Financial inclusion and financial stability nexus revisited in South Asian countries: evidence from a new multidimensional financial inclusion index

Purpose The main purpose of this paper is to examine the relationship between financial inclusion and financial stability in South Asian countries. Design/methodology/approach To measure the financial inclusion, a multidimensional time-varying index is constructed following the Human Development Index method. The long-run relationship between financial inclusion and financial stability is examined by using the panel cointegration test, fully modified ordinary least squares and dynamic ordinary least squares approaches to show the long-run elasticity of explanatory variables on dependent variables. Further, Dumitrescu-Hurlin panel causality test is used to find the direction of causality between financial inclusion and financial stability. Data set is of annual frequency of seven countries for the period from 2004 to 2018. Findings The empirical findings of this study confirm that financial inclusion has a positive and statistically significant impact on financial stability. These results suggest that South Asian countries can attain long-run financial stability by improving the coverage of financial inclusion. Further, panel causality test shows a unidirectional causality from financial inclusion to financial stability. Research limitations/implications The major limitation of the study is the availability of time series data for all important variables. Various socioeconomic variables can be used to measure financial stability, but this study included only the Z -score as the proxy for financial stability. Due to the data constraint, this study is unable to use the time series econometric analysis. Practical implications As the study confirms that financial inclusion is one of the main drivers of financial stability, it is suggested that the policymakers should emphasize on financial sector reforms to enjoy financial stability in the long run, especially in developing countries. So governments and policymakers of study countries need to address the issues involved in access to financial services to increase financial stability. Furthermore, it is also important to remove limitations of access to formal financial services for marginalized sections of the society with proper supervisions. Originality/value This is a new contribution on the present topic. This study has constructed a new multidimensional financial inclusion index (FII) following the Human Development Index method for South Asian countries based on annual data and using ten indicators of formal financial services related to availability, accessibility and usage. To the best of the authors’ knowledge and information, this is the first study on South Asian countries to construct and apply the new multidimensional FII. Further, the study examines the long-run elasticity of financial inclusion on financial stability employing FMOLS and DOLS approach.