Financial Development and Poverty Reduction Although the relationship between financial development and growth is well established,

the same cannot be said for the direct link between financial development and income inequality, beyond the growth relationship itself. Beck, Demirguc-Kunt, and Levine (2004) provide a comprehensive analysis of this important question. As the authors note, economic theory is ambiguous when it comes to the relationship between financial development and changes in poverty and income distribution. Some models imply that financial development enhances growth and reduces inequality. According to these models, financial market imperfections such as information problems, transaction costs, and contract enforcement costs may be especially binding on poor entrepreneurs who lack collateral, credit histories, and connections. These credit constraints will impede the flow of capital to poor individuals pursuing high-return projects, thereby reducing the efficiency of capital allocation and worsening income inequality. Viewed from this angle, financial development reduces poverty by (i) disproportionately relaxing credit constraints on the poor and reducing income inequality, and (ii) improving the allocation of capital and accelerating growth. Other theories, however, question whether financial development reduces poverty. Some research suggests that the poor primarily rely on informal, family connections for capital, so that improvements in the formal financial sector tend to help the rich rather than the poor. For instance, Greenwood and Jovanovic (1990) developed a model that predicts a nonlinear relationship between financial development and income inequality during the process of economic development. At the early stages of development, only the rich can afford to access and profit from financial markets so financial development intensifies income inequality. At higher levels of economic development, financial development helps an increasing proportion of society. Other models imply that if financial development reduces income inequality, the reduction could slow aggregate growth and increase poverty. If the rich save more than the poor, the argument goes, a reduction in income inequality could reduce aggregate savings and slow growth, with adverse implications for poverty. A great deal more empirical evidence is needed before any of the competing theoretical predictions can be declared the winner. Beck, Demirguc-Kunt, and Levine (2004) attempt to settle the issue by assessing the relationships among financial development, poverty alleviation, and changes in the distribution of income. Employing broad cross-country comparisons, they find that financial development alleviates poverty and reduces income inequality. Their findings also indicate that financial development exerts a disproportionately positive influence on the poor. Their research yields three key findings: Even when controlling for real per capita GDP growth, financial development reduces income inequality beyond the growth effects themselves

Financial development induces a drop in the Gini coefficient, the leading measure of income inequality Financial development reduces the fraction of the population living on less than $1 or $2 a day and shrinks the poverty gap

Jalilian and Kirkpatrick (2005) also find that financial development reduces income inequality, but only beyond certain income levels, in line with Greenwood and Jovanovics (1990) prediction of an inverted-U relationship. Widening Access to Financial Services Although financial services can have very beneficial effects, their use in developing countries is far from universal, as Claessens (2005) has noted. Instead of helping the poor, financial systems cater mainly to large enterprises and wealthier individuals. Finance is often allocated on the basis of connections and other nonmarket criteria. Often, many segments of the enterprise and household sectors suffer from lack of access to finance at reasonable costs, hindering gro wth. Claessens finds that for most developing countries, basic bank account usage does not exceed 30 percent of households; in the lowest-income countries, usage is less than 10 percent. Although low usage may reflect lack of demand rather than lack of access, Claessens argues that this is unlikely in many developing countries, precisely because usage is so low. The supply of financial services in such countries is clearly limited, but why? Is it because banks are unwilling to supply financial services to the poor because they believe them to be unprofitable customers? Or are there barriers to supply? If so, can those barriers be removed, for example, through microfinance or through savings and payments services provided by postal and saving banks? Or is there some form of market failure that government intervention can address? Demand may be slack if financial services are too costly and not well tailored to customer needs. If this is the case, households and firms may rely instead on informal forms of fi nance. But there are some grounds for hope here. For instance, in 2004 in South Africa, the countrys major banks launched a low-cost bank account aimed at extending banking services to lowincome households. Initial take-up was reportedly very high. A sharp drop in the costs of international remittances also suggests that banking services are being extended at a more reasonable cost to wider segments of the population. For a sample of more than 90 countries, Beck, Demirguc-Kunt, and Martinez-Peria (2005) showed that those countries with better-developed financial systems have services that are more evenly distributed among banking clients. This suggests that the overall institutional environment can play a role in the supply of banking services. Furthermore, the institutional environment a sound legal system, secure property rights, and reliable sources of information is especially important for the supply of credit to small firms. Banking-system regulations can also affect the

rate of usage of financial services. For instance, restrictions on interest rates and other limits on lending can make it difficult for providers of financial services to offer profitable saving or lending instruments. Against this backdrop, it appears that many developing countries need to improve their legal and regulatory systems as these bear on financial services. Better infrastructure and systems related to information and payments appear to be needed as well. These are all difficult and timeconsuming reforms. To complement them, Honohan (2004) suggests that an important way to enhance access one often easier than improving the institutional environment is to improve competition in banking systems. For instance, small nonbank financial institutions (including department stores) may be allowed greater use of existing financial networks. Liberalizing entry by foreign banks can further enhance competition and access to banking services by the population at large. Claessens (2005) cites the example of Mongolia, where the failed government-owned Agricultural Bank was sold to a Japanese investor and quickly became a successful bank that provides far greater access to the population at large. Foreign ownership can also induce greater financial stability and improve the overall efficiency of financial intermediation. Whether universal usage should be a public policy goal is, however, an open question. The fact that the poor do not use financial services may be a problem of poverty more than one of access. Also, our knowledge of the benefits and impacts of finance remains insufficient at the micro level. For example, access to credit may be a problem when it leads to overindebtedness, as the poor can be uninformed and overborrow, often on unfavorable terms. Public interventions may be useful in some cases, but they will need to be carefully introduced and tracked. Governments might try to make social security, tax, and other payments in a manner that encourages more bank access, notably by making them electronic where feasible. Authorities could also mandate banks to provide minimum banking services for otherwise excluded segments of the market.