Amidrzic an inclusive financial system including financial services’ affordability,

Amidrzic et al(2014) defined financialinclusion as an economic state where individuals and firms have access to basicfinancial services based on motivations except for efficiency criteria. Theyconcluded that financial inclusion played an important role in sustainingemployment, 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 listedbelow on Table 1.

1), providing an additional tool which could be used for monitoringand policy purposes on a regular basis. The index had some limitations; it did not have countryspecific information, geographical aspects and gender dimension. Due to lack ofappropriate data, Sarma was not able to combine numerous aspects of an inclusivefinancial system including financial services’ affordability, timeliness and  quality. In sum, Sarma (2008) followed a different approach tocalculate the indicator. He first computed a dimension index for each financialinclusion dimension and then aggregated each index as the normalized inverse ofEuclidean distance. The distance is calculated with respect to an idealreference point, and then normalized by the number of dimensions in the compositeindex. The index did not impose any weights for each dimension.   Diverging from UNDP’s methodology of using a simple arithmeticaverage, this index was a measurement of the distance from the ideal.

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Additionally,the choice of minimum and maximum values for the dimensions was different. Whilethe UNDP methodology preferred pre-fixed values for the minimum and maximumvalues for each dimension to calculate the dimensional index, this paper preferredminimum and maximum in their dataset for each dimension. It was difficult todetermine the minimum and maximum for any dimension of financial inclusion. Forseveral dimensions such as the literacy rate and life expectancy, used in UNDP’s HDI, it was easyto define limits. However, this was a dynamic index where min/ max values forany dimension may alter at different time points. The methodology for this index was similar to UNDP’s computationof well-known development indices such as the HDI, the HPI, the GDI.

As in theseindexes, the paper proposed a dimension index for each dimension of thefinancial inclusion. The dimension is then calculated by subtracting theminimum value from the actual value and dividing it by the difference betweenthe maximum and minimum value. Then the index was calculated by the normalizedinverse Euclidian distance of the ideal point. The index took into account threebasic dimensions including banking penetration (measured by number of bankaccounts 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 dimensionswere selected as a result of the data availability for large number of countriesand recent trends in literature. Sarma (2008) described financial inclusion as the easeof access, availability and usage of formal financial system. This paper followeda multidimensional approach while proposing an index of financial inclusion(IFI).

The calculated index in this paper could be utilized to compare differentlevels of financial inclusion across economies at a specific time point. Itcould also be utilized for observing the advancement of policy initiatives forfinancial inclusion over time period. The calculated index containedinformation on various dimensions of an inclusive financial system.Additionally, it is easy to calculate the index. This paper filled the gap of acomprehensive measure that can be utilized to measure the extent of financialinclusion across economies. The index was a multi-dimensional capturinginformation on various dimensions of financial inclusion under one single digitbetween 0 and 1, where 0 displayed complete financial exclusion and 1 reflectedcomplete financial inclusion in an economy. The advantage was that the proposedindex 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 compositeindices of financial inclusion that combine various banking sector variables toreveal accessibility, availability and usage of banking services. These indicesassign equal weights to all variables and dimensions, with the assumption thatall dimensions have the same impact on financial inclusion. Financial inclusion as a concept attracted a mountinginterest from the academia. Burgessand Panda (2005) found that the expansion of bank branches in ruralIndia had a significant impact on alleviating poverty. Brune et al. (2011) conducted experimentsin rural Malawi examining how access to formal financial services improves thelives of the poor, pertaining to saving products. Allen et al. (2013) explored the factors behindthe financial development and inclusion among African countries.

 Although there is a consensus on how financialinclusion 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 indicatorwhich captures the adult population in an economy with access to formalfinancial intermediaries.

  The compositefinancial access indicator is formulated by utilizing household survey data foreconomies with existing data on financial access. For those without householdsurvey on financial access, the indicator is constructed by utilizinginformation about bank account numbers and GDP per capita. The data isconstructed as a cross-section series using the most recent data as thereference year varying across economies. However, Honohan’s (2007 and 2008) calculations deliver a snapshot offinancial inclusion and is not appropriate for comprehending changes over timeand across economies.   In contrast, Amidži?, Massara, and Mialou (2014) and Sarma (2008)directly define financial inclusion.

Amidži?, Massara, and Mialou (2014) describefinancial inclusion as an economic state where individuals and firms haveaccess to basic financial services.  Existing literature on financial inclusion hasdifferent definitions of the concept. Many studies define the concept in termsof financial exclusion which is connected to a broader context of socialinclusion. Leyshon andThrift (1995) defined financial exclusion as the processes which serveto preclude some social groups and/or individuals from accessing the formalfinancial system.

According to Sinclair (2001), financial exclusion was the incapability toaccess essential financial services. Carbo et al. (2005) defined financial exclusion as theincapacity of some groups in accessing the financial system. The Government ofIndia defined financial inclusion as the practice of guaranteeing access tofinancial services with timely and acceptable credit conditions at anaffordable cost by exposed groups including low income groups. Financialinclusion also includes the extension of financial services to those people whodo not have access and the deepening of financial services for those peoplewith limited access (Rajan2014). Definition ofFinancial Inclusion and Index Formation In the literature, both definition of financialinclusion and index formation to define financial inclusion have been extensivelydiscussed.

Studies of causes of financial inclusion either focused onparticular regions or covered all countries. First, index formation will bediscussed then literature looking at financial inclusion’s impact on growth,stability and income equality will be presented.