In the latter case, to change incentives for financial inclusion, reforms outside of the purview of financial policy must be implemented.

At the theoretical level, we thus distinguish between the lack of access (supply side constraint) and voluntary financial exclusion (demand side constraint). We focus on the market clearing outcome of financial inclusion—that is the use of financial services (account ownership, payments, savings, credit, and insurance). Using several distinct dimensions of the financial inclusion concept enables us to capture the possible different purposes for which each financial service is used, and separate the behavior of individuals from firms. Individuals can use financial services, for instance, to finance consumption, make payments, invest in education, and insure against the loss of income in old age (World Bank, 2014). Moreover, their use of financial services can affect an occupational choice between being an entrepreneur versus wage earner. Firms can use financial services, for instance, to finance the working capital, expand production, invest in facilities and equipment, and insure against business risks.

Financial stability is defined in a broad sense to capture (i) resilience of the financial system; (ii) volatility in key segments of financial intermediation; and (iii) negative, low probability events associated with financial crises. Given the dominant role of banks in most of the world’s financial systems, and given data availability, our measures focus on banks. Conceptually, however, we are aiming to approximate stability of the broader financial system. The first dimension, resilience, is important because it indicates the degree to which the system can withstand future shocks. The second dimension, volatility, is important because greater uncertainty, risk, and dispersion in outcomes are intrinsic to unstable financial development. Even relatively resilient financial systems can under-deliver due to spillover and contagion effects reflected in market volatility. Third, to properly account for low probability risks in our analysis, we explicitly cover financial crises, which are extreme events when the financial sector fails to perform its core functions. Figure 1 exemplifies these concepts of financial inclusion and financial stability, along with the measures used in this study.

The complete list of variables used in the analysis, along with the description and data sources, appears in Table 1. The set of empirical indicators is described in the next two sub-sections.

# **_3.1 Financial inclusion: Measures_**

We measure the use of financial services primarily with data from the Global Findex<sup>1</sup> and Enterprise Surveys.<sup>2</sup> We distinguish between individuals and firms,<sup>3</sup> and classify our variables according to the type of financial services. We choose a parsimonious set of indicators that consistently measure our definition

> 1 <u>http://www.worldbank.org/en/programs/globalfindex. The World Bank partners with the Bill & Melinda Gates</u> Foundation and the Gallup World Poll to produce the data set.

> 2 <u>http://www.enterprisesurveys.org/data. The World Bank partners with other institutions to conduct the survey in</u> different parts of the World, such as the European Bank for Reconstruction and Development (EBRD), Inter-American Development Bank (IDB), COMPETE Caribbean, the European Investment Bank (EIB), and the UK's Department for International Development (DFID).

> 3 The distinction between firms and individuals can become blurry at the micro-enterprise level, but for practical purposes, we refer to firms when financial services are used for business purpose.

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