Unraveling the Nexus Between Competition and Banking Efficiency in an Emerging Economy: A Two-Stage Stochastic Frontier Analysis Framework

Pakistan’s banking sector faces a critical juncture as rising competition intersects with uneven efficiency, jeopardizing financial stability. This study employs a two-stage empirical framework: (1) evaluating cost-efficiency (CE) evolution via a novel stochastic frontier analysis (SFA) framework incorporating desirable and undesirable outputs (e.g., nonperforming loans) and (2) assessing competition’s impact using a novel multi-product Lerner index across loan, deposit, and asset markets, analyzed via a two-step dynamic panel data system generalized method of moments. The first stage reveals an average CE of 81%, with significant ownership-based disparities. The second stage shows that market power enhances CE overall, supporting the banking-specificity hypothesis, suggesting that regulators balance competition with operational scale benefits. However, market power exhibits duality such as elevating CE in high-efficiency quartile banks but reducing it in low-efficiency quartile ones, confirming the efficient structure hypothesis. This highlights the need for policies promoting efficiency-driven consolidation and addressing structural bottlenecks in underperforming banks. Bank-specific and macroeconomic factors also significantly influence CE. The findings offer a policy roadmap to cultivate a competitive, efficient banking ecosystem, fostering sustainable economic growth.