NON-PERFORMING LOANS AND PROFITABILITY OF THE CONVENTIONAL BANKING SECTOR IN PAKISTAN: THE MODERATING ROLE OF CAPITAL ADEQUACY

Abstract

Significance: Non-Performing Loans (NPLs) are an important concern for the stability of banking sectors in emerging markets such as Pakistan. However, weak credit risk management and inconsistent enforcement of recovery regulations can lead to rising NPLs that erode bank earnings and weaken confidence among depositors and investors. Existing studies give results about how NPLs influence bank profitability. Most studies look at NPLs or capital adequacy separately. They pay little attention to how capital adequacy might change this effect in the conventional banking sector.  Objective: This study examines the effect of NPLs on the return on assets (ROA) of Pakistan’s conventional banks and tests whether capital adequacy (CAR) moderates this relationship. Methodology: Using annual sector-level data for 1991-2025 from the State Bank of Pakistan and the World Bank, the study applies ARDL bounds testing to separate short-run and long-run effects of NPLs on ROA. Capital adequacy (CAR) enters through a mean-centered interaction term to test its moderating role, with bank size, cost-to-income ratio, and net interest margin as controls. Findings: The bounds test confirms a stable long-run relationship (F = 15.68), with significant adjustment toward equilibrium (ECT = -1.648, p < 0.001). Contrary to conventional expectations, NPLs have a positive and significant long-run effect on ROA (β = 0.1145, p < 0.01), consistent with a risk-return trade-off, while their short-run effect is negative (β = -0.3688, p < 0.001). Capital adequacy significantly moderates the relationship The negative interaction (β = -0.0133, p = 0.015) shows that stronger capital buffers weaken the NPL-ROA relationship, with the long-run NPL effect falling from 0.157 to 0.072 as CAR rises. Implications: Regulators and bank managers should assess NPLs together with provisioning quality and capital buffers. The State Bank of Pakistan should encourage timely provisioning and regular stress testing, while banks should also control operating costs.