Financial sector development must go beyond improving access to bank credit. Financial systems should develop in a balanced way through both bank and non-bank subsectors, including capital markets, the insurance sector, and other nonbank financial institutions to properly support inclusive growth in Europe and Central Asia, says a new World Bank report.

Risks and Returns: Managing Financial Trade-Offs for Inclusive Growth in Europe and Central Asia, launched today at the National Bank of Poland in Warsaw, notes that financial system in emerging countries in the Europe and Central Asia region is significantly less developed and less diversified than the financial system of their closest benchmark, Western Europe, and many of its middle-income peers.

For example, only about 38 percent of adults use savings products, compared with the developing world average of 54 percent, and just a few percent use insurance products. Distrust in banks among people is also higher than in any other region of the world.

“Overcoming this distrust and increasing the diversity of the financial system is crucial for sustainable growth. Policies need to focus on creating market incentives while also reducing barriers to ensure that the financial system benefits a wide spectrum of people and firms,” said David Gould, a World Bank Lead Economist in the Europe and Central Asia (ECA) region and author of the report.

“This report analyses key dimensions of financial development and provides a robust framework for policy makers to set priorities and manage policy tradeoffs.”

To achieve sustainable and inclusive growth, the report argues that countries in the region must look at four key dimensions of financial development:

•     Stability (e.g. addressing nonperforming loans and decreasing the volatility of private credit)
•     Efficiency (e.g. reducing overhead costs and net interest margins on assets)
•     Inclusion (e.g. increasing the use of electronic payments and  insurance)
•     Depth (e.g. developing capital markets and diversifying a country’s financial system)

The report points out that throughout the 1990s countries across the Europe and Central Asia region opted for a model of rapid financial development, focused on expanding bank credit often funded by foreign capital. This model helped boost the financial inclusion of firms and households – but was also accompanied by lower financial efficiency and increased vulnerability. Consequently, the region experienced two major banking crises, first in the late 1990s and again after 2008.

“While we have seen some recovery, what we are also seeing is that banks alone will be unable to support the kind of inclusive growth needed to drive the region in the long term,” says Martin Melecky, co-author of the report and a World Bank Lead Economist in the South Asia Region.

“Weak income growth, particularly among people with lower incomes, is leading to increased dissatisfaction with the status quo and greater mistrust in the financial sector – making the need for financial sector reforms that much more urgent.”

The report stresses the importance for ECA countries to consider certain policy options including tackling the high level of nonperforming loans, setting up the framework for macroprudential policy in ECA countries, strengthening governance frameworks for state-owned banks, increasing the use of electronic payments, and promoting the use of insurance against increasing risks from climate change.

Report by the World Bank Group