Digital finance and bank stability in developing economies: the fortifying role of internet penetration

With the accelerating pace of the digital revolution across economies, its impact on the soundness of banks is of significant interest to researchers and policy makers. Understanding this relationship in the context of developing economies, characterized by fragile financial systems and weak regulatory controls, is particularly important to formulate sustainable economic growth strategies and financial inclusion. This chapter investigates the effect of digital finance on bank stability in 35 developing countries, focusing on their nonlinear nexus and the moderating role of internet penetration. Using two-step IV-GMM estimation across multiple model specifications, we find evidence of a U-shaped relationship – digital finance initially weakens bank stability, but beyond a threshold, it supports stability. Crucially, internet penetration moderates this relationship: the U-shaped curve flattens and shifts upward, signifying better and sustained stability irrespective of the digital finance level. These findings imply that while growth in digital finance is vital to support economic and social equity, strengthening a country’s information technology infrastructure and policies to boost internet penetration is a precondition for sustainable financial inclusion. The chapter discusses policy implications for developing countries, showing that internet access amplifies the benefits of digital finance only when embedded within a broader ecosystem of institutional readiness and risk management.