The Impact of Credit Risk Indicators on Bank Profitability in an Emerging Economy: Evidence from Pakistan

Abstract

Credit risk continues to be the major problem threatening banking stability and profitability, especially in developing countries like Pakistan, due to consistently high non-performing loans ratios that continue posing financial sustainability problems for banks. This study addresses a research gap by jointly examining the influence of NPLs, capital adequacy ratio (CAR), and loan-to-deposit ratio (LDR) on bank profitability, using recent post-2020 data capturing macroeconomic shocks such as inflation and exchange rate volatility. The objective is to assess the combined impact of these credit risk indicators on the sustainable financial performance, measured by return on assets (ROA), of Pakistan's five largest listed commercial banks (HBL, UBL, MCB, NBP, and ABL). Using a quantitative, explanatory design, the study analyze a balanced panel of 75 observations (2008–2022) sourced from audited annual reports, State Bank of Pakistan publications, and PSX records. Chow and Hausman tests confirmed the suitability of a fixed-effects regression model. Findings show NPLs have a significant negative effect on ROA (β = –0.025, p < 0.01), while CAR (β = 0.011, p < 0.01) and LDR (β = 0.002, p < 0.05) have significant positive effects, with the model explaining about 49% of within-bank variation in ROA (F = 15.62, p < 0.001). Descriptive statistics show mean ROA of 1.05%, mean NPL of 7.8%, mean CAR of 13.6%), and mean LDR of 68.2%. The research finds that effective credit risk management, sufficient capital cushions, and balanced lending are critical in ensuring the sustainability of bank profitability.

Keywords: Credit Risk, Bank Profitability, Return on Assets, Panel Data, Fixed Effects Model, Financial Sustainability

https://doi.org/10.5281/zenodo.23038617