Abstract 

This paper analyzes the effect of financial participation on consumer's financial vulnerability, which is pervasive in countries in the developing world. We suggest the need to observe the financial behavior of consumers, through financial health, to analyze the effects of such participation rather than taking into account only the narrower concept of financial inclusion. Our hypothesis is that welfare gains are not directly derived from the standalone ownership of bank accounts (i.e. financial inclusion) or having access to credit, but from their appropriate and responsible use. Firstly, we developed a stylized general framework to study the mechanisms and develop a measure to monitor financial health. Secondly, evidence on how participation in the financial system affects vulnerability is shown for five Latin American countries (Bolivia, Chile, Colombia, Ecuador, and Peru). We find that financial health has a higher impact on financial vulnerability than does financial inclusion. Human capital and financial literacy also affect financial vulnerability. The higher the level of these variables, the higher (lower) the probability of being financially safe (vulnerable). The structure of income and the environment in which individuals live affects financial vulnerability as well.   

 

Introduction 

Across countries, both developed and developing, individuals share a common aspiration for financial health. Good financial health generates a comfortable lifestyle, affecting welfare and physical health, as well as making consumers less vulnerable. Many consumers and households experience moments of financial difficulty, prompted either by a personal shock, such as losing a job, or a macroeconomic shock affecting personal finance (i.e. an economic recession). People react to these stressful events in different ways. An important question is how quickly they can recover from these shocks and this recovery depends not only on being financially included, but on their past financial behavior. Financial vulnerability describes the ability to recover from sudden financial shocks, which include unexpected loss of income and/or an uncontrollable increase in expenditure. Such ability is crucial to understanding consumer welfare. Moreover, it is a critical early warning to guarantee an inclusive economic growth and prosperity. Financial systems allow households to increase their opportunities and smooth their consumption, not only over the business cycle but also over the life cycle (Dynan, 2009). However, the mechanism is not straightforward. This paper attempts to contribute to a better understanding of the role of the financial system in consumer’s welfare by studying the determinants of financial health and assesses its effect on financial vulnerability. 

Since the publication of the first global, demand-side database to study the usage of financial services by the World Bank in 2011, literature that studies the link between finance and economic growth, entrepreneurship, technological innovation, poverty alleviation, distribution of income or health has flourished (Agénor and Canuto, 2017; DablaNorris et al., 2015; Laeven et al., 2015; Trabelsi and Cherif, 2017; Hu et al. (2019), among others). These works try to shed some light on the mechanism through which financial systems (financial contracts, markets, and intermediaries) contribute to build more prosperous societies. Demirgüç-Kunt and Levine (2018) provide a detailed review of this literature. However, these works use a narrow definition of participation in the financial system, since they mainly try to capture such effect through access to the financial system and, in a few instances, through ownership of financial products. Only papers that use randomized control trials obtain more comprehensive information with which to assess the outcome of financial participation (Dupas and Robinson, 2013 and Prina, 2015). Our paper aims to fill this gap. 

From the supply side, there is evidence demonstrating that financial inclusion benefits society in many ways, managing risk (Froot et al., 1993), fostering economic growth (e.g. Levine, 2005), alleviating poverty, reducing inequality (Beck et al., 2007), and promoting entrepreneurship (Guiso et al., 2004 and Mollica and Zingales, 2007). However, having access to the financial system is only a necessary condition for benefiting from participating in the financial system. From the demand side, the lack of use or misuse of innovative financial tools, which constitutes one of the main roots of the last global financial crisis, often prevents consumers from overcoming difficult situations and pursuing their life goals. Similarly, without health services, the person's physical health is clearly more vulnerable. In addition, the interconnection of financial markets, an insufficient level of regulation, as well as incentive and risk control mechanisms within inadequate financial institutions constituted, among other factors, triggering elements of the crisis (Financial Crisis Inquiry Commission, 2011; Crotty, 2009 and Plosser, 2009). These factors, combined with complex financial products, lead to consumer over-indebtedness (Lusardi and Mitchell, 2014 and Dimova, 2015) that had an impact on the real economy. Thus, being financially included or the mere use of financial services is not always good per se. Financial inclusion may not be sufficient to achieve improvements in consumer welfare, since it is not an end in itself, but a means to an end. We claim for the need to observe the financial behavior of consumers through its outcome in order to analyze the effects of financial participation on consumer welfare. 

The aim of this paper is to create a framework for understanding the channels through which participation in the financial system, measured by financial health, impact financial welfare by minimizing financial vulnerability. Also, a measure of consumers' financial health is presented. We estimate the impact of financial health on financial  vulnerability by using microdata from surveys at individual bases for five Latin American countries (Bolivia, Chile, Colombia, Ecuador, and Peru). Financial health is a relatively new term that has emerged after the global financial crisis in the U.S. It aims to measure the impact of participating in the financial system on consumer welfare (WEF, 2018). The Consumer Financial Protection Bureau (CFPB) defines financial health, or financial well-being, as “a state of being wherein a person can fully meet current and ongoing financial obligations, can feel secure in their financial future, and is able to make choices that allow enjoyment of life” (CFPB, 2015, 2017). A way of identifying whether an individual is in this state, is by observing financial behavior through the use of financial tools to manage personal finance. In order to understand how financial outcomes affect consumer welfare through financial vulnerability, it is necessary to analyze, both theoretically and empirically, the mechanisms of such effects. Our hypothesis is that welfare gains are not only derived from the standalone ownership of bank accounts or having access to credit, but also from their appropriate and responsible use. The key findings of our paper are the following: financial health has an impact on financial vulnerability, and this impact is higher than that derived from financial inclusion. These results are robust to alternative approaches of the financial health indicator. There is a primary set of relevant factors affecting financial vulnerability, especially those associated with human capital and financial literacy. The higher the level of these variables, the higher (lower) the probability of being financially safe (vulnerable). In the case of financial literacy, the impact is more important when we focus on interest rate issues. There is a second set of variables, the effect of which is also important, albeit more complex—the structure of income and the environment in which individuals live. Finally, we also find that financial vulnerability is pervasive in the countries included in our sample.

The rest of the paper is organized as follows. Section 2 presents a simple theoretical version for the financial consumer problem in a general equilibrium model that allows consumers facing different degrees of financial participation. In addition, some stylized facts for the diagnosis of the degree of financial vulnerability of adults in Latin America are shown. Section 3 presents the composition of the index for measuring financial health and the empirical strategy. Section 4 illustrates the findings and sensitivity analysis. Section 5 concludes.

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This document was prepared by Banco Bilbao Vizcaya Argentaria’s (BBVA) Research Department on behalf of itself and its affiliated companies (each a BBVA Group Company) for distribution in the United States and the rest of the world and is provided for information purposes only. The information, opinions, estimates and forecasts contained herein refer to that specific date and are subject to changes without notice due to market fluctuations. The information, opinions, estimates and forecasts contained in this document have been gathered or obtained from public sources believed to be correct by the Company concerning their accuracy, completeness, and/or correctness. This document is not an offer to sell or a solicitation to acquire or dispose of an interest in securities.

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