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This paper extends the Schure and Wagenvoort (1999) study, which considers economies of scale and efficiency in European banking, in a number of directions. Firstly, we introduce what we believe to be important improvements to estimating efficiency. Secondly, we examine more closely the characteristics of the banks on the cost frontier and draw comparisons between the characteristics of these banks and those of the relatively inefficient banks in our sample. In contrast with the results of Schure and Wagenvoort (1999), we find that both X-efficient savings banks and Xefficient commercial banks have cut their average cost, independent of input price movements or changes in the output mix, by about 5 percent each year during the five-year period following the implementation of the Second Banking Directive of the European Union on the first of January 1993. In other words, we observe structural shifts in the cost frontier, possibly due to technological progress. X-inefficient banks became only slightly more inefficient than their efficient counterparts. Therefore, these banks also experienced substantial reductions in average cost. However, these reductions are mainly explained by lower interest expenditures because of lower real interest rates rather than structural changes. Additionally to the results of Schure and Wagenvoort (1999), an examination of the output mix of efficient and inefficient banks reveals that the efficient banks are likely to be more involved in more 'commercial' (or fee-based) activities since their ratio of commission revenue to total operating income is higher. The profitability of savings banks appears strongly determined by their cost efficiency which supports the efficient structure hypothesis. The average profitability of efficient commercial banks seems mainly driven by other factors, such as possibly output prices, rather than cost considerations.

AbstractWe assess the efficiency of the European banking sector in the 5‐year period following the implementation of the Second Banking Directive of the European Union (EU). We first determine the degree of cost efficiency of EU banks in 1993–1997. After that, we explore to what extent efficient European banks are managed differently than their inefficient peers. Our datasets comprise 5 years of observations on 1347 savings and 873 commercial banks. We use the new recursive thick frontier approach (RTFA) method to establish our results. We find that structural factors, such as technological progress or increased bank competition, have lowered the cost base of banks by about 5% annually during the sample period. Managerial inability to control costs (X‐inefficiency) is with 17–25% the main source of bank inefficiency in the EU. Managerial efficiency varies a great deal within Europe, and there seems to be no tendency towards convergence. We find that small savings banks can exploit economies of scale. The EU savings bank sector would cut costs by about 3% if small savings banks merged.