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.
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.
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.
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.
