Profitability, Efficiency, and Leverage as Drivers of Financial Stability: Evidence from the Banking Sector

Abstract

By examining the stability of commercial banks in Pakistan (in respect to its operations and profitability), the paper reflects on the tie between the efficiency in operations and leverage against the current stability of commercial banks in an emerging market. The analysis of panel data that considers 31 commercial banks in the 2019-2023 period was made using the random effect panel regression model that was validated by carrying out the Hausman specification test. A composite measure of the insolvency risk which is measured in the form of Z-score is being considered as a measure of the stability of the bank. As the proxies of the explanatory variables, profitability, Net interest Margin (NIM), and operational efficiency are studied along with the Non Interest-Expense to Total assets ratio (NIE/TA) and leverage in the form of the Debt-to-Assets (D/A) ratio is used; the log of total assets (LnTA) is used to reflect the size of the bank as a controlling variable. The empirical evidence reveals that there is a momentous influence of operation efficiency, leverage without considering its effect on bank stability, NIM illustrates insignificant effect hence stating that profitability based on the traditional measurements does not illustrate stability during uncertain and flux macroeconomic conditions. The findings also confirm the reason why big banks enjoy the economies of scale, risk diversification and higher capital buffer. The literature contribution that the study offers is that it has included aspects of the financial performance in its analysis, operational effectiveness, and capital structure on bank stability in the study region of South Asia. It is proposed to restrict its use of leverage, reduce operations, digitalized, and use state of the art stability assessment instruments to come up with some regulatory and management decisions.