Financial Development Bad for the Poor?

What is the relationship between financial development^[1] and income inequality? Answering this question has proven to be harder than expected. The existing economic theory provides answers in both directions – positive and negative –, and the empirical literature also presents mixed findings. On the one hand, more financing may make it easier for the poor to borrow money for viable projects, which in turn may reduce income inequality (Galor and Moav, 2004). Financial imperfections, such as information and transaction costs, are especially binding on the poor, who lack collateral and credit histories.  A relaxation of these credit constraints may therefore benefit them (Beck et al., 2007). On the other hand, improvements in the formal financial sector might benefit the well‐off, who rely less on informal connections for capital (Greenwood and Jovanovic, 1990). So which side has the stronger arguments?

New support for the negative effects on equality comes in the form of a KOF Working Paper: “Finance and income inequality: A review and new evidence” by Jakob de Haan and Jan-Egbert Sturm. De Haan and Sturm show that a higher level of financial development, financial liberalization and the occurrence of a banking crisis all increase income inequality. This inclusion of three variables at the same time distinguishes de Haan and Sturm’s approach from other studies, which include two of these variables at best. Furthermore, they test to what extent the effect of financial liberalization is conditional on the level of financial development and institutional quality.

For their analysis, they use a panel fixed effects model for a sample of 121 countries covering the period from 1975 to 2005, and then examine how financial development, financial liberalization and banking crises are related to income inequality. Their dependent variable of choice are the five‐year averages of Gini coefficients based on the gross income of households. The Gini coefficient is derived from the Lorenz curve and ranges between zero (perfect equality) and 100 (perfect inequality). They use five‐year, non‐overlapping averages for three reasons: First, annual macroeconomic data are noisy, and this applies especially for data on income inequality. The annual income inequality data are imputed for years for which no information was available in the underlying databases (there are only infrequent measures of inequality for large parts of Africa, Latin America, and Asia). Second, some of the explanatory variables used are only available for five‐year intervals. Third, they are not so much interested in short‐term driven effects (e.g. business cycle).

A systemic banking crisis in a five-year period is mostly followed by a substantial increase in income inequality. In contrast to the prediction by Bumann and Lensink (2016), De Haan and Sturm’s results suggest that, if there are high levels of financial development, financial liberalization increases income inequality. Whereas good political institutions do reduce income inequality overall, the positive impact of financial liberalization on income inequality is actually higher in countries with a higher quality of political institutions, as measured by the level of democratic accountability. Furthermore, institutional quality does not condition the impact of financial development on income inequality. This stands in contrast to the prediction by Rajan and Zingales (2003), who say that if institutions are of high quality, financial development will reduce inequality.

^{[1] Financial Development is measured as "Private Sector Credit to GDP". Hence, the definition is concentrating on how well developed the banking sector is.}