ABSTRACT

This manuscript examines the macroeconomic determinants of non-performing loans (NPLs) followed by the impact of these default loans on the profitability of Pakistan’s banking sector. Employing an unbalanced panel dataset of 53 banks for year 2007-2023, this research employs static panel analysis followed by our core estimation technique of system GMM, to capture the autoregressive nature of NPLs and to encounter the sensitivity of various macroeconomic variables to changes in NPLs. Dynamic panel results show that the past values of NPLs strongly influence current default rates confirming the persistence of NPLs with time horizon. Additionally, macroeconomic indicators of policy rate, unemployment and inflation significantly affect NPL fluctuations, highlighting the vulnerability of Pakistan’s banking sector to aggregate macroeconomic environment. The study further finds that public banks experience an unprecedented share of NPLs, primarily due to mismanagement and inefficient resource allocation. Regarding impacts of these loans on the performance and profitability of banks, the analysis shows that NPLs shocks (ΔNPLs) significantly impact overall bank profitability measured by both return on assets (ROA) and return on equity (ROE) while bank size and liquidity ratio also emerge as important determinants of profitability. These insights pin the importance of both sound macroeconomic policies and credit policies in banks to enhance financial stability which ensures that banks are resilient to macroeconomic shocks.