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Assessing cost efficiency and economies of scale in the European banking system, a Bayesian stochastic frontier approach

Cost efficiency of banks is a key indicator that provides valuable insight to researchers and policymakers about the functioning of the financial intermediation process, as well as, the overall performance of the entire financial system. This thesis focuses on the cost efficiency of the European banking market for which we identify fourteen nation-specific frontiers and also perform cross country comparisons under a common frontier assumption. Our interest in the subject is twofold. At the nation level, cost efficiency influences the relative competitiveness of banks, setting the profile of the national banking industry with direct implications on economic growth. At the European Union level, the financial, institutional and regulatory integration raise questions about the existence of a common cost frontier or the presence of economies of scale as they could encourage banks to take advantage of the single market and consolidate. The empirical approach uses a more general Bayesian stochastic frontier model that allows for a continuous shift from the individual frontiers of each country to the common “European” frontier through varying priors. Results show differences in the frontiers of the countries that we studied, and the selected banks exhibit economies of scale greater than one more often than not, irrespective of size.