January, 2009, Leora Klapper and Bilal Husnain Zia (DECRG)
The current financial crisis and consumer credit losses is driving new research to better understand how to promote more responsible and prudent individual saving and borrowing behavior. The ability of consumers to make informed financial decisions is critical to developing sound personal finance, which contributes to efficient allocation of financial resources and financial stability. Greater financial literacy can also be an important component to efforts to increase saving rates and lending to the poorest and most vulnerable consumers.
Earlier studies by Annamaria Lusardi and others have found that lower financial literacy is linked to lower household savings, as well as higher reported over-indebtedness. For instance, individuals with lower levels of debt literacy transact in higher-cost manners (interest rates, fees, etc.) and report that their debt loads are excessive or that they are unable to judge whether their debt is appropriate. In addition to greater susceptibility to fraud and abuse, the lack of financial literacy might lead to borrower behavior that increases financial fragility (i.e. greater loan losses). Informed consumers also exercise innovation-enhancing demand on the financial sector and play an important monitoring role in the market that can help improve transparency and honesty in financial institutions. Furthermore, financial illiteracy appears to be particularly severe for key demographic groups: women; less educated; low income; ethnic minorities; and older respondents.
Financial literacy appears to also be linked to economic development: for instance, the percentage of individuals in the United States that correctly answered questions on interest compounding and inflation was 72%, versus 52% in Indonesia, 46% in Russia and 34% in Rural India. Forthcoming work by Klapper and others shows a relationship between financial literacy, penetration, and vulnerability in Russia. This has led policy makers around the world to advocate increased expenditure on literacy education, in hopes of increasing household savings and increasing financial market participation, with the ultimate goal of reducing poverty and improving welfare.
Figure 1: Financial Literacy, % of individuals answering correctly
Yet, we know little about the causal impact of financial literacy training on improved financial outcomes. New research projects aim to explore this avenue in detail. For instance, a recently completed project in Indonesia highlights the importance of the design and incentives for financial education programs. Bilal Zia and others conducted a nationally representative field study on financial literacy training to test the role of financial literacy in determining demand for banking services. The experiment offered a randomly selected set of unbanked individuals an afternoon-long product-specific financial literacy training session. The authors find that financial literacy education substantially increases the demand for banking services, but only among those with low initial levels of financial literacy and low levels of education. The results of this research offer valuable insight into the design and targeting of financial training programs.
At the small firm-level, a study by David McKenzie provided a randomized sample of firms in Sri Lanka with information on loan products offered by a microfinance bank and showed them how to complete application forms – which led to a doubling in the number of firms taking a new loan in a 3 month period. Another study by David McKenzie and others will provide financial education to a randomized sample of Pacific Island immigrants in New Zealand about hidden exchange rate fees, and how to use dual ATM card methods to send money cheaply. This study is designed to test the impact of remittance costs through financial literacy, relative to individuals that do not receive training.
Other current projects focus on the impact of business training for entrepreneurs on the use of new loans (which can impact return on capital and repayment rates). For example, Xavier Gine and Ghazala Mansuri are conducting a randomized experiment in Pakistan which offers loans to male and female microfinance clients, and additionally offers financial training to some, in order to test if the use of the loan varies according to business training skills. Miriam Bruhn and Bilal Zia are studying how to improve youth entrepreneurship in Bosnia using a randomized experiment to measure the impact of providing young borrowers with business training and credit in order to encourage them to open new businesses. David McKenzie and others are studying the impact of business training of microenterprise owners in Sri Lanka by offering business training to a randomized sample of females considering opening a business.
These new research studies can provide valuable insights into the role of financial and business education, across countries and demographic groups, and motivate efforts to improve personal and household finance. This research should be of particular interest to policy makers who perceive financial capability of the population as a necessary component of development policy. Stay tuned for further interesting research findings in this area.
Bruhn, Miriam and Bilal Zia, 2009. “Business Training and Youth Entrepreneurship in Bosnia-Herzegovina.” Ongoing Project.
Bruhn, Miriam, Dean Karlan and Antoinette Schoar, 2009. “The Effect of Mentorship on SME Growth in Mexico.” Ongoing Project.
Cole, Shawn, Thomas Sampson and Bilal Zia, 2009. “Valuing Financial Literacy Training.” Working Paper.
de Mel, Suresh, David McKenzie and Christopher Woodruff, 2009. “The Impact of an Incentive Scheme to Credit Staff.” Ongoing Project.
Gine, Xavier and Ghazala Mansuri, 2009. “Constraints to Female Entrepreneurship: Ideas or Capital?” Ongoing Project.
Klapper, Leora and Annamaria Lusardi, 2009. “Financial Literacy in Russia.” Ongoing Project.
Lusardi, Annamaria, 2009. Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs, book manuscript.
Lusardi, Annamaria and Peter Tufano, 2008. “Debt Literacy, Financial Experience, and Overindebtedness”, Harvard Business School working paper.