A Comprehensive Approach to Measuring Financial Vulnerability and Literacy: Unveiling Connections

In the aftermath of the 2007-08 financial crisis, the worsening financial conditions of households increased concerns about their financial vulnerability (FV). In this context, policymakers embraced the notion of financial knowledge to foster sound financial behaviors among individuals and households, aiming to mitigate the detrimental effects of FV on households' financial wellbeing and the overall economy. However, the relationship between FV and financial literacy remains inconclusive. This lack of definitive findings may stem from limitations in measuring FV and narrow focus on specific dimensions of financial literacy. This paper analyzes the relationship between financial literacy and FV by creating a comprehensive measure of (the level of) FV and considering different dimensions of financial literacy. Using a sample of 8,554 individuals in Spain obtained from the 2016-17 Survey of Financial Competences, we construct a continuous measure of FV by using Nonlinear Principal Components Analysis (NLPCA). Then, we employ OLS and ordered probit regressions to examine the potential association between different dimensions of financial literacy and FV. The findings indicate that the level of FV is negatively related to self-perceived financial knowledge, while no statistically significant relationship is found regarding objective financial knowledge. Evidence also reveals that "highly financially included" individuals are more likely to exhibit financial resilience. These findings highlight the need for the development of financial education initiatives that are action-oriented.