Moreover, the largest U.S. banking firm today is still not even in the worldwide top ten largest banks list based on 1995 total assets, suggesting that there may be room for further consolidation among large U.S. banks. Nevertheless, one cannot rule out the alternative hypothesis that entrenched managers use mergers and acquisitions to increase the size of the firm with the objective of enhancing their own welfare. While scale efficiency is about whether a banking firm has the right size, a potentially more important question is whether a firm produces as efficiently as it possibly can, given its size. X-efficiency stems from technical efficiency, which measures the degree of friction and waste in the production process, and allocative efficiency, which measures whether the right levels of various inputs are used. If the observed total operating cost is higher than the minimized cost, the difference represents the bank's X-efficiency.
Researchers find that X-efficiency appears to vary substantially across banks.
On average, the deviation from the minimum cost is found to be quite large, in the neighborhood of 20 to 25 percent of total costs, and it seems to dominate the effect of scale inefficiency. The findings suggest that for an average bank, the biggest room for efficiency gains lies in improving its operating efficiency, that is, doing things right, rather than on scale efficiency, that is, being the right size. After identifying X-efficiency in banking firms, it is important to find out what may cause this type of inefficiency. While we do not have a conclusive answer to this question, preliminary evidence suggests that X-efficiency seems to be related to at least three things. To the extent that large banks, which operate in metropolitan markets, face stronger competition than smaller banks, many of which operate in suburban or rural areas, it is not surprising that competition forces large banks to operate more efficiently.