The Impact Of Financial Inclusion And Institutional Quality On Bank Efficiency Moderated By Economic Freedom: Evidence From Low-Income Countries

Abstract

This study examines how financial inclusion and institutional quality influence bank efficiency in low-income countries, with a specific focus on the moderating role of financial freedom. Using panel data and IV-2SLS estimation techniques to address endogeneity, the analysis explores two measures of bank efficiency: Bank Overhead Costs to Total assets (BOC) and Bank cost to Income Ratio (BIC). The findings reveal that financial inclusion (FI), political stability (POL), and control of corruption (COR) significantly affect banking costs, while rule of law (RL) is exogenous in this context. FI and POL are associated with increased banking costs, potentially due to the financial and administrative burden of expanding access and ensuring political stability. In contrast, stronger control of corruption reduces banking costs by improving governance and reducing inefficiencies. The study also finds that financial freedom (FF) significantly moderates these relationships: it weakens the cost-increasing effects of FI and POL and reduces the cost-saving impact of COR. This suggests that while FF can improve efficiency in weaker institutional settings, it may offset benefits in contexts with stronger governance mechanisms. The study recommends that policymakers in low-income countries pursue an integrated strategy that promotes financial freedom alongside institutional strengthening to achieve optimal bank efficiency and broader financial sector development.

JEL Classification: G21, O16, O43, and C33