Monetary Policy, Basel III Liquidity Regulation, and Bank Stability: Evidence from the Pakistani Banking Sector

Abstract

The study investigates the relationship between monetary policy and bank stability in Pakistan and how the Basel III liquidity regulations moderate the relationship. The analysis is conducted using a panel dataset of 21 commercial banks for the period 2012-2023, and a dynamic panel estimation method of the two-step System GMM is used to deal with the endogeneity, persistence and unobserved bank-specific heterogeneity in the data. The empirical results show that monetary policy has a significant effect on bank stability. The cash reserve ratio and the interest rate on lending are negatively related to the Z-Score in most specifications and are statistically significant, indicating that tighter monetary conditions could have a negative impact on bank stability by reducing liquidity and raising the cost of borrowing. Operational efficiency, capitalization and profitability are also important bank-specific factors that impact financial resilience. The results also show that Basel III's liquidity requirements, especially LCR, have a positive impact on the bank stability. The interaction results suggest that the impact of monetary policy is cushioned by regulatory liquidity buffers, suggesting that more robust liquidity positions allow banks to absorb shocks of monetary policy. Overall, the results highlight the importance of coordination between monetary policy and macro prudential regulation in maintaining financial stability in Pakistan’s banking sector.