Examining the Mediating Role of Leverage in to the Linkage between Credit Risk and Firm Financial Performance: Empirical Evidence from Banking Sector

Abstract

This study examines the mediating role of leverage in the relationship between credit risk and financial performance within the banking sector. Credit risk, arising from potential borrower defaults, is a significant concern for banks as it can severely impact profitability and long-term stability. Leverage, which refers to the proportion of debt in a bank's capital structure, may amplify the effects of credit risk on financial performance. Despite substantial research on credit risk and financial performance, the interaction between credit risk, leverage, and performance remains under explored. This research aims to fill this gap by analyzing empirical evidence from Pakistani commercial banks. Using data from 2010 to 2023, the study investigates whether leverage mediates the relationship between credit risk (measured by the non-performing loan ratio) and financial performance (assessed through Return on Assets, ROA). The findings reveal that higher credit risk leads to increased leverage, which in turn exacerbates the negative impact of credit risk on profitability. The results confirm that leverage partially mediates the relationship between credit risk and financial performance. These findings highlight the importance of managing credit risk and optimizing capital structure to improve financial outcomes in the banking sector. This study offers valuable insights for policymakers, bank managers, and investors on maintaining financial stability while managing credit risk effectively.

Keywords: Credit risk, Leverage, Financial performance, Banking sector, Non-performing loans, Return on assets, Capital structure, Mediation analysis