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Prices or Knowledge? What Drives Demand for Financial Services in Emerging Markets?
Professor Shawn Cole of Harvard business school and co-authors (Prof. Thomas Sampson of Harvard business school and Bilal zia of the world bank) write on the effect of financial literacy & moderate subsidies on the probability of opening a bank savings account in emerging, highly populated nations like India and Indonesia.
Issue Date - 10/11/2011
 
Why is there apparently limited demand for financial services in emerging markets? On the one hand, low-income individuals may not want formal services when informal savings, credit, and insurance markets function reasonably well, and the benefits of formal financial market participation may not exceed the costs. On the other hand, limited financial literacy could be the barrier. If people are not familiar or comfortable with products, they will not demand them. These two views carry significantly different implications for the development of financial markets around the world, and would suggest quite different policy decisions by governments and international organisations seeking to promote “financial deepening”. The paper reveals how financial literacy education has no effect on the probability of opening a bank savings account for the full population, though it significantly increase the probability among those with low initial levels of financial literacy and low levels of education. In contrast, modest financial subsidies significantly increase the share of households that open a bank savings account within the subsequent two months.

Financial development is critical for growth, but its micro-determinants are not well understood. We test leading theories of low demand for financial services in emerging markets, combining novel survey evidence from Indonesia and India with a field experiment. We find a strong correlation between financial literacy and behaviour. However, a financial education program has modest effects, increasing demand for bank accounts only for those with low levels of education or financial literacy. In contrast, small subsidies greatly increase demand. A follow-up survey conforms these findings, demonstrating the newly opened accounts remain open and in use two years after the intervention.

Financial development is widely recognised as an important determinant of economic growth, with a large literature examining the determinants of the supply of banking and financial intermediation services (Levine, 2005). Yet, the determinants of the demand for financial services are much less well understood, particularly in the emerging market countries.

An important feature of emerging markets is the size of the informal sector. Recent estimates place the size of the informal economy as 14% of GDP in China, 23% in Indonesia and 24% in India, against 8% in the United States (Buehn and Schneider, 2009). In 76 emerging market countries, the average size of the informal sector is almost 36% of GDP. Arguably, drawing these individuals and firms into the formal financial sector would be one of the fastest ways to foster financial development in emerging markets. Two leading views may explain limited demand for formal financial services. First, because these services are expensive to provide, involving high fixed costs, it may simply be that low income individuals do not demand formal financial services at market prices.

 
Indeed, there is evidence that informal savings, credit, and insurance markets function reasonably well in emerging markets, and the benefits of formal financial market participation may simply not exceed the relatively large fixed transactions costs associated with such products (Beck, Demirguc-Kunt, and Peria, 2007). An alternative view argues that limited financial literacy serves as an important barrier to demand for services: if individuals are not familiar or comfortable with products, they will not demand them. While not mutually exclusive, these two views have significantly different implications for the development of financial markets around the world, and would suggest quite different actions for financial institutions, governments, and international organisations seeking to expand financial services use. This paper aims to test the above theories. To do so, we conducted novel surveys in India and Indonesia, measuring household financial literacy and demand for financial services. [The survey in Indonesia represents the first nationally representative household survey on financial literacy in a developing country.] We supplemented this survey data with a randomised field experiment among unbanked households in Indonesia, to directly test the role and relative importance of financial literacy and prices in determining demand for banking services. An intervention offering a financial education program on bank accounts was randomly assigned to half of 564 unbanked households identified by our survey team. Orthogonal to this treatment, individuals were randomly offered small subsidies, ranging from $3 to $14, for opening a bank account. The design therefore allowed us to directly compare the effect of financial literacy education to price subsidies.

We found that financial literacy education has no effect on the probability of opening a bank savings account for the full population, although it does have an impact among those with low initial levels of education and financial literacy. Modest financial subsidies, in contrast, have large effects, significantly increasing the share of households that open a bank savings account within the subsequent two months. Specifically, an increase in subsidy from $3 to $14 increases the share of households that open a bank savings account from 3.5% to 12.7%, an almost three-fold increase.

Follow-up analysis conducted two years after the intervention shows that bank accounts are “sticky” [those who were originally offered high subsidies are, two years later, significantly more likely to have used bank accounts in the past year to deposit, withdraw, send or receive funds]. These long run findings confirm our main short-run findings: financial literacy education alone does not lead to greater demand for financial services in the general population, as the share of individuals who opened a bank account in the two years since the intervention is no different in the treatment versus the control group.
          

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