Objective: Non-performing loans (NPLs) are among the most important indicators of banking sector soundness and financial stability. A high level of NPLs can weaken banks’ lending capacity, increase credit risk, reduce profitability, and ultimately threaten the stability of the financial system. Over the past decade, the Iranian economy has experienced persistent inflation, substantial exchange rate volatility, international sanctions, and recurring economic downturns, all of which have affected the quality of banks’ assets and borrowers’ repayment capacity. Against this backdrop, the present study aims to investigate the determinants of non-performing loans in the Iranian banking sector and to examine how the effects of macroeconomic and bank-specific factors on NPLs evolve over time.

Methodology: This study employs quarterly data from 16 publicly listed Iranian banks over the period 2011–2022. The ratio of non-performing loans to total loans is used as the dependent variable. The explanatory variables include the exchange rate, inflation rate, unemployment rate, business cycles, return on assets (ROA), return on equity (ROE), and the current ratio (CR). Business cycles are extracted from real gross domestic product data using the Hodrick–Prescott (HP) filter and subsequently seasonally adjusted through the SEATS/TRAMO procedure. Prior to estimation, cross-sectional dependence is examined using Pesaran’s test, while stationarity is assessed through the Cross-Sectionally Augmented IPS (CIPS) unit root test. To capture the dynamic and time-varying nature of the relationships, the study applies a time-varying coefficient panel data model estimated using the Averaged Local Linear Method. This approach allows the impact of explanatory variables on NPLs to change over time and provides greater flexibility than conventional panel data models.

Findings: The findings reveal that the effects of both macroeconomic and bank-specific variables on non-performing loans are not constant over time and vary according to prevailing economic conditions. The exchange rate exerted only a limited influence on NPLs during the early years of the study period; however, its positive effect intensified significantly after 2014, particularly following the escalation of economic sanctions and exchange rate shocks. Rising exchange rates increased production costs, reduced firms’ profitability, and weakened borrowers’ repayment capacity, thereby contributing to higher levels of non-performing loans.

Inflation was found to have a consistently positive impact on NPLs throughout the study period. By eroding households’ real income and increasing production costs, inflation reduced the ability of both individuals and businesses to meet their debt obligations. Similarly, unemployment generally exerted a positive effect on NPLs, particularly during periods of economic recession and intensified sanctions, when declining employment opportunities reduced borrowers’ income and repayment capacity.

The results regarding business cycles indicate that economic expansions initially contributed to lower NPL ratios, whereas recessions increased them. However, in later years, structural economic shocks and financial instability weakened this conventional relationship. Consequently, even periods of economic expansion were unable to substantially reduce non-performing loans. Among the bank-specific variables, both return on assets and return on equity had a negative effect on NPLs, suggesting that more profitable banks are better able to manage credit risk and maintain higher-quality loan portfolios. Notably, return on equity exhibited the strongest mitigating effect on non-performing loans among all variables considered. In contrast, the current ratio exerted a predominantly positive influence on NPLs throughout most of the study period, indicating weaknesses in liquidity management and short-term financial obligations within the banking sector.

Conclusion and Discoussion: The results demonstrate that macroeconomic factors—particularly exchange rate fluctuations, inflation, unemployment, and business cycle conditions—play a significant role in increasing non-performing loans in Iranian banks. Conversely, bank profitability indicators, especially return on equity and return on assets, help mitigate the adverse effects of macroeconomic shocks and contribute to reducing NPL levels. These findings highlight the importance of maintaining macroeconomic stability through inflation control, exchange rate stabilization, support for productive economic activities, and employment creation. Furthermore, strengthening banking supervision, improving operational efficiency and profitability, enhancing credit risk management systems, and adopting advanced credit assessment and monitoring technologies can significantly reduce the accumulation of non-performing loans and improve the resilience of the banking sector. Overall, the study underscores the need for coordinated macroeconomic and banking policies to enhance financial stability and effectively manage credit risk within Iran’s banking system.