Does the Shadow Economy Cast a Cloud on Banking Sector Resilience?

Employing 127 countries over the 1991–2017 period, we investigate whether the shadow economy affects banking sector resilience, as measured by bank non-performing loans, bank capital to total assets, and bank regulatory capital to risk-weighted assets. Using several different methodologies including System GMM, IV estimation, the High Dimensional Fixed Effects (HDFE) estimator, and Least Squares Dummy Variable (LSDV) estimation, we find that the shadow economy significantly negatively affects banking sector resilience. The Juodis et al. (2021) Granger non-causality tests further reveal a bi-directional causality between the shadow economy and bank non-performing loans and bank capital to total assets.