FINANCE AND

ECONOMIC
GROWTH: THEORY
AND EVIDENCE
RABIN DAHAL
Nexus between Financial Sector
and Economic Growth
The costs of acquiring information, enforcing contracts, and making
transactions create incentives for the emergence of particular types
of financial contracts, markets and intermediaries.
Different types and combinations of information, enforcement, and
transaction costs in conjunction with different legal, regulatory, and
tax systems have motivated distinct financial contracts, markets,
and intermediaries across countries and throughout history.
In arising to ameliorate market frictions, financial systems naturally
influence the allocation of resources across space and time
For instance, the emergence of banks that improve the acquisition
of information about firms and managers willundoubtedly alter the
allocation of credit.
Similarly, financial contracts that make investors more confident that firms
will pay them back will likely influence how people allocate their savings.
To organize a review of how financial systems influence savings and
investment decisions and hence growth, we focus on five broad functions
provided by the financial system in emerging to ease information,
enforcement, and transactions costs.
In particular, financial systems:
• Produce information about possible investments and allocate capital
• Monitor investments and exert corporate governance after providing
finance
• Facilitate the trading, diversification, and management of risk
• Mobilize and pool savings
• Ease the exchange of goods and services
Each of these financial functions may influence savings and
investment decisions and hence economic growth.
Since many market frictions exist and since laws, regulations, and
policies differ markedly across economies and over time,
improvements along any single dimension may have different
implications for resource allocation and welfare depending on the
other frictions at play in the economy.
Theory focuses on particular functions provided by the financial
sector – producing information, exerting corporate governance,
facilitating risk management, pooling savings, and easing exchange
– and how these influence resource allocation decisions and
economic growth.
Bank Based vs Market Based
Finance
There are important differences among the financial systems.
The size of financial markets and the importance of bank and non-
bank financial intermediaries (such as mutual funds, private
pension funds, and insurance companies) differ substantially across
countries.
Financing is almost exclusively provided by banks and stock
markets in most of the countries.
A key question is how these differences in financial systems affect
macroeconomic outcomes.
A system that relies heavily on selling securities in the
open market is considered to be a market-based system.
Here, investors conduct their own due diligence and bear their own
risk when they lend money to corporations.
On the other hand, a financial system in which investors
invest their money in banks and these banks then invest the
money in corporations is called a bank-based financial
system.
Here, the bank plays the role of a gatekeeper i.e. they inspect the
financials of the company on behalf of the investor before making a
final investment.
Both these methods of financing exist in almost every economy
around the world.
However, a system is called a market-based or bank-based system
depending upon the predominant system of investing prevailing in
that economy.
Economic literature makes a distinction between so-called ‘bank-
oriented’ systems in which financial institutions are the predominant
source of financing and a ‘market-oriented’ model whereby funds are
raised primarily via the securities markets.
Banks are responsible for channeling funds from savers to borrowers,
particularly non-financial corporates.
By performing this intermediation role, banks constantly ‘monitor’ the
borrowers on behalf of the deposit holders, a function which could not be
conducted individually by each of those deposit holders or lenders.
In a market-oriented system, the companies are more inclined to issue
securities (shares, bonds, etc.).
Savers purchase these securities directly through distribution networks or
banks.
However, the key difference is the absence of any financial intermediary
that alters the nature of the security issued.
Although both forms of financing coexist in all jurisdictions, countries
differ in terms of the relative weight of each model.
Access to Finance
and Financial
Inclusion
Outline
Definition
Measuring Financial Access and Inclusion
Access to Finance in Nepal
Policies adopted in Nepal
Background and Definition
The basic services offered by financial institutions typically are
categorized into savings, credit, insurance, and payment services.
Payment services reduce transaction costs in the exchange of
goods and services between people and over time.
Savings and credit allow efficient use of capital by delinking
consumption (or saving) from investment decisions.
Insurance contracts allow households to hedge and diversify risks
and smooth consumption.
Background and Definition, contd.
The strong relationship between financial
development and economic growth is well
documented in the literature as we discussed
before.
In more recent years the debate expanded to
include the notion of financial “exclusion” as a
barrier to economic development and the
need to build inclusive financial systems
through increasing effective access to finance.
Size, depth, and stability are not the only
criteria by which financial systems are
evaluated; outreach and access are now
recognized to be as important.
Background and Definition, contd.
Financial inclusion has both private and social
benefits - growth, poverty alleviation and low
income inequality.
Recent empirical evidence using household data
indicates that access to basic financial services
such as savings, payments and credit can make
a substantial positive difference in improving
poor people’s lives.
Access to finance is multidimensional in nature.
Generally, access to finance commonly
refers to the availability of quality financial
services at reasonable cost.
Background and Definition, contd.
Leyshon and Thrift (1995) define financial exclusion as referring
to those processes that serve to prevent certain social groups
and individuals from gaining access to the formal financial
system.
Carbo et al. (2005) have defined financial exclusion as broadly
the inability (however occasioned) of some societal groups to
access the financial system.
According to Conroy (2005), financial exclusion is a process that
prevents poor and disadvantaged social groups from gaining
access to the formal financial systems of their countries.
According to Mohan (2006) financial exclusion signifies the lack
of access by certain segments of the society to appropriate, low-
cost, fair and safe financial products and services from
mainstream providers.
So, a Government Committee on financial inclusion in India
defines financial inclusion as the process of ensuring access to
financial services timely and adequate credit where needed by
vulnerable groups such as the weaker sections and low income
groups at an affordable cost (Rangarajan Committee, 2008)
Background and Definition, contd.
Financial inclusiveness is understood as providing
and ensuring reliable and affordable financial
services to all segment of society.
Although access to finance is necessary for all
members of society, it is particularity more
important for disadvantaged and low income
segments of society, as it provides opportunities for
them to save and invest, and protect themselves
from various risks such as natural disasters, illness,
and loss of livelihoods.
Access to finance will enable the poor and low
income people to make economic self-realization and
give chances to break the vicious cycle of poverty. (
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s--Key_Note_remarks_for_National_Conference_on_Fi
nancial_Inclusion_in_Nepal-new.pdf
)
Background and Definition, contd.
There could be five types of financial exclusion
(Sarma and Pais, 2011) such as
(1) access exclusion due to geography and “risk
management of the financial system”,
(2) condition exclusion “due to conditions that are
inappropriate for some people,”
(3) price exclusion due to non-affordability of
financial services,
(4) marketing exclusion due to the non-
attractiveness of conducting business with certain
groups within society (lending risk), and
(5) self-exclusion (voluntary), due to “fear of refusal
or due to psychological barriers or lack of
awareness or knowledge.
Background and Definition, contd.
Three dimensions of access to finance or
inclusive finance (physical access,
affordability, and eligibility).
Physical access refers to number and
convenience of points of service delivery.
Affordability refers to the costs associated
with the use of financial services, such as
minimum balances or fees paid to open an
account or obtain a loan.
Eligibility refers to the requirements for
obtaining services, such as documentation
(for example, identification card, wage slip,
or proof of residence).
Background and Definition, contd.
High fees, high minimum balances, and strict
documentation requirements can make financial
products unaffordable for a large section of the
population, while less convenient service
delivery mechanisms and long loan
application waiting times may lead potential
clients to seek alternative financial service
providers.
Financial exclusion occurs mainly to people who
are at the margins of the society.
Background and Definition, contd.
Financial inclusion has become a policy
priority in many countries.
Lack of access to finance can be a serious
barrier to investment and business activity in
general.
Access to finance is the indispensable
lubricant for entrepreneurship.
Initiatives for financial inclusion have come
from the financial regulators, the
governments and the banking industry.
Background and Definition, contd.
Access to finance, whether through mainstream
financial institutions or through microfinance
and other specialized institutions, can expand
the opportunities for poorer households to engage
in productive activities.
Access to finance confers substantial welfare gains
for poorer households by, for example, allowing
them to smooth their lifetime consumption
and coping with negative shocks.
Therefore, access to finance can contribute to
broaden economic growth as well as broader social
development.
Financial inclusion brings about a more inclusive
growth with lower poverty and inequality.
 MeasuringFinancialAccessandInclusion

Measuring financial access as well as inclusion is not

straightforward.
Aggregate financial development indicators such as
the ratio of bank credit to GDP, M2/GDP can hide
substantial disparities across the population of
individuals and firms in the economy. These
indicators do not show inclusiness nature of finance
Financial inclusiveness, whether for households or for
firms, ultimately depends on both demand and supply
side variables.
Provider (or supply side) data could include regulatory
agency surveys or financial institution data on
parameters such as the number of accounts
maintained, number of clients, number of
branches, regulatory requirements, and so forth.
Supply Side Indicators
Measuring Financial Access and Inclusion, contd.

A core limitation of supply side data for estimating

access to financial services for individuals or
households is the inability of the data to address
the nature of the individuals who are the actual
users of the services.
The presence of branch banks in a given
neighborhood does not say much about the clients
who use the branches, and greater branch density
need not imply that banking services are availableMor
to the poor. e
tha
Another intrinsic limitation of supply side data is n
that the data necessarily focus on formal, regulated170
providers of financial services, about which 00
regulators can offer information, whereas Savi
individuals and households use a broad spectrum ng n
of informal and semiformal sources, especially in Credit
developing countries. Coo
Measuring Financial Access and
Inclusion, contd.
Household surveys on financial access can be undertaken from user
sides.
Surveys of enterprises provide a direct approach to measuring
firms’ access to finance.
Enterprise surveys have been conducted by multilateral
organizations, national statistical agencies, and central banks.
The poor are largely served by semiformal and informal
institutions, and information for such institutions is more difficult
to obtain.
Demand side indicators
Measuring Financial Access and Inclusion, contd.
The index of financial inclusion is a measure of
inclusiveness of the financial sector of a country. It is
constructed as a multidimensional index that
captures information on various aspects of financial
inclusion such as banking penetration, availability of
banking services and usage of the banking system
(see Sarma and Pais for detail).
Accessibility has been measured by the penetration
of the banking system proxied by the number of
bank A/C per 1000 population.
Availability has been measured by the number of
bank branches and number of ATMs per 100,000
people.
The proxy used for the usage dimension is the
volume of credit plus deposit relative to the GDP.
Measuring Financial Access and
Inclusion, contd.
Singapore’s per capita GDP is twelve times higher than that of
Namibia while its geographic branch penetration is more than 5,000
times higher. And South Korea’s per capita income is more than
fourteen times that of Nepal, but its geographic ATM penetration is
more than 2,900 times greater (Bar et. al, 2007, Ch2)..
Way of Extending Access and
Inclusions
Institutions
Infrastructure (ATM, mobile banking, branchless banking)
Government support (Antidiscrimination laws, financial supports,
directed policy, consumer protection)
Expanding financial literacy
Way of Extending Access and
Inclusions

Source:
https://www.worldbank.org/en/news/infographic/2016/10/04/gateway-to-
Access to Finance in Nepal
Nepal Rastra Bank (NRB) released the findings from the
recent FinScope demand side survey on financial
inclusion for Nepal in Kathmandu on 13 August 2015 (
http://www.afi-global.org/news/2015/8/16/nepal-rastra-b
ank-releases-survey-results-financial-inclusion-conferen
ce-kathmandu
)
The survey was conducted in late 2014 and covered a
representative sample of 4,014 adults in Nepal, aged 18
years and above, across 70 districts.
The results indicate that 61 percent of Nepalese
adults are formally banked while 21 percent use
informal channels and 18 percent remain financially
excluded.
In line with global trends, the survey findings also show
men have higher levels of access to banking services
and are more financially included compared to women
in Nepal.
Access to Finance in Nepal, contd.
40 percent of adult population is banked. Taking
into account the cooperatives and other formal non
bank financial institutions, about 61 percent of
adult population is formally served.
Money lenders in Nepal still feature highest as a
source of credit.
82 percent of the adults agree that money lenders
are an important part of their community.
28 percent of adult population said that they are
aware of insurance, while only 11 percent claim to
have a form of insurance.
Policies Adopted in
Nepal
Encouraging establishment of microfinance financial
institutions
Providing interest free loans to BFIs for opening branches
in unbanked areas.
Mandatory opening of branches in rural areas before
opening branch in city areas.
Continuation and strict enforcement of the deprived sector
lending.
Focus on expanding financial literacy
Special refinance facility to cottage and small industries
Establishment of Rural Self Reliance Fund for subsidized
credit to the poor and marginalized population through
Coperatives,
Directives on consumer protection,
References
Estrada, G., Park, D. and Ramayandi, A. (2010).
Financial Development and Economic Growth in
Developing Asia, ADB Working Paper.
Michael S. Barr, Anjali Kumar, Robert E. Litan,
(editors) (2007). Building inclusive financial systems :
a framework for financial access. THE BROOKINGS
INSTITUTION.
Sarma, M. and Pais, J.(2011), "Financial Inclusion and
Development", Journal of International Development,
23(5): 613-628
World Bank (2018). Gains in Financial Inclusion, Gains
for a Sustainable World,
https://www.worldbank.org/en/news/immersive-story/
2018/05/18/gains-in-financial-inclusion-gains-for-a-sus
tainable-world
Nepal Financial Inclusion Country Report 2014 ,