The Impact of Monetary Policy on Banks' Risk-Taking Behaviour in Pakistan: The Role of Basel III

Abstract

This study uses the data of 252 bank-years across 21 scheduled commercial banks in Pakistan covering the period of 2014 to 2025. It examines if alteration in the cash reserve requirement and in the interest-rate charged on loans are related to alteration in non-performing loans, as well as if Basel III liquidity protections change such connections. The non-performing loans as a proportion of gross advances are used to measure credit risk. Empirical design uses a combination of dynamic specifications and two-step System GMM to address issues of persistence, bank-specific unobservable, simultaneity and potential endogeneity in a single framework. Estimates reveal significant persistence in credit risk. Baseline equations show a varying relationship between the credit risk and reserve requirements and lending rates, with efficiency and profitability generally being negatively related to credit risk. There is no single direct effect that LCR and NSFR have in common in all the equations. Most importantly, the interaction estimates suggest that the sensitivity of credit risk to monetary conditions may vary by banks' prudential-liquidity stance. The evidence thus suggests an interdependence between the characteristics of the bank balance sheet, monetary transmission and liquidity regulation, rather than a uniform monetary-policy impact on bank risk.