Breaking the Cycle: How Financial Inclusion Drives Development in Procyclical Financial Systems

Our paper examines how financial inclusion contributes to financial development when financial systems behave procyclical - amplifying economic upswings and downturns. Using a novel nonparametric quantile regression approach on a balanced panel of 100 countries from 2002 to 2021, we investigate not only the average relationship but also how the effect differs across the financial development distribution and across income groups. Our findings reveal a clear asymmetry: financial inclusion significantly promotes financial development in economies with lower income levels and in countries situated at the lower and middle quantiles of financial development. These effects, however, fade as we move toward the upper quantiles and become statistically insignificant at the 90th quantile, suggesting that more advanced financial systems are less sensitive to inclusion driven shocks - possibly due to stronger institutional buffers and greater market maturity. By interacting with financial inclusion with procyclicality, we show that inclusive access to financial services can mitigate, but also be shaped by, the cyclical behavior of the financial sector. The positive effects are concentrated on developing economies, where broader financial access appears to enhance capital allocation, stabilize financial intermediation, and support deeper financial markets. In contrast, high income countries exhibit no significant inclusion–development link across most quantiles, indicating diminishing marginal returns of inclusion for already advanced financial systems. Additional robustness checks using GMM estimation confirm these patterns. Overall, our results underscore the importance of accounting for procyclical dynamics when designing policies that leverage financial inclusion as a development tool. They also highlight that the benefits of inclusion are not uniform: they are strongest in financially less developed and more vulnerable economies, where targeted inclusion policies can meaningfully strengthen financial resilience and long term development.