Financial Inclusion and Bank Stability: Heterogeneous Effects of Bank Size and Capital: Evidence from an Emerging Economy
Purpose: This study examines the effect of financial inclusion on bank stability in Pakistan, with particular attention to the moderating roles of bank size and capital adequacy. Design/Methodology/Approach: The study employs a dynamic system Generalized Method of Moments (GMM) estimator using an unbalanced panel of commercial banks in Pakistan covering the period 2011–2025. Two-stage least squares (2SLS) estimation is employed as a robustness check. Bank stability is measured using the Z-score, while financial inclusion is captured through a multidimensional index incorporating both traditional and digital access indicators. Findings: The results indicate that financial inclusion has, on average, a positive effect on bank stability. This effect is significantly stronger among smaller banks, for which the stability gains associated with an expanded and diversified deposit base outweigh the relatively modest marginal benefits observed among larger banks. In addition, well-capitalized banks are substantially better positioned to translate inclusion-driven growth into improvements in solvency and overall stability. These findings highlight significant heterogeneity in the relationship between financial inclusion and bank stability according to banks' institutional characteristics. Practical implications: The findings suggest that financial inclusion policies in Pakistan should account for differences in banks' institutional characteristics rather than being applied uniformly across the banking sector. Policies should target smaller banks, which gain more stability from inclusion, and be paired with sound capital adequacy requirements, since better-capitalized banks are better placed to convert inclusion into stability. Regulators should also strengthen cybersecurity, consumer protection and digital literacy as inclusion becomes more digital. Originality/Value: This study examines whether the effect of financial inclusion on bank stability differs by bank size and capital adequacy, using a 2011–2025 panel of Pakistani commercial banks. It builds a multidimensional inclusion index combining traditional and digital indicators and addresses endogeneity through system GMM. The results are specific to Pakistan but provide a basis for comparative research in other emerging banking systems.