Credit Risk Shocks and Bank Resilience in Pakistan: Evidence from Dynamic Z-Score and NPL Interactions

Abstract

The present study investigated the effect of credit risk management on the financial performance of commercial banks in Pakistan by utilizing quarterly data for eighteen listed commercial banks representing 80% of total banking assets during 2010-2022. This research employed Altman Z-score and dynamic panel regression as well as Vector Autoregression (VAR) models to identify the effects of credit risk (Gross Non-Performing Loan Ratio) on bank stability and performance. IRF analysis indicated that a one standard deviation shock to the GNPLR caused an approximate 0.23 decrease in Z-scores within eight quarters, with a peak impact in the second quarter. FEVD analysis determined that variation in the Z-scores accounted for between 12 and 15 percent of the variation in the Z-scores for a two-year forecast horizon. In panel regression results, prudent credit risk management reflected by non-performing loan ratios significantly impacts higher Z-scores, higher ROA, and higher equity to asset ratios. Also, macroeconomic factors such as GDP growth, inflation, and treasury bill rates significantly moderate the impact of credit risk shocks. The study will add to the nascent body of research on banking sector resilience in developing economies and provide pragmatic policy recommendations for banking regulators and commercial banks' management.