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Abstract: Shadow banking has become an important part of many financial systems despite having contributed to the financial crisis of 2008/2009. This study analyzes the relationship between shadow banking and economic growth using a panel of 28 developed and emerging economies. We employ panel feasible GLS technique and find a positive association between shadow banking and economic growth in the long-run. Further, we test for the Finance–Growth relationship using Granger causality tests and find a bi-directional relationship between shadow banking and economic growth. Stock market development and bank credit also have positive bi- directional relationships with economic growth. Our findings emphasize the role of financial innovation in enhancing economic performance given a stable regulatory environment. We suggest regular review of macro-prudential policy to carter for new financial activities and also to allow for development of new financing techniques.
Keywords: Shadow banking; economic growth; financial development; panel data.
JEL Classifications: G23, C23, O11
1. Introduction
The importance of shadow banking activities to the broader macro economy cannot be understated considering its role in the recent financial crisis (Hsu et al., 2013). Whilst several studies have criticized shadow banking activities as encouraging high risk taking and thereby increasing financial risk, there is no documented empirical evidence on the impact of shadow banking on overall performance of the economy. Available literature generally assumes two channels through which shadow banking impacts economic performance; first, it negatively affects the economy through propagating systemic risk, which can result in a crisis such as the 2008/2009 Global Financial Crisis (GFC). The second channel is its ability to increase credit, which can encourage economic activity, through increased access to capital by productive units within the economy (Adrian and Ashcraft, 2016; Rateiwa and Aziakpono, 2017). We set out in this paper to analyze the relationship between shadow banking activities and economic growth using a panel of 28 countries participating in the Financial Stability Board (FSB) Non-bank financial intermediation monitoring. To the best of our knowledge, this is the first paper that seeks to directly relate shadow banking to economic activity. Increased financial innovation in modern economies has seen a surge in financial activities outside the traditional banking system, generally referred to as shadow banking.1 Shadow banking is primarily associated with institutions that are not regulated by the monetary authorities, although recent developments have seen commercial banks and other regulated financial institutions extending credit through the shadow banking system (Harutyunyan et al., 2015). The term shadow banking as coined by McCulley (2009) refers to financial conduct outside the normal banking system. However, shadow banking is neither new nor static, but a continuously evolving sector. Its nature derives from the two main drivers of shadow banking, regulatory arbitrage and the profit incentive (Tang and Wang, 2015). Regulatory arbitrage arises from the need to maximize self-interest by economic agents, even if it means circumventing regulation in some cases. The profit incentive as suggested in Tang and Wang (2015) implies that financial institutions including commercial banks prefer shadow banking activities to traditional banking because it is highly profitable. The risk-return trade-off however
limits the extent to which these profits can be pursued.
Whilst increased activity in the shadow banking sector prior to GFC occurred mainly in the United States (US) and other developed countries, emerging economies have recently had an upsurge in shadow banking activity. The FSB (Board, 2016) reports that emerging economy countries were leading in shadow banking growth between 2006 and 2018, with China having a spiraling shadow banking sector. Although growth of shadow banking activities has slowed down in advanced economies, the proportion of shadow banking assets in these economies has remained high. However, in comparison with their emerging counterparts, emerging economies portray a steady increase in shadow banking assets during and after the crisis, whereas most advanced economies had a drop in shadow banking assets between 2008 and 2010. Figure 1 shows the growth of shadow banking in selected countrie
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