Banking and Financial Access Reforms, Labor Markets, and Financial Shocks

The degree of bank competition and firms' and households' participation in the domestic banking system differs considerably in developing and emerging economies (EMEs) relative to advanced economies (AEs). We build a small-open-economy model with endogenous firm entry, monopolistic banks, household and firm heterogeneity in participation in the banking system, and labor search to analyze the labor market and business cycle consequences of financial participation and banking reforms in EMEs. Our key finding is that there is a pre-reform threshold level of firm participation in the banking system below which reform implementation leads to sharper unemployment and aggregate fluctuations. Thus, for initially low (high) levels of firm and household financial participation, joint financial inclusion and bank competition reforms have adverse (beneficial) volatility effects. Our findings suggest that banking reform can reduce labor market and aggregate volatility by fostering household financial participation and bank competition in tandem, but only after a certain threshold of firm participation in the banking system is achieved.