Amidrzic an inclusive financial system including financial services’ affordability,

Amidrzic et al
(2014) defined financial
inclusion as an economic state where individuals and firms have access to basic
financial services based on motivations except for efficiency criteria. They
concluded that financial inclusion played an important role in sustaining
employment, economic growth, and financial stability.  However, it was not robustly measured yet.
There was no new composite index with weighting methodology. In their paper,
countries were ranked based on the new composite index (variables are listed
below on Table 1.1), providing an additional tool which could be used for monitoring
and policy purposes on a regular basis.

 

The index had some limitations; it did not have country
specific information, geographical aspects and gender dimension. Due to lack of
appropriate data, Sarma was not able to combine numerous aspects of an inclusive
financial system including financial services’ affordability, timeliness and  quality.

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In sum, Sarma (2008) followed a different approach to
calculate the indicator. He first computed a dimension index for each financial
inclusion dimension and then aggregated each index as the normalized inverse of
Euclidean distance. The distance is calculated with respect to an ideal
reference point, and then normalized by the number of dimensions in the composite
index. The index did not impose any weights for each dimension. 

 

Diverging from UNDP’s methodology of using a simple arithmetic
average, this index was a measurement of the distance from the ideal. Additionally,
the choice of minimum and maximum values for the dimensions was different. While
the UNDP methodology preferred pre-fixed values for the minimum and maximum
values for each dimension to calculate the dimensional index, this paper preferred
minimum and maximum in their dataset for each dimension. It was difficult to
determine the minimum and maximum for any dimension of financial inclusion. For
several dimensions such as the literacy rate and life expectancy, used in UNDP’s HDI, it was easy
to define limits. However, this was a dynamic index where min/ max values for
any dimension may alter at different time points.

 

The methodology for this index was similar to UNDP’s computation
of well-known development indices such as the HDI, the HPI, the GDI. As in these
indexes, the paper proposed a dimension index for each dimension of the
financial inclusion. The dimension is then calculated by subtracting the
minimum value from the actual value and dividing it by the difference between
the maximum and minimum value. Then the index was calculated by the normalized
inverse Euclidian distance of the ideal point. The index took into account three
basic dimensions including banking penetration (measured by number of bank
accounts divided by the total population), availability of the banking services
(the number of bank branches per 1000 inhabitants) and banking system usage
(the volume of credit and deposit divided by the GDP of the country). These dimensions
were selected as a result of the data availability for large number of countries
and recent trends in literature.

 

Sarma (2008) described financial inclusion as the ease
of access, availability and usage of formal financial system. This paper followed
a multidimensional approach while proposing an index of financial inclusion
(IFI). The calculated index in this paper could be utilized to compare different
levels of financial inclusion across economies at a specific time point. It
could also be utilized for observing the advancement of policy initiatives for
financial inclusion over time period. The calculated index contained
information on various dimensions of an inclusive financial system.
Additionally, it is easy to calculate the index. This paper filled the gap of a
comprehensive measure that can be utilized to measure the extent of financial
inclusion across economies. The index was a multi-dimensional capturing
information on various dimensions of financial inclusion under one single digit
between 0 and 1, where 0 displayed complete financial exclusion and 1 reflected
complete financial inclusion in an economy. The advantage was that the proposed
index was very simple and was comparable across countries.

 

In order to overcome the aforementioned deficiencies,
Sarma (2008, 2010, and 2012) and Chakravarty and Pal (2010) suggested composite
indices of financial inclusion that combine various banking sector variables to
reveal accessibility, availability and usage of banking services. These indices
assign equal weights to all variables and dimensions, with the assumption that
all dimensions have the same impact on financial inclusion.

 

Financial inclusion as a concept attracted a mounting
interest from the academia. Burgess
and Panda (2005) found that the expansion of bank branches in rural
India had a significant impact on alleviating poverty. Brune et al. (2011) conducted experiments
in rural Malawi examining how access to formal financial services improves the
lives of the poor, pertaining to saving products. Allen et al. (2013) explored the factors behind
the financial development and inclusion among African countries.

 

Although there is a consensus on how financial
inclusion is defined, there is no standard way of measuring it. As a result,
existing studies offer different measuring techniques of financial inclusion.
For instance, Honohan (2007 and 2008) constructed a financial access indicator
which captures the adult population in an economy with access to formal
financial intermediaries.  The composite
financial access indicator is formulated by utilizing household survey data for
economies with existing data on financial access. For those without household
survey on financial access, the indicator is constructed by utilizing
information about bank account numbers and GDP per capita. The data is
constructed as a cross-section series using the most recent data as the
reference year varying across economies. 
However, Honohan’s (2007 and 2008) calculations deliver a snapshot of
financial inclusion and is not appropriate for comprehending changes over time
and across economies. 

 

In contrast, Amidži?, Massara, and Mialou (2014) and Sarma (2008)
directly define financial inclusion. Amidži?, Massara, and Mialou (2014) describe
financial inclusion as an economic state where individuals and firms have
access to basic financial services.

 

Existing literature on financial inclusion has
different definitions of the concept. Many studies define the concept in terms
of financial exclusion which is connected to a broader context of social
inclusion. Leyshon and
Thrift (1995) defined financial exclusion as the processes which serve
to preclude some social groups and/or individuals from accessing the formal
financial system. According to Sinclair (2001), financial exclusion was the incapability to
access essential financial services. Carbo et al. (2005) defined financial exclusion as the
incapacity of some groups in accessing the financial system. The Government of
India defined financial inclusion as the practice of guaranteeing access to
financial services with timely and acceptable credit conditions at an
affordable cost by exposed groups including low income groups. Financial
inclusion also includes the extension of financial services to those people who
do not have access and the deepening of financial services for those people
with limited access (Rajan
2014).

 

Definition of
Financial Inclusion and Index Formation

 

In the literature, both definition of financial
inclusion and index formation to define financial inclusion have been extensively
discussed. Studies of causes of financial inclusion either focused on
particular regions or covered all countries. First, index formation will be
discussed then literature looking at financial inclusion’s impact on growth,
stability and income equality will be presented.