Are European savings banks too small? A comparison of scale elasticity and scale efficiency

Studies on the cost structures of banks tend to find that economies of scale are negligible whereas improvements in X-efficiency facilitate much larger cost reductions. The implication is that banks should reduce costs by emulating industry best practice rather than increasing size. This interpretation is questionable because it is based on comparisons of two different economic concepts scale elasticity and Xinefficiency. As pointed out by Evanoff and Israilevich (1995), more accurate cost comparisons can be made if one compared scale efficiency with X-inefficiency but, as far as we are aware, few studies (to date) make such comparisons. This paper employs the Fourier flexible cost function and stochastic frontier methodologies to estimate scale elasticity and scale efficiencies for a large sample of European savings banks. In contrast with previous studies, we find that scale efficiency is potentially a larger source of cost reduction than improving X-efficiency for different bank sizes, but particularly so for smaller institutions. The average savings bank could reduce costs by 38% if it attained cost scale efficiency compared with 16.5% if it lay on the Xefficient cost frontier.