Does Banking Inclusion Induce Credit Risk? Evidence of Reverse Causality in Developing Countries

Abstract

This paper investigates the dynamic interrelationship between banking inclusion and credit risk across 28 developing countries from 2004 to 2020. A robust empirical approach is employed, combining a panel vector autoregressive model with the generalized method of moments. Within this framework, impulse response functions are used to characterize the interaction between banking inclusion shocks and credit risk, capturing both the magnitude and persistence of their effects over time. Subsequently, forecast error variance decompositions quantify the relative contribution of each variable to the variance in the other, thereby underscoring the strength and direction of their dynamic interdependence. The findings indicate that positive shocks to banking inclusion, characterized by a rapid expansion in access to financial services, are associated with increased credit risk. This rise in risk is primarily attributable to a higher probability of loan defaults, particularly when the pace of inclusion exceeds banks’ capacity to adequately assess and manage borrower risk. Conversely, heightened credit risk induces banks to adopt more prudent lending practices, including restricting credit access and increasing borrowing costs. Banks may also constrain the development and deployment of innovative financial products, thereby impeding further progress in banking inclusion. Policy measures should align financial inclusion with effective risk assessment.