulations, it is crucial to avoid a backlash against financial inclusion. In this chapter, we argue that greater financial inclusion presents opportunities to enhance financial stability. Our arguments are based on the following insights: —Financial inclusion poses risks at the institutional level, but these are hardly systemic in nature. Evidence suggests that low-income savers and borrowers tend to maintain solid financial behavior throughout financial crises, keeping deposits in a safe place and paying back their loans.1 —Institutional risk profiles at the bottom end of the financial market are characterized by large numbers of vulnerable clients who own limited balances and transact small volumes. Although this profile may raise some concerns All views are those of the authors alone. The authors thank Lara Gidvani, Celina Lee, and David Saunders from AFI as well as Mateo Cabello from Oxford Policy Management for their valuable contributions. 1. The Bank Rakyat Indonesia units experienced unprecedented deposit growth from small customers during the worst of the financial crisis, while a conservative lending policy contributed to maintaining good loan portfolio quality. See Patten, Rosengard, and Johnston (2001) and Hannig and Jansen (2008). financial inclusion and financial stability 285 regarding reputational risks for the central bank and consumer protection, in terms of financial instability, the risk posed by inclusive policies is negligible. —In addition, risks prevalent at the institutional level are manageable with known prudential tools and more effective customer protection. —The potential costs of financial inclusion are compensated for by important dynamic benefits that enhance financial stability over time through a deeper and more diversified financial system. In the following pages, we present the current state of financial inclusion globally. We also explore some trends in financial inclusion and what the most effective policies are to favor it. In doing so, we suggest that innovations aimed at countering financial exclusion may help strengthen financial systems rather than weaken them. What Is Financial Inclusion? Financial inclusion aims at drawing “unbanked” populations into the formal financial system so that they have the opportunity to access financial services ranging from savings, payments, and transfers to credit and insurance. Financial inclusion neither implies that everybody should make use of the supply, nor that providers should disregard risks and other costs when deciding to offer services. Both voluntary exclusion and unfavorable risk-return characteristics may preclude a household or a small firm, despite unrestrained access, from using one or more of the services. Such outcomes do not necessarily warrant policy intervention . Rather, policy initiatives should aim to correct market failures and to eliminate nonmarket barriers to accessing a broad range of financial services.2 Despite the considerable progress made by microfinance institutions, credit unions, and savings cooperatives over the last two decades, the majority of the world’s poor remain unserved by formal financial intermediaries that can safely manage cash and intermediate between net savers and net borrowers. According to the Consultative Group to Assist the Poor (CGAP), the absolute number of savings accounts worldwide is reported to exceed the global population.3 And yet half of the world’s adult population—2.5 billion people—does not, in fact, have access to savings accounts and other formal financial services.4 Financial inclusion as a policy objective represents the current consensus in a long-standing debate on the contribution of finance to economic development and poverty reduction (see box 11-1). It reflects the evolution of financial sector policies in developing countries over the past decades, and embodies important insights 2. Demirguç-Kunt, Beck, and Honohan (2008). 3. CGAP (2009a). 4. Chaia and others (2009). 286 alfred hannig and stefan jansen into the positive impact that financial services have on the (economic) lives of the poor.5 Financial sector policies have evolved through three stylized stages: first, fostering state-led industrial and agricultural development through directed credit; second, market-led development through liberalization and deregulation; and third, institution building that aims at balancing market and government failures. At least until the 1980s, many developing countries channeled public funds to target groups like farmers and small enterprises, and...