Development of Financial Inclusion Index and its Impact on the Banks’ Financial Stability in Pakistan

Abstract

This study examines the impact of financial inclusion on the stability of banks in Pakistan, focusing on two categories: conventional banks and Islamic banks. A sample of 12 banks, six from each category, was analyzed using annual reports from 2012 to 2022. A Financial Inclusion Index was developed using parameters such as access to and usage of financial services for banks. Bank stability was measured using the Z-score based on asset returns, leverage, and return volatility. The study employed panel regression models, including Panel Ordinary Least Square and Feasible Generalized Least Squares, to address heteroscedasticity and autocorrelation issues. Diagnostic tests, including the Wald and Wooldridge tests, confirmed the presence of these issues, validating the choice of Feasible Generalized Least Squares. Control variables such as bank size, loan ratio, loan loss provisions, income diversification, management quality, capitalization, gross domestic product, and gross domestic product per capita were included in the models. Results indicate that financial inclusion positively impacts the stability of conventional and Islamic banks, driven by broader customer bases, increased deposits, and diversified revenue streams. Bank-specific variables like size, capitalization, and loan ratios significantly enhanced stability, while loan loss provisions had a destabilizing effect. Macroeconomic indicators yielded mixed results, highlighting the need for economic stability in fostering banking sector resilience. The study suggests policy interventions aimed at enhancing financial inclusion while balancing operational efficiency and risk management. It calls for expanded Shariah-compliant services for Islamic banks. Future research should explore longer timeframes, broader geographic contexts, and digital financial inclusion's evolving role.

Keywords: Financial Inclusion, Conventional Banks, Islamic Banks, Bank Stability.