The shadow economy and the soundness of the financial system

Abstract

This study investigates the influence of the shadow economy on the soundness of the financial system for a sample of 57 countries from 2010 to 2018. First, we construct a composite financial system soundness index by applying principal component analysis to eight indicators representing four aspects of financial soundness: earnings and profitability, capital adequacy, asset quality, and liquidity. Our composite index shows that the soundness of the financial system decreased slightly from 2010 to 2014 and then improved from 2014 to 2018. Second, we estimate the influence of the shadow economy on our composite financial system soundness index and find that the growth of the shadow economy is negatively associated with financial system soundness. Specifically, the shadow economy exerts significant negative impacts on three out of four aspects of financial system soundness: capital adequacy, earnings and profitability, and liquidity. We propose and test two potential channels and find that the shadow economy reduces official economic growth and institutional quality. We also find that lower economic growth might transmit to lower financial system soundness. Last, we show that the negative influence of the shadow economy is stronger in countries with lower institutional quality. Moreover, the influence of the shadow economy is stronger in countries with no colonial history, no socialist history, several dominant religions, higher industrial development, higher trade openness, higher unemployment, and lower Internet usage. The findings have important policy implications.