Shadow Banking, Cross-border Shocks, and Financial Stability in Emerging Economies : A Global VAR Analysis

The shadow banking system is an alternative source of finance to formal banking channels and has expanded rapidly in the past two decades. This expansion has had a two-dimensional impact on economies: a threat to financial stability, and an increase in credit extended to firms. In this paper, we analyse whether the growth of shadow banking has had any effect on the financial stability of emerging market economies or not. We use a Global VAR Model and report impact elasticities and impulse response functions. Our results show strong cross-country financial linkages through the shadow banking sector among emerging economies and also between emerging economies and the global economy. We suggest a pro-active and targeted approach to regulation where transmission of financial disturbances in one country can be nipped before they can impact other countries.