Are cooperative and commercial banks equally effective in reducing the shadow economy? International evidence

Are cooperative and commercial banks equally effective in reducing the shadow economy? Although theory and evidence indicate that the expansion of the financial system reduces the size of the shadow economy, little is known on the role played by cooperative and commercial banks in shaping the size of the shadow economy. We address this issue using data from 42 developed and developing countries over the 2006–2017 period. For our empirical purposes, Generalized Least Squares (GLS) and Instrumental Variable (IV) estimators have been employed. Evidence indicates that cooperative banks significantly reduce the size of the shadow economy. On the contrary, commercial banks are shown to increase the shadow economy. Consistent with previous literature, while for cooperative banks increased financial outreach encourages small firms to enter the formal sector, thereby reducing the size of the shadow economy, the expansion of commercial banks exacerbates the latter by tightening credit constraints for small firms.