Editor's Note: Raju Jan Singh recently presented the findings of the paper discussed in the following blog post at a session of the FPD Academy. Please see the FPD Academy page on the All About Finance blog for more information on this monthly World Bank event.
The recent financial crisis has renewed concerns about the merits of financial development, especially for the most vulnerable parts of the population. While financial development and its effects on economic growth have attracted much attention in the literature, far less work has been done on the relationship between financial deepening and poverty. Yet some economists have argued that lack of access to finance is among the main causes of persistent poverty.
Studies on the relationship between financial development and income distribution have been inconclusive. Some claim that by allowing more entrepreneurs to obtain financing, financial development improves the allocation of capital, which has a particularly large impact on the poor. Others argue that it is primarily the rich and politically connected who benefit from improvements in the financial system.
Financial institutions operate with incomplete information. Entrepreneurs seeking financing have more information about their projects than their banks do. Projects that differ in their probability of success are indistinguishable from the viewpoint of a financial institution. To grant loans to only the most promising projects, banks have to gather information or require collateral. In this setting governance, property rights, and creditor information could play a major role.
In Financial Deepening, Property Rights, and Poverty: Evidence from Sub-Saharan Africa, Yifei Huang (from Boston University) and I look at a sample of 37 countries in Sub-Saharan Africa from 1992 through 2006. Our results suggest that financial deepening can reduce income inequality and poverty and that stronger property rights reinforce these effects. But simply liberalizing interest rates and lending could be detrimental to the poor if not accompanied by institutional reforms—in particular, stronger property rights and wider access to creditor information.
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