Insolvency risk determinants and capital regulation effect on conventional and Islamic banks of Pakistan

In the wake of several recent bank collapses following the 2008 global financial crisis, insolvency risk, previously understudied, emerges as one of the key risks in the banking sector. Hence, this study aims to fulfill this gap by investigating insolvency risk ( measured by Z-SCORE) and its dependency on asset quality (nonperforming loans (NPL), provision for nonperforming loans (PNPL)), income structure (IATA, IITA, FBTA), macroeconomic factors (GDP growth, inflation (INF), Interest (INT) and Corruption (CUR). Capital regulation (CAR) is incorporated in the research model to assess its moderating effect on the relationships between those independent variables and insolvency risk. 161 conventional banks and 35 observations from Islamic banks of Pakistan were analyzed from 2007 to 2015 period. The data were collected from the several sources such as Annual report of banks, Economic Surveys of Pakistan, World Bank database and Transparency International reports. Random Effect, Common Effect model and Hierarchical Regression were performed to identify the determinants of insolvency risk and the moderating effect of CAR on the banks. The results show that NPL, IITA, FBTA, GDP, INF and CUR were found significant with insolvency risk in conventional banks, while CAR moderated NPL, PNPL and INF with insolvency risk. For Islamic banks, GDP was negatively whilst CUR was positively related to insolvency risk. Both were significant. In contrast to conventional banks, CAR strengthened NPL, PNPL, IATA, IITA and FBTA relationship with the Z-SCORE. The findings of CAR effect on the relationship between asset quality, income structure and macroeconomic factors with insolvency risk were mixed in conventional and Islamic banks of Pakistan. The mixed results imply that policy makers and practitioners should develop different prudential regulations and risk management strategies to conventional and Islamic banks in order to mitigate insolvency risk, hence increase the sustainable growth of Pakistani banks.