Beyond linearity: the U-shaped impact of shadow economy on bank profitability and risk in MENA
Mohamed AlbaityPurpose
The shadow economy represents a critical institutional feature in the Middle East and North Africa (MENA), yet its micro-level impact on banking stability remains underexplored. This study aims to examine the non-linear link between the shadow economy and bank profitability and risk-taking, alongside the moderating role of gross domestic product (GDP) growth.
Design/methodology/approach
Using a dynamic panel of 175 banks across 17 MENA countries from 2010 to 2024, we employ a two-step system generalized method of moments (GMM) estimator to address endogeneity, persistence and dynamic panel bias.
Findings
Results reveal a robust U-shaped relationship between the shadow economy and bank profitability (return on assets (ROA)/ return on equity), indicating that while initial informality erodes performance, banks adapt beyond a threshold. Risk-taking responses vary by proxy (SDROA vs SDROE), with GDP growth significantly attenuating the adverse effects of informality on both profitability and volatility.
Originality/value
This study makes three original contributions to MENA banking literature. It is the first to micro-found the shadow economy's impact on bank-level profitability and risk-taking using a non-linear specification. In addition, it identifies empirically grounded informality thresholds at which the shadow economy transitions from a profitability-reducing to a performance enabler, absent from prior MENA banking studies.