The transition economies are known to have quite different market structures from the market economies. State-owned banks accounts for a major part of the financial sector in East European countries before the transition period. Since the input prices of the sector are frequently under the control of those governments, the misallocated resources may incur the loss of economic efficiency. This paper attempts to gauge the technical and allocative efficiency using unbalanced panel data of 340 banks from 14 transition countries under the framework of the Fourier flexible shadow cost function. Accommodating technical and allocative efficiencies simultaneously, as suggested by Atkinson and Cornwell (Int Econ Rev 35:231–243, 1994a) and Kumbhakar and Wang (J Econom 134:317–340, 2006a), avoids potential specification errors and leads to consistent parameter estimates. The average total cost savings resulting from greater technical and allocative efficiency are around 28.31 and 7.13%, respectively. Foreign-owned banks are found to be the most economically efficient. The enforcement of financial liberalization does gradually improve upon the sample banks’ technical efficiency. The allocative inefficiency arises from over capitalization and excess funds. Scale diseconomies appear to prevail in the sample states with a few exceptions.