This paper examines the relationship between problem loans and cost efficiency in commercial banks, using Granger-causality techniques to test four hypotheses. The data suggest that problem loans precede reductions in measured cost efficiency, and that cost efficiency precedes reductions in problem loans. Additionally, reductions in capital at thinly capitalized banks precede increases in problem loans. These findings indicate that cost efficiency may be an important indicator of future problem loans and problem banks. The results are mixed regarding whether controlling for problem loans should be included in efficiency estimation. The study provides insights into the underlying relationships between problem loans and cost efficiency, which have implications for policy and research in the banking industry.This paper examines the relationship between problem loans and cost efficiency in commercial banks, using Granger-causality techniques to test four hypotheses. The data suggest that problem loans precede reductions in measured cost efficiency, and that cost efficiency precedes reductions in problem loans. Additionally, reductions in capital at thinly capitalized banks precede increases in problem loans. These findings indicate that cost efficiency may be an important indicator of future problem loans and problem banks. The results are mixed regarding whether controlling for problem loans should be included in efficiency estimation. The study provides insights into the underlying relationships between problem loans and cost efficiency, which have implications for policy and research in the banking industry.