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Financial deepening is a term used by economic development experts to refers to the increased provision of financial services with a wider choice of services geared to all levels of society. This includes the unbanked and underbanked in a society. It includes the developedment of financial markets, increasing the number of financial institutions and increasing the diversity in financial instruments.
It also refers to the macro effects of financial deepening on the larger economy. Financial deepening generally means an increased ratio of money supply to GDP or some price index. It refers to liquid money. The more liquid money is available in an economy, the more opportunities exist for continued growth.
It is seen by some as playing an important role in reducing risk and vulnerability for disadvantaged groups, and increasing the ability of individuals and households to access basic services like health and education, thus having a more direct impact on poverty reduction. The association between economic growth and financial deepening has been a wide-ranging subject of experiential research. The practical evidence suggests that there is a significant positive relationship between financial development and economic growth.
Financial Deepening in India
There is a general consensus among economists that financial development spurs economic growth. Theoretically, financial development creates enabling conditions for growth through either a supply-leading (financial development spurs growth) or a demand-following (growth generates demand for financial products) channel. A large body of empirical research supports the view that development of the financial system contributes to economic growth (Rajan and Zingales, 2003). Empirical evidence consistently emphasises the nexus between finance and growth, though the issue of direction of causality is more difficult to determine. At the cross-country level, evidence indicates that various measures of financial development (including assets of the financial intermediaries, liquid liabilities of financial institutions, domestic credit to private sector, stock and bond market capitalisation) are robustly and positively related to economic growth (King and Levine, 1993; Levine and Zervos, 1998). Other studies establish a positive relationship between financial development and growth at the industry level (Rajan and Zingales, 1998). Even the recent endogenous growth literature, building on 'learning by doing' processes, assigns a special role to finance (Aghion and Hewitt, 1998 and 2005).
A developed financial system broadens access to funds; conversely, in an underdeveloped financial system, access to funds is limited and people are constrained by the availability of their own funds and have to resort to high cost informal sources such as money lenders. Lower the availability of funds and higher their cost, fewer would be the economic activities that can be financed and hence lower the resulting economic growth.
Some of the recent concerns on financial inclusion have emanated from the results of the All-India Debt and Investment Survey (AIDIS), 2002. Over a period of 40 years, the share of non-institutional sources of credit in sources of credit for cultivator households had declined sharply from about 93 per cent in 1951 to about 30 per cent in 1991, with the share of money lenders having declined from 69.7 per cent to 17.5 per cent. In 2002, the AIDIS revealed, however, that the share of money lenders had again increased to 27 per cent, while that of non-institutional sources overall rose to 39 per cent. In other words, notwithstanding the outreach of banking, the formal credit system has not been able to adequately penetrate the informal financial markets; rather it seems to have shrunk in some respects in recent years. Coincidentally, it is also true that the rate of agricultural growth during the last decade has slowed down and it is particularly striking in respect of foodgrains production. Since the green revolution, banks have been mainly focused on financing crop loans connected largely with food grains. There is, therefore, reason to believe that financial exclusion may actually have increased in the rural areas over the last 10-15 years.
Some Important Aspects
- One of the key features of financial deepening is that it accelerates economic growth through the expansion of access to those who do not have adequate finance themselves. Typically, in an underdeveloped financial system, it is the incumbents who have better access to financial services through relationship banking. Moreover, incumbents also finance their growth through internal resource generation. Thus, in an underdeveloped financial system, growth is constrained to the expansion potential of incumbents. In mature financial systems on the other hand, financial institutions develop appraisal techniques, and information gathering and sharing mechanisms, which then enable banks to even finance those activities or firms that are at the margin, thereby leading to their growth-inducing productive activities in addition to the incumbents. It is this availability of external finance to budding entrepreneurs and small firms that enables new entry, while also providing competition to incumbents and consequently encouraging entrepreneurship and productivity.
- RBI view on Financial Inclusion plans must be integrated with the normal business plans of the banks. We believe that banking to the poor is a viable business opportunity but costs and benefit exercise needs to be attempted by the banks to make financial inclusion congruent with their business models. Banks must view financial inclusion as a huge business opportunity and perfect their delivery models.**
Financial Deepening for Macroeconomic Stability and Sustained Growth
Promoting well-managed financial deepening in low-income countries (LICs) can enhance resilience and capacity to cope with shocks, improve macroeconomic policy effectiveness, and support solid and durable inclusive growth.
Financial deepening and macro-stability has been identified as a priority area in the years ahead for the Fund, as reflected in its Financial Surveillance Strategy paper. Managing Volatility and Supporting Low-income Country Growth Enhancing macro-economic policy effectiveness Shallow financial systems limit fiscal, monetary, and exchange rate policy choices; hamper macroeconomic policy transmission; and impede opportunities for hedging or diversifying risk. This is of particular concern because LICs are vulnerable to external shocks, such as sharp swings in commodity prices and fluctuations in external financing. Limited policy space and instruments to mitigate the ensuing macroeconomic volatility often translate into large growth and welfare costs for these countries.
Fostering inclusive growth. More varied and accessible financial services also support growth and reduce poverty and inequality. Financial development enables bigger investments and more productive allocation of capital, which lead to higher income growth. At the same time, better and cheaper services for saving money and making payments allow firms and households to avoid the cost of barter or cash transactions, cut the costs of remitting funds, and provide the opportunity to accumulate assets and smooth income. Current State of Play Financial systems in LICs have grown and become more inclusive over the past two decades, but they still remain relatively small and undiversified (Chart 1). Encouragingly, although they have much lower levels of financial depth than high- and middle-income countries, low-income countries are experiencing financial deepening at rates far faster than higher income countries. But financial deepening will be of low quality if financial services are available to only a few firms or households. Access to finance is as pivotal as the depth of the financial system. Here again, there are encouraging signs, but more could be done.
Challenges for Deepening
How far can and should LICs go in promoting financial deepening? How realistic is it to expect LICs to deepen and diversify their financial systems to the levels observed in emerging market countries? Structural characteristics of countries, policy factors, and exogenous influences (e.g., the technology available, sociopolitical conditions) determine the environment within which financial deepening may either flourish or stagnate.
- High fixed costs in financial provision explain why larger low-income country economies can sustain more diversified financial systems and why, for instance, small island economies tend to have shallow systems. Similarly, low national incomes, a high degree of informality, and low population density are factors that increase the costs and risks for financial institutions. These structural factors work to exclude large segments of the population from formal financial services and explain why many LICs have underdeveloped financial systems.
- A confluence of demand and supply factors constrains financial deepening in LICs . For example, low mobilization of deposits, financial illiteracy, and high fees and documentation requirements can limit financial intermediation. Similarly, for a wide variety of LICs persistent macroeconomic instability, weak collateral regimes, limited completion, and regulatory restrictions often act as barriers to the deepening and diversifying of their financial systems.
These impediments not only affect macro-financial stability but also reduce the growth dividends from deepening. At the same time, unsustainable expansion of financial systems can pose risks for stability. Weak and limited supervisory and regulatory frameworks and capacity, deficient early warning and resolution systems, and governance problems in LICs increase the risks of such fragility. The considerable heterogeneity among LICs, however, suggests that there is no "one-size-fits-all" solution. Different areas and approaches may be needed to promote financial deepening generally. Policies Matter Cross-country experiences in emerging market and low-income countries suggest that targeted and balanced initiatives to encourage competition, put in place information and market infrastructure, address collateral issues, limit excessively intrusive public sector interventions and dominance, maintain macroeconomic stability, and exercise appropriate macro-prudential oversight to avoid creating new sources of instability can help overcome specific impediments to increasing the depth, breadth, and inclusion of financial systems.***
- Shaw, Edward (1973). Financial Deepening in Economic Development. Oxford University Press.