Measuring efficiency at U.S. banks: Accounting for heterogeneity is important

Estimates of bank cost efficiency can be biased if bank heterogeneity is ignored. I compare X-inefficiency derived from a model constraining the cost frontier to be the same for all banks in the U.S. and a model allowing for different frontiers and error terms across Federal Reserve Districts. I find that the data reject the single cost function model; X-inefficiency measures based on the single cost function model are, on average, higher than those based on the separate cost functions model; the distributions of the one-sided error terms are wider for the single cost function model than for the separate cost functions model; and the ranking of Districts by the level of X-inefficiency differs in the two models. The results suggest it is important when studying X-inefficiency to account for differences across the markets in which banks are operating and that since X-inefficiency is, by construction, a residual, it will be particulary sensitive to omissions in the basic model.