Business Essays - Bank Interest Rates

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Bank Interest Rates


Empirical literature on the interest rate pass-through provides an adequate amount of results regarding the speed and the size of the adjustment of bank interest rates to money market rates (and also regarding the break point of interest rate pass-through).

One of the first papers to deal with this topic is Cottarelli - Kourelis (1994). They mainly studied the degree of lending rate stickiness in several countries in the euro area and they related this stickiness with structural features of the financial system. The model they employed was based on autoregressive distributed lag specification estimated with time series. What they found is that the speed of adjustment of lending rates is higher in high inflanatory environments. Secondly, they found that the dynamics of lending rate adjustment vary depending on the type of the lending rate. Another thing they discovered is that in the longrun, all types of rates tend to change in the same amount and the lending rate stickiness is highly influenced by the financial system's structure. Finally, they concluded that the competition among banks, the ownership system of a bank, the money market growth, the degree of the development of the financial system and the openness of the economy are the key factors that can potentially improve lending rate flexibility.

An author that contributed significantly towards the understanding of how interest rate pass-through operates is De Bondt with two papers, one in 2002 and a following one in 2005.In the first he analyses both lending and deposit rates in the euro area so as to discover the way retail interest rates are determined in the euro area. For that he is using an error correction model. He found a cointegration relationship between market and bank interest rates. Moreover, he found that in the short-term, rates appear to be sticky meaning that the pass-through is incomplete for both deposit and lending interest rates. However, since the introduction of the euro the pass-through process of retail interest rate has become quicker. De Bondt believes that this is because of an increase in competition, in interest rate elasticity of bank products' demand and because of a decrease in asymmetric information costs in the retail bank market.

In the second paper De Bondt examines the interest rate pass-through in the euro area focusing on the pass-through of official interest rates to long-term market interest rates using rates with comparable maturities. This time he uses two different models, an error correction model and a vector autoregressive model. The results that he obtains suggest that the money market rates of up to three months are fully controlled by the monetary policy and that the bank interest rates are sticky in the shortrun. Furthermore, he discovers that the long-term pass-through of market to retail bank interest rates is complete. Finally, he finds that the retail bank interest rate has become quicker since the introduction of the euro, increasing its speed to around one month for deposit and three months for lending rates. According to De Bondt's point of view these differences in the speed of adjustment arise due to the competitive forces in the different parts of the retail bank market.

Another important paper is the one written by Mojon (2000).In this paper Mojon analyses two aspects of the monetary transmission. Firstly he focuses on the pass-through of monetary to bank interest rates and then on the balance sheet structure of the non-financial private sector. The model Mojon uses in order to draw conclusions is once again an Error-Correction model .Our field of interest is only the first part of his study, in which he further sub-categorizes the time period in two main periods, one before and one after the EMU . What Mojon finds is that first of all stickiness exists in retail bank rates. Additionally, he proves that heterogeneity exists among different countries in the Eurozone. Finally, he found that EMU is likely to increase the pass-through speed meaning that short-term responds faster than long-term rates. Moreover he identified some features that he believes are responsible for the lending rate stickiness. These are mainly the competition that exists among banks and from direct finance, the monetary policy regime and finally the rigidity of bank's costs.

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Borio and Fritz (1995) discuss the pass-through of policy to market rates in the basis of short-term period. The econometric approach employed is a general-to-specific error-correction model. What Borio and Fritz found is that the short-term lending rate pass-through is not fully complete and also that the respond to policy rates mainly depend on whether the interest rates are falling or rising.

Sander and Kleimeier (2003) in their paper search endogenously for the break point and then examine the impact of the interest rate pass-through using a well specified Error-Correction Model. They find that the break point occurs actually much before the introduction of the euro. Sander and Kleimeier, from the results of their study, appear to believe that the speed and the size of the pass-through have increased. However, this only takes place when using the overnight rate as proxy for the monetary policy rate, which in line indicates a monetary policy efficiency increase. Another thing that they found is that the markets are still fragmented, except for the shortrun lending to enterprises. Finally, some convergence is possible to be achieved by means of nominal, real and structural convergence, but total convergence is prevented by legal and cultural differences.

Sorensen and Werner (2006) are making a rather simplistic assumption that the structural break indeed occurred at the introduction of euro and move on focusing on the period after that. They use a dynamics panel data econometrics framework to identify the pass-through mechanism under a single currency regime. They conclude that a high degree of heterogeneity in the longrun of the interest rate pass-through exists in the euro area. The prevailing differences that come up regarding the long-term multipliers and the speed of adjustment across countries are indicating some degree of fragmentation and no integration in the euro area at the bank sector. These differences are due to different degree of competition between countries and cyclical and structural determinants, according to the authors.

Chionis-Leon (2004) conducted a study that focuses on the pass-through of the money market rate to the Greek bank interest rate, an aspect of interest rate pass-through that we are interested in exploring as well. They examined the pass-through process for lending and deposit rates for an 8 year period up until 2004 using bivariate cointegration and error-correction model. According to this paper, the structural break occurred in Greece with the introduction of the euro. After Greece entered the EMU the impact multipliers were activated and the speed of adjustment became faster. Nevertheless, even after the accession in the EMU the transmission mechanism is not complete. However, these results should be accepted with extreme caution as the time framework is really narrow.

Apart from the previous studies, which were dealing with the pass-through mechanism of the interest rates in the whole euro area, there are several other studies dealing with the pass-through process for different countries. All of these papers draw more or less the same conclusions. Most of the studies argue that the actual break point of monetary transmission did not come with the introduction of euro, but it is different for every country.

Marotta (2007) searched for the break point in a big sample of European countries using an Autoregressive distributed Lags approach. The results that he obtained demonstrate that in some countries there were more that one structural breaks after the inception of EMU (Austria, Germany, Italy, Portugal) while in others ,although there was only one break point, it came after January 1999(Germany, Ireland) and only for France there was strong evidence suggesting a structural break before accession to EMU. There is even one case where no structural break is detected (Belgium). Moreover this study provides evidence that regarding the last break-free period, the equilibrium pass-through decreases and is incomplete. The fact that the pass-through is incomplete means that the effectiveness of the single currency regime is decreased. Nevertheless, he finds that the speed of adjustment to equilibrium becomes faster. Finally, Marotta discovers grater uniformity in the cross-countries transmission mechanism, (but nonetheless with big differences).

Most papers come to the same conclusion regarding the size and the speed of the adjustment of the shortrun pass-through, using mainly the same econometric framework of Error-Correction model. In countries such as Germany(Weth(2002)), Chile(Espinosa-Vega and Rebucci(2003)), Romania(Tieman(2004)) and Italy(Di Lorenzo and Marotta(2005)) the interest rate pass-through in the shortrun has actually increased and become faster, and only in Portugal(Di Lorenzo and Marotta(2005)) the equilibrium pass-through has fallen by half. Finally in Ireland (Bredin, Fitzpatrick and O Reilly (2002)) the speed of adjustment appears to vary across countries.?

Regarding the long run pass-through, there are some mixing results. In several occasions it appears to be incomplete, like in Chile (Espinosa-Vega and Rebucci (2003)) and Ireland (Bredin, Fitzpatrick and O Reilly (2002)).While in others, like Germany (Weth (2002)), all banks indeed reach a long-term relationship.

In spite of all these differences, one thing that all these studies have in common is the identification of the factors that cause lending rate stickiness. The first and foremost is, as already mentioned, the competition that exists not only among banks but also with market terms, such as money market and corporate bond market. Another significant factor is the refinance condition of credit institutions. In other words, banks can be categorized into banks with market related refinancing conditions and banks that depend on a smaller extent on money market movements. Other factors enlisted are banks' uncertainty, credit demand shifts, rigidity of banks' costs and adjustment costs. Finally, a very important role plays each bank's credit structure and size.


1. Borio, C. and Fritz, W. (1995), The response of short-term bank Lending Rates to Policy Rates: A Cross-Country Respective, BIS Working Paper, No 27

2. Bredin, D. and Fitzpatrick, T and O Reilly, G. (2002), Retail Interest Rate Pass-Through: The Irish Experience, The Economic and Social review, Vol.33, No.2, pp.223-246

3. Chionis, D. and Leon, C. (2004), Modelling Interest Rate Transmission Dynamics in Greece. Is there any Structural Break after the EMU? , Social Sciences Research Network, viewed at June 21, 2008 <>

4. Cottarelli, C. and Kourelis, A (1994), Financial Structure, Bank Lending Rates and the Transmission Mechanism in the monetary policy. IMF Staff Papers, Vol.41, No.4, pp. 587-623

5. De Bondt, G. (2002), Retail Bank Interest Rate Pass-Through: New Evidence at the Euro Area Level , European Central Bank, Working Paper, No 136

6. De Bondt, G. (2005),Interest Rate Pass-Through: Empirical Results for the Euro Area, German Economic Review, Vol.6, No.1, pp.37-78

7. Di Lorenzo, G. and Marotta, G. (2005), A less Effective Monetary Transmission in the Wake of EMU? Evidence from Lending Rates Pass-Through, Universita degli studi di Modena e Reggio Emilia, Working paper, No.482

8. Espinosa-Vega, M. and Rebucci, A. (2003), Retail Interest Rate Pass- Through: Is Chile atypical? IMF Working paper, No. 03, 112

9. Heinemann, F and Schuler, M. (2002), Integration Benefits on the EU Retail Credit Markets-Evidence from Interest Rate Pass-Through, ZEW Discussion Paper, No.02, 26

10. Hofmann, B. and MIzen, P. (2001), Interest Rate Pass-Through and Monetary Transmission: Evidence from Individual Financial Institutions' Retail Rates, Economica, Vol.71, pp.99-123

11. Marotta, G. (2007), Structural Breaks in the Lending Interest Rate Pass-Through and the Euro, Social Sciences Research Network, viewed at June 18, 2008

12. Mojon, B. (2000),Financial Structure and the Interest Rate Channel of the ECB Monetary Policy, European Central Bank, Working Paper, No.40

13. Sander, H and Kleimeier, S. (2004a), Converge in Eurozone Retail Banking? What Interest Rate Pass-through tells us about Monetary Policy Transmission, Competition and Integration, Journal of International and Finance, Vol.23, pp.461-492

14. Sorensen, C. and Werner, T. (2006),Bank Interest rate Pass-through in the Euro Area: A Cross Country Comparison, European Central bank Working Paper, No.580


15. Tiemer, A. (2004), Interest Rate Pass-Through in Romania and Other Central European Economies, IMF Working paper, No. 04, 211

16. Van Leuvensteijn,M. and Sorensen,C. and Bikker,J. and Van Rixtel,A.,(2008) Impact of Bank Competition on the Interest Rate Pass-Through in the Euro Area , European Central bank Working Paper,No.885