The Influence of Risk Aversion, Efficiency, Credit Risk, Diversification on Cost of Financial Intermediation in Lower-Middle-Income Economies around the World
Abstract
Previous empirical studies reveal inconsistent outcomes regarding the relationship between risk aversion, efficiency, credit risk, diversification, liquidity, industry-specific factors, macroeconomic variables, and the social cost of financial intermediation. This study investigates the impact of risk aversion, efficiency, credit risk, diversification, liquidity, industry-specific factors, and macroeconomic conditions on the cost of financial intermediation (CFI) in lower-middle-income countries (LMIC), using secondary data obtained from the World Bank (2023, 2025) for the years 2000 to 2021. This study deployed POLS, fixed-effect (FE), and random-effect (RE) estimators, and the best estimator was selected utilizing the Hauman and Breusch-Pagan LM tests. Our findings indicate that income diversification reduces CFI in LMIC. Inefficiency, credit risk, risk aversion, and liquidity contribute to an increase in CFI. Bank concentration, an industry-specific variable, also enhances CFI. Banking sector development (BSD) negatively impacts CFI. The macroeconomic variable inflation positively affects CFI, whereas GDP growth negatively impacts CFI. This study presents several policy implications derived from our findings, particularly concerning lower-middle-income countries (LMIC): (1) Policymakers should promote competition to enhance efficiency and diversification by reducing entry barriers and providing tax incentives and subsidized loans; (2) policymakers should encourage banks to expand their deposit bases by attracting a larger number of depositors and decreasing reliance on a small number of large deposits, which significantly reduces the need to maintain higher liquidity and equity capital; and (3) policymakers should implement monetary policies aimed at reducing the inflation rate, fostering economic growth, and supporting the development of the banking sector.
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