ABSTRACT

This study investigates the determinants of interest rate spreads (IRS) in Pakistan’s commercial banking sector from 2000 to 2023, incorporating bank-specific, industry-specific, and macroeconomic variables within a panel data framework. After conducting several diagnostic and specification tests, the Fixed Effects Model was identified as the most appropriate for controlling unobserved heterogeneity across banks.

The empirical findings reveal that macroeconomic factors, namely GDP growth, inflation, and interest rates—play a significant role in influencing the banking spread. Specifically, higher interest rates are associated with an increase in the spread, whereas GDP growth and inflation exhibit significant negative relationships, indicating that economic expansion and inflationary conditions tend to narrow spreads through competitive adjustments in lending and deposit rates. In contrast, most bank-level and industry-level variables, including systemic importance, non- remunerated deposits, and asset exposure, were not statistically significant in the overall sample, though they became relevant in subgroup analysis. For banks with smaller spreads, systemic importance negatively affects the spread, while for banks with larger spreads, GDP growth and inflation remain key determinants.

These results highlight that Pakistan’s persistently high spreads are largely driven by macroeconomic conditions and structural inefficiencies rather than competitive dynamics. The study contributes to the literature by emphasizing the heterogeneous behavior of spreads across bank   categories   and   identifying   the   dominant   role   of   monetary   variables.   Policy recommendations include strengthening competition through proactive regulatory oversight, improving inflation and interest rate management by enhancing monetary policy transparency, and promoting financial inclusion to diversify funding sources. Collectively, these measures could foster greater efficiency, reduce spreads, and promote sustainable financial sector development.