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German Economic Review 6(1): 3778

Interest Rate Pass-Through: Empirical Results for the Euro Area


Gabe J. de Bondt
European Central Bank

Abstract. This paper empirically examines the interest rate pass-through at the euro area level. The focus is on the pass-through of official interest rates, approximated by the overnight interest rate, to longer-term market interest rates, which, in turn, are a proxy for the marginal costs for banks to attract deposits or grant loans, and therefore passed through to retail bank interest rates. Empirical results, on the basis of a (vector) error-correction and vector autoregressive model, suggest that the pass-through of official interest to market interest rates is complete for money market interest rates up to three months, but not for market interest rates with longer maturities. Furthermore, the immediate pass-through of changes in market interest rates to bank deposit and lending rates is found to be at most 50%, whereas the final pass-through is typically found to be close to 100%, in particular for lending rates. Empirical results for a subsample starting in January 1999 show qualitatively similar findings and are supportive of a quicker interest rate pass-through since the introduction of the euro. It is shown that the difference between the adjustment speed of bank deposit and lending rates (typically around one versus three months since the common monetary policy) can to a large extent significantly be explained by credit risk considerations. JEL classification: E43; G21. Keywords: Interest rate pass-through; overnight, market and bank interest rates; euro area.

1. INTRODUCTION
The interest rate pass-through process is from a price and financial stability perspective important for monetary policy. Central banks exert a dominant influence on money market conditions and thereby steer money market interest rates. Changes in money market interest rates, in turn, affect market interest rates with longer maturities and retail bank interest rates, albeit to varying degrees. Bank decisions regarding the yields paid on their assets and
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G. J. de Bondt liabilities have an impact on the expenditure and investment behaviour of deposit holders and borrowers and thus real economic activity. In other words, a quicker and fuller pass-through of official and market interest rates to retail bank interest rates strengthens monetary policy transmission and thus may affect price stability. Furthermore, prices set by banks influence their margins and therefore bank profitability and consequently the soundness of the banking system and thus financial stability. Many factors ultimately influence the adjustment of retail bank interest rates: marginal pricing costs, (expected) bank exposure to interest rate risk, credit and other risk premia, competition and regulation in different segments of the deposit and credit market, bankcustomer relations, the administrative cost of effectively changing interest rates, the degree of passive behaviour on the part of deposit holders and borrowers, etc. This study particularly examines the first-mentioned determinant of the interest rate pass-through process at the euro area level. Banks marginal pricing costs are approximated by interest rate movements in the money and capital markets, since they are the market-based sources for banks to subsequently attract deposits or grant loans. Banks offer deposits and loans at rates which are competitive to those on money market mutual funds and non-bank sources of finance. The main contribution of this paper is that the bank and market interest rates considered have a comparable maturity to avoid distortions from yield curve effects and to accurately capture the marginal pricing costs of banks. For the first time both bank deposit and lending rates at the level of the euro area are analysed. The focus is on the euro area instead of country-specific experiences in order to analyse the impact of the introduction of a common monetary policy in the euro area in January 1999. The shift from national central banks to the European Central Bank (ECB) may have affected banks behaviour and therefore the interest rate pass-through process, as theoretically shown by Bagliano et al. (2000). The ECB monetary policy reacts to conditions at the euro area level and not to country-specific developments, and monetary policy may affect banks incentive to collude in the credit market through its influence on the cost of raising funds. Therefore, the euro area experience is examined using three different empirical frameworks for a sample starting in January 1996, the first date for which publicly euro area retail bank interest rate data are available, and a sub-sample starting with Stage Three of EMU, i.e. January 1999. The main lesson of this empirical study is threefold. First, a complete passthrough of official interest rates to money market interest rates up to three months is observed, suggesting that monetary policy fully controls money market rates up to three months. The impact of a change in official interest rate to market interest rates declines with the maturity of the market instruments. No statistical significant relationship is found between the official interest rate and government bond yields, suggesting a credible monetary policy at the euro area level. Second, it is shown that euro area

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Interest Rate Pass-Through: Empirical Results for the Euro Area banks adjust their rates on deposits and loans generally closely in line with market interest rate developments, but that this pass-through process differs between the different segments of the retail bank market in the euro area. The immediate, i.e. within one month, adjustment of retail bank interest rates to a 100 basis point change in market interest rates is up to 50 basis points, whereas the final or long-term pass-through is close to 100 basis points, at least for bank lending rates. The interest rate on overnight deposits, deposits redeemable at notice of up to three months and on consumer lending are comparatively sticky with an immediate pass-through of around 5%. The third and final lesson, of a more speculative nature but supported by our empirical findings, is that the interest rate pass-through process has changed since the introduction of the euro. Official interest rates are for this subsample also immediately completely passed through to money market interest rates up to three months. This suggests that the monetary policy control of the short-end of the yield curve at the euro area level has strengthened since January 1999, in line with the introduction of a common monetary policy in the euro area. For all retail bank interest rates the speed at which they adjust to market interest rate developments is found to have become quicker. The mean adjustment speed of retail bank rates to finally adjust to market interest rate developments is, since January 1999, typically around one month for deposit rates and around three months for lending rates. The observed difference in the adjustment speed between deposit and lending rates can to a large extent be significantly explained by credit risk. Other likely explanations for the significantly quicker pass-through process since the single currency are an increase in the degree of competition, as reflected in an increasing role for non-deposit or market-based funding by euro area banks and a rise in the interest rate elasticity of the demand for retail bank products, and a decrease in asymmetric or switching costs in different segments of the euro area retail bank market. The paper proceeds as follows. Section 2 briefly reviews interest rate passthrough studies for individual euro area countries. Section 3 presents a theoretical background and empirical specifications of the interest rate passthrough process. The interest rate pass-through is divided into the passthrough of changes in the official interest rate, approximated by the overnight interest rate, to longer-term market interest rates, and of market interest rates, as a proxy for the marginal costs for banks to attract deposits or grant loans, to retail bank interest rates. Section 4 describes the euro area data on official and retail bank interest rates and presents a correlation analysis to detect the most comparable market interest rates for the bank interest rates considered. Section 5 discusses the empirical results based on (i) a vector error-correction model (VECM), (ii) a vector autoregressive (VAR) model, and (iii) a univariate errorcorrection model (ECM). Section 6 follows with a presentation of the empirical results for a sub-sample, starting in January 1999. Section 7 summarizes with concluding remarks. Appendices A and B present impulse responses and their confidence bands based on VAR models for interest rate pairs. Appendix C
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G. J. de Bondt presents German results for the retail bank interest rate pass-through process to check the hypothesis of Bagliano et al. (2000) that less collusion among German banks is a likely outcome of the shift in monetary policy from the Bundesbank with a German focus to the ECB with a euro area-wide focus.

2. INTEREST RATE PASS-THROUGH STUDIES FOR INDIVIDUAL EURO AREA COUNTRIES


While there is voluminous literature on monetary policy transmission, the retail bank interest rate pass-through process has, at least for several years, been surprisingly underexplored. Table 1 summarizes the main findings of interest rate pass-through studies performed for individual euro area countries. All studies show cross-country differences in the interest rate pass-through without a clear pattern of these cross-country differences. Nevertheless, it seems to be the case that short-term bank lending rates to enterprises in Belgium, Spain and the Netherlands adjust less sluggishly after three months compared with the other euro area countries. As regards bank lending rates, studies from the mid-1990s broadly show that changes in official and/or money market rates are not fully reflected in short-term bank lending rates to enterprises after three months, but that the pass-through is higher in the long term (BIS, 1994; Cottarelli and Kourelis, 1994; Borio and Fritz, 1995). Recent cross-country studies by Kleimeier and Sander (2000, 2002), Donnay and Degryse (2001) and Toolsema et al. (2001) confirm this finding. Mojon (2000) and Heinemann and Schuller (2002) also find short-term sluggishness in short-term bank lending rates to enterprises, but assume a priori a complete long-term pass-through. This short-term stickiness is also found for consumer credit rates (Heinemann and Schuller, 2002; Kleimeier and Sander, 2002). For long-term bank lending rates all studies, except BIS (1994) and Heinemann and Schuller (2002) which take long-term market rates as costs of funds for long-term bank rates, typically show that the pass-through tends to be less complete than for short-term bank lending rates to enterprises. This finding may be driven by the fact that the marginal cost prices are approximated by money market interest rates which may not be the most appropriate marginal funding costs for long-term loans. Turning to bank deposit rates, one study examines the adjustment of deposit rates to changes in the money market interest rate in individual euro area countries (Mojon, 2000). The main finding is an incomplete short-term pass-through for deposit rates, notably for savings deposits, and that deregulation has significantly affected the interest rate pass-through process for deposits, but not for loans. Several studies also examine the issue of an asymmetric interest rate passthrough process. The response of bank rates to changes in official rates and/or money market rates seems to depend in some cases on whether market interest rates are rising or falling (Borio and Fritz, 1995; Mojon, 2000;

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Table 1 Interest rate pass-through studies for individual euro area countriesa (adjustment of retail bank rates to 100 basis points change in money market interest rates in basis points)
Study Short-term loans to firms BIS (1994) Cottarelli and Kourelis (1994) Borio and Fritz (1995) Kleimeier and Sander (2000) Mojon (2000) Donnay and Degryse (2001) Toolsema et al. (2001) Heinemann and Schuller (2002) Kleimeier and Sander (2002) ST LT ST LT ST LT ST LT ST LT ST LT ST LT ST LT ST LT AT 68 BE 85 112 67 87 95 93 110 100 100 85 92 76 102 83 100 81 85 DE 18 106 87 100 36 98 97 36 100 66 72 72 90 13 100 10 63 ES 78 110 78 94 100 105 107 55 100 102 100 103 114 75 100 52 84 FI FR 15 23 28 53 59 195 72 71 100 43 75 53 62 45 100 39 96 117 101 61 82 107 107 GR IE IT 10 61 60 83 72 107 114 62 100 60 86 61 62 167 100 15 85 59 LU NL 58 107 82 82 95 103 91 112 100 53 87 84 97 62 100 31 90 PT Euro area 28 89 75 90 65 95 100 61 100 58 74 70 80 75 100 27 81

Interest Rate Pass-Through: Empirical Results for the Euro Area

95 95

112

15 18

36 42

20 18

11 14

44 100 25 74

3 100 27 64

53 100 42 95

Long-term loans to firms Mojon (2000) Donnay and Degryse (2001)

ST LT ST LT

61 100 21 10

18 100 69 40

87 93

42 100 23 50

25 64

17 16

78 99

37 100 54 67
(Continued)

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Table 1
Study

Continued
AT ST LT ST LT ST LT ST LT ST LT ST LT ST LT 60 100 15 85 BE 98 100 79 101 82 5 100 19 48 107 100 32 57 DE 23 100 17 49 48 89 45 100 20 44 99 100 36 31 ES 46 100 69 65 27 11 100 40 14 35 100 15 66 FI FR GR IE IT LU NL PT 32 100 33 26 26 88 21 88 33 100 34 27 97 100 13 43 Euro area 3 100 26 49 41 82 35 100 27 41 83 100 25 51

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Consumer credit Heinemann and Schuller (2002) Kleimeier and Sander (2002) Mortgages BIS (1994) Mojon (2000) Donnay and Degryse (2001) Heinemann and Schuller (2002) Kleimeier and Sander (2002)

53 80

1 19 90 41 100

G. J. de Bondt

26 32 14 100 14 72

39 61

30 77

16 29

16 6 56 100 23 57

63 103 47 100 30 68

7 35 11 100 16 103

Savings deposits Mojon (2000)

ST LT

27 100

9 100

13 100

6 100

11 100

Time deposits Mojon (2000)


a

ST LT

94 100

82 100

15 100

63 100

83 100

65 100

ST 5 short-term pass-through, that is adjustment after 3 months; LT 5 long-term pass-through; euro area figures are based on available country results using January 2001 country weighting structures as applied for euro area retail bank interest rates. Sources: BIS (1994, Table 5, 198493); Cottarelli and Kourelis (1994, Table 1, Model 2); Borio and Fritz (1995, Table 8, 199094); Kleimeier and Sander (2000, Table 5, 199498); Mojon (2000, Table 2a, 199298); Donnay and Degryse (2001, Table 3, 19922000); Toolsema et al. (2001, Table 3, 19802000); Heinemann and Schuller (2002, Table 6, 199599); Kleimeier and Sander (2002, Table A4, 19952000).

Interest Rate Pass-Through: Empirical Results for the Euro Area Heinemann and Schuller, 2002) or whether bank interest rates are below or above equilibrium levels as determined by cointegration relations (Kleimeier and Sander, 2000, 2002).1 Industrial organization-based literature examines the pricing behaviour of banks using bank data. The focus of this strand of the literature is typically on the link between bank interest rate margins and the market structure of the banking system (Hannan and Berger, 1991; Neumark and Sharpe, 1992; Angbazo, 1997; Hannan, 1997; Wong, 1997; Corvoisier and Gropp, 2002). The main lesson of these banking structure studies is that the pricing behaviour of banks may depend on the degree of competition and contestability in the different segments of the retail bank market. For instance, Corvoisier and Gropp (2002) conclude that for demand deposits and loans increasing bank concentration in individual euro area countries during the years 199399 may have resulted in less competitive pricing by banks, whereas for savings and time deposits the opposite seems to be the case.

3. INTEREST RATE PASS-THROUGH MODEL 3.1. Theoretical background


Central banks exert a dominant influence on money market conditions and thereby steer the short-term money market interest rates, which, in turn, may affect market interest rates with a longer maturity (first stage of the interest rate pass-through process). Changes in market interest rates, in turn, affect retail bank interest rates, albeit to varying degrees (second stage of the interest rate pass-through process). As regards this second stage, in the textbook world of perfect competition with complete information prices equals marginal costs and the derivative of prices with respect to marginal costs equals one. This derivative typically becomes less than one when the perfect competition and information assumption are relaxed. Applying this idea to the price setting of banks results in the following marginal cost pricing model equation (Rousseas, 1985):2 br g0 g1 mr 1

where br is the price set by banks, that is the bank interest rate, g0 is a constant markup and mr is the marginal cost price approximated by a comparable market interest rate. The underlying idea is that market interest rates are the
1. See Scholnick (1996) for an analysis of an asymmetric interest rate pass-through process in Malaysia and Singapore. 2. Another approach to model the interest rate pass-through, not followed in this paper, is along the lines of the Klein (1971)Monti (1971) model or Tobin (1982) model and extensions of these models (Dermine, 1986). These studies particularly focus on the impact of capital requirements on bank pricing policy.
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G. J. de Bondt most appropriate marginal cost prices, because of their accurate reflection of the marginal funding costs faced by banks. The coefficient g1 depends on the demand elasticity of deposits and loans with respect to the retail bank interest rate. If the demand for deposits and loans is not fully elastic, parameter g1 is expected to be less than one. Deposit demand is expected to be relatively elastic with respect to the bank deposit rate when close substitutes for deposits exist, for instance, money market funds. The loan demand elasticity depends, among other factors, on whether borrowers have access to alternative sources of finance. Parameter g1 will also be less than one if banks have some degree of market power. Retail bank interest rates in less competitive or oligopolistic segments of the retail bank market adjust incompletely and only with a delay, while bank interest rates set in a fully competitive environment respond quickly and completely (Laudadio, 1987). A wide range of factors influence market power. For instance, entry into the banking sector is restricted by regulatory agencies, creating one of the preconditions for a degree of monopoly power and administrated pricing (Niggle, 1987). Market power and an inelastic demand for retail bank products may also result from the existence of switching costs and asymmetric information costs. Switching costs may arise when bank customers consider switching from one bank to another, for example when a household intends to transfer its savings deposits from bank A to bank B. Switching costs, such as costs of acquiring information and search and administrative costs, are potentially important in markets where significant information or transaction costs exist. They are also expected to be high in markets with long-term relationships and repeated transactions (Sharpe, 1997; Kim et al., 2003).3 However, even in the presence of small switching costs, the theory predicts that the smaller the proportion of customers that are new to the market, the less competitive prices will be. Klemperer (1987) shows that generally the existence of switching costs results in market segmentation and reduces the demand elasticity. Even with non-cooperative behaviour, switching costs result in a retail bank interest rate adjustment of less than one to a change in the market interest rate (Lowe and Rohling, 1992). As regards the setting of lending rates by banks, asymmetric information costs introduce problems of adverse selection and moral hazard (Stiglitz and Weiss, 1981). If banks increase their lending rates they may attract riskier borrowers (adverse selection) or the increase of lending rates will give adverse incentives for borrowers to choose riskier projects (moral hazard). In other words, banks expected receipts may actually fall when they increase their lending rates even if funding costs increase, if the probability of default rises sufficiently.
3. Kim et al. (2003) empirically show that for the Norwegian banking industry around a quarter of the bank customers added value is due to the lock-in phenomenon generated by switching costs. Their model estimates an average duration of the bankcustomer relationship of 131 2 years.

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Interest Rate Pass-Through: Empirical Results for the Euro Area Consequently, banks will set lending rates below the market clearing rates and ration the amount of credit supply accordingly. In this case of credit rationing, bank lending rates exhibit upward stickiness. However, this result of lending rate stickiness does not necessarily hold up if credit is not rationed. Consider a world in which there are two broad classes of borrowers to which banks can lend. For the first class of loans, such as fully secured lending, the probability of default is zero, while for the second class of borrowers, the probability of default is positive and increasing in the lending interest rate through adverse selection and moral hazard. Assume that banks can distinguish between the two borrower types, but not between customers within each class and that banks are risk neutral. Given perfect competition, banks must earn the same expected return on both classes of loans, as formulated in equation (2): br1 1 Pbr2 br2 g0 mr 2

where br1 is the rate charged by banks on the riskless loan, P( ) is the probability of default on the second class of loan and br2 is the bank lending rate on these loans. For the first type of loans @ br1/@ mr 5 1; that is, changes in the marginal cost of funds get transmitted one-for-one into changes in the lending rate on the riskless loans. However, when banks are lending to the second borrower type, @ br2 /@ mr41, since @ P/@ br240. For these loans banks must increase their lending rate by an amount greater than the increase in the market interest rate to compensate for the decrease in the probability of repayment. At some interest rate banks will not be able to increase the interest rate sufficiently to compensate for this risk and all lending will be made to the first type of borrower, also known as the flight-to-quality phenomenon. However, until this happens, the bank rate on these loans should be very sensitive to changes in the market interest rate. In other words, a more than one-to-one adjustment of bank lending rates to changes in market interest rates, as shown in some cases in Table 1, suggests that bank credit was on average not rationed and consisted of relatively risky loans during the period under review.

3.2. Empirical model specifications


Three different empirical frameworks are used in order to check the robustness of the empirical results. First, a VECM is applied to simultaneously model both stages of the interest rate pass-through process. The main advantage, besides the one-step or simultaneous approach, is that a distinction is made between the short-term dynamics and the long-term or equilibrium relationships. For instance, in the presence of fixed adjustment costs retail bank interest rates will adjust to changes in market interest rates only if those adjustment costs are lower than the costs of maintaining a
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G. J. de Bondt non-equilibrium bank rate (Hannan and Berger, 1991). Furthermore, demand curves are likely to be more inelastic in the short than in the long term. The greater the elasticity of demand for deposits and loans, the higher the cost of keeping retail bank interest rates out of equilibrium. Second, the two stages of the interest rate pass-through process are separately examined by performing an impulse response analysis based on a VAR model of interest rate pairs in levels. This framework maximizes the long-term information in the dataset and delivers super-consistent coefficient estimates. It avoids the possibility of imposing inappropriate cointegration relations, which can lead to biased estimates and hence may bias the impulse responses. The third and final empirical framework is a univariate ECM, which has the advantage of an economically very appealing interpretation of the model parameters. This framework explicitly examines the immediate or within one-month passthrough, the final pass-through, and the mean speed at which the final passthrough is reached. At the same time, however, any interaction between official, market and bank interest rates is fully ignored. 3.2.1. Vector error-correction model A three-variable VECM is specified to simultaneously model the interest rate pass-through process: Yt c with: 3 official rate Yt 4 market rate 5 bank rate t Q The rank of the matrix determines the number of cointegration vectors. A uniform rank of one, as generally indicated by the trace and maximum eigenvalue tests ( Johansen and Juselius, 1990; Johansen, 1991), has been assumed to allow differences in the pass-through process across instruments to be compared. The cointegration relation has been normalized on the bank rate. In addition, in all cases the long-term coefficient of the official interest rate is set to zero in the cointegration relation. This binding restriction on the official interest rate is tested by the likelihood ratio test. The lag order is determined by a lag structure test and is typically one or two months and in some cases up to four months. 3.2.2. Vector autoregressive model For a VAR model in levels a uniform lag order is applied for all interest rate pairs to allow differences in the pass-through process across instruments to be 2
n1 X i1

Gi DYti

Ytn et

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Interest Rate Pass-Through: Empirical Results for the Euro Area compared. Moreover, overparametrization is considered to be a larger problem than underestimation of the lag order given the short sample. The lag order is therefore set at two months, as low as possible given the wide range of optimal lag orders derived from the Akaike, HannanQuin and Schwartz criteria and the residual properties. This leads to the following uniform VAR model specification: Yt c with:  Yt or  Yt market rate bank rate  4b
t 2 X i1

Ai Yti et

official rate market rate

 4a
t

In computing the impulse-response functions the missing identification of the contemporaneous relationships between each pair of interest rates is solved by using the traditional Cholesky decomposition of the residual variancecovariance matrix (Hamilton, 1994). This decomposition relies on the idea that a shock on the last ordered variable in the system does not contemporaneously affect the previous one. For the interest rate pass-through analysis, the Cholesky decomposition method matches well with economic intuition. With the order of equation (4), a shock in the market/retail bank interest rate will have no contemporaneous effect on the official/market interest rate, while shocks in the official/market interest rate may have an immediate impact on market interest rates with a longer maturity/retail bank interest rate. 3.2.3. Univariate error-correction model A univariate error-correction model, which also examines separately the two stages of the interest rate pass-through process, is specified as follows: Dmrt a1 a2 Dort b1 mrt1 b2 ort1 et Dbrt a1 a2 Dmrt b1 brt1 b2 mrt1 et 5a 5b

The coefficient a2 reflects the immediate or short-term pass-through, parameter b2 the final or long-term pass-through and (1 a2)/b1 equals the mean adjustment lag at which the official/market interest rate is fully passed through to market/bank interest rates (Hendry, 1995). The existence of cointegration between the interest rate pairs can be directly tested by examining
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G. J. de Bondt the significance of the coefficient of the error-correction term, b1, using the critical values as proposed by Kremers et al. (1992) and Boswijk (1994).

4. DATA 4.1. Official interest rate


Instead of using the ECB interest rate on the main refinancing operations, an interest rate which changes only infrequently,4 the overnight interest rate has been used in the empirical analysis, since 1 January 1999 (the euro overnight index average, EONIA). The overnight interest rate is the interest rate central banks try to control by using instruments such as reserve requirements, standing facilities and open market operations ( Perez Quiros guez Mendizabal, 2001). Control normally means an attempt to and Rodr keep the daily overnight rate around an official rate which in some countries, for example the United States, is a target rate and in others, for example the euro area, is the rate of the open market operations. For the euro area this control is not perfect, but the EONIA closely fluctuates around the ECB main refinancing rate. In the first eighteen months since the start of Stage Three of EMU the mean spread between the EONIA and the rate on the main refinancing operation of the eurosystem was 7 basis points (Bindseil and Seitz, 2001). This average spread may, however, overestimate the actual spread because the sample is dominated by a cycle of expectations of interest rate increases. In addition, the volatility of the EONIA, which is mainly driven by liquidity concerns, may be high, in particular at the end of the maintenance period (Gaspar et al., 2001). Sharp adjustments at the end of the maintenance are, however, usually taken back at the beginning of the new maintenance period. It is assumed that the volatility dynamics are not dominant, since monthly averages of daily EONIA rates are used in the empirical analysis. In other words, the overnight interest rates considered are more related to changes in the expectation of official interest rates and less to liquidity issues. Empirical studies support the assumption that the EONIA reflects relatively well official interest rate decisions. Gaspar et al. (2001) show, using daily EONIA rates, that markets are able to predict the ECBs interest rate decisions quite accurately within a reserve maintenance period. Hartmann et al. (2001) show with thick data that rate expectations by the market have been relatively precise during the period under review, with the absolute expectation error in the EONIA before monetary policy decisions averaging only about 5 basis points. The latter compares to the usual 25 and 50 basis point step size in monetary policy decisions.
4. For instance, in the first three years of a single monetary policy in the euro area, 12 ECB interest rate changes occurred.

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Interest Rate Pass-Through: Empirical Results for the Euro Area

4.2. Retail bank interest rates


The euro area retail bank interest rates on the deposits and loans considered are average monthly data, including synthetic euro area data before 1 January 1999. From 1 January 2001 onwards, euro area retail interest rate data include Greece. The bank rates on five deposit categories (overnight deposits, saving deposits up to and over three months notice and time deposits up to and over two years) and four loan categories (loans to enterprises up to and over one year and loans to households for consumer lending and house purchase) are examined. The retail bank interest rates considered reflect almost 100% new business, although the exact definition of new business may differ across euro area countries.5 Differences in country weights across instruments are large, but fairly stable over time. For instance, the interest rate on deposits redeemable at notice of over three months for the euro area is actually only based on German data. The retail bank interest rate statistics and further explanations are made available on the Euro area statistics download page of the ECBs website (http://www.ecb.int). Figure 1 plots the average monthly interest rates charged by monetary financial institutions (MFIs) in the euro area on the deposits and loans considered, respectively, for the sample period January 1996 to May 2001.6 Figure 1 illustrates that the level of bank deposit rates depends on maturity: typically the lower the maturity of the deposits the lower the deposit rate. The interest rate on overnight deposits is also low compared to other bank deposit rates, partially due to the fact that in some countries this deposit rate is administrated to be zero during the period under review. Turning to bank lending rates, prima facie the maturity of the instruments also plays a role in determining the level of bank lending rates: the lower the maturity the higher the level of the bank lending rate. This is noteworthy since the yield curve is generally positively sloped. However, the differences in the level of bank lending rates can be explained by differences in secured and unsecured lending practices. Short-term borrowing by enterprises, such as overdrafts, is unsecured, while long-term lending to enterprises is mostly secured on corporate assets. Mortgages are collateralized, while this is typically not the case for consumer credit. Another explanation is that the information and monitoring costs of banks are higher for short-term loans, because borrowers

5. The exceptions are the interest rate on overnight deposits, deposits redeemable at notice of up to three months and on loans to enterprises up to one year. For the two deposit rates the distinction between amounts outstanding and new business is rather artificial because of the short-term nature of these deposits. As regards the lending rate, it is only for one country that the lending rate does not reflect close to 100% new business. Furthermore, the euro area aggregate data are based on non-harmonized country data, with the potential risk that the empirical results for the euro area aggregate retail bank interest rates are to some extent distorted by an aggregation bias. 6. See ECB (2001) for charts of the spread between retail bank interest rates and comparable market interest rates.
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G. J. de Bondt
Bank deposit rates Bank lending rates

6 5 4 3 2 1 0 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01

6 5 4 3 2 1 0

14 12 10 8 6 4 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01

14 12 10 8 6 4

Figure 1
Source: ECB.

Retail bank interest rates ( percentages per annum; monthly averages)

with severe information asymmetries will tend to borrow more heavily at short maturities.7 Turning to the relative importance of the different retail bank interest rates, the most important deposits in terms of the total deposits outstanding were overnight deposits (demand deposits), closely followed by deposits redeemable at notice of up to three months (savings deposits). They accounted each to 25% to 30% of total deposits at the end of 2000. Deposits with an agreed maturity of over two years and up to two years (time deposits) each amounted at around 20% of total deposits. Deposits redeemable at notice over three months were very small compared to the other deposit categories considered. As regards loans, loans to households for house purchase and loans to enterprises over one year were the most important in terms of amounts outstanding (each around 30% of total loans). Loans to households for consumer lending and loans to enterprises up to one year were of almost equal importance and amounted to around 18% of total loans at the end of 2000.

4.3. Correlation analysis to detect comparable market interest rate


A correlation analysis between retail bank rates and market interest rates is performed to detect which market interest rates are most closely related to the bank interest rate analysed. The idea is to capture adequately the marginal cost price. A distinction is made between the correlations of the variables in levels and in first differences (the change in the interest rate). The market interest rates analysed, with Reuters as data source, are the overnight market interest rate, money market rates at 1, 3, 6 and 12 months maturities and government bond yields at 2, 3, 5 and 10 years maturities. Correlations are computed both across maturities and for different lags of the market interest rates. Table 2 presents the results of the correlation analysis for the sample
7. See Section 1.6 on debt maturity theories in de Bondt (2000).

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Table 2

Correlation analysis between bank and market interest rate


Market rate Lag in Correlation months Market rate Lag in Correlation months Market rate Lag in Correlation months Market rate chosen

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Interest Rate Pass-Through: Empirical Results for the Euro Area

Bank rate Level Deposit rate Overnight Up to 3 months notice Over 3 months noticeb Maturity up to 2 years Maturity over 2 years Lending rate Up to 1 year to firms Over 1 year to firms Consumer lending House purchase First difference Deposit rate Overnight Up to 3 months notice Over 3 months noticeb Maturity up to 2 years Maturity over 2 years Lending rate Up to 1 year to firms Over 1 year to firms Consumer lending House purchase
a b

1996.12001.5a

1996.11998.12a

1999.12001.5

Overnight 1 month 1 year 2 years 3 years 6 months 5 years 10 years 5 years

0.89 0.89 0.79 0.96 0.97 0.90 0.94 0.98 0.97

8 7 1 5 1 7 4 7 2

Overnight 1 month 1 year 3 months 5 years 6 months 10 years 10 years 10 years

0.92 0.94 0.30 0.96 0.98 0.91 0.98 0.98 0.99

8 1 1 1 1 0 3 4 0

Overnight 1 month 6 months 3 months 2 years 3 1 2 2 months year years years

0.99 0.96 0.99 0.99 0.99 0.99 0.98 0.98 0.99

1 4 1 1 0 2 0 4 0

Overnight 1 month 6 months 3 months 2 years 6 1 1 5 months year year years

1 1 1 6 2

month month year months years

0.54 0.53 0.77 0.73 0.70 0.60 0.70 0.52 0.71

1 2 1 1 0 1 0 3 0

1 month 1 month 1 year 3 months 10 years 3 months 10 years 1 year 5 years

0.22 0.57 0.78 0.67 0.64 0.38 0.46 0.36 0.72

2 2 1 1 0 1 0 3 1

1 1 6 3 2 6 1 1 2

month month months months years months year year years

0.79 0.54 0.79 0.80 0.89 0.70 0.81 0.57 0.86

1 1 0 0 0 2 0 2 0

Overnight 1 month 6 months 3 months 2 years 6 1 1 5 months year year years

3 months 1 year 1 year 10 years

Data for the interest rate on loans to enterprises with a maturity of over one year is available since November 1996. Results for the samples starting in January 1996 are biased downward, since the interest rate on deposits redeemable at notice of over three months is a 100% German interest rate and the money market rates considered are euro area money market rates. Sources: ECB, Reuters and authors calculations.

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G. J. de Bondt starting in January 1996 as well as two sub-samples: 1996.11998.12 and 1999.12001.5. The last column of Table 2 shows the comparable market rates selected for the empirical analyses of Sections 5 and 6. Looking at the total sample results (see columns 24 in Table 2), the correlation coefficients in level terms broadly vary between 0.89 and 0.98, implying that bank and market rates move closely together. The lag with the highest correlation varies between 1 and 8 months, suggesting that retail bank rates do not collectively react by the same speed to market interest rate changes. In first differences, the correlation coefficients are lower with a range of 0.52 and 0.77. For all bank interest rates, the same or a lower optimal lag applies than for the levels. As regards the two sub-samples, the same qualitative picture emerges. However, two striking differences emerge when comparing the two subsamples. First, the correlation coefficients for the sample starting in January 1999 are higher than for the years 199698. Second, the lags with the highest correlation are typically lower for the sample starting in January 1999 than for the three-year sample starting in January 1996. These findings suggest that the co-movement between retail bank rates and market interest rates has become closer since the introduction of the euro, suggesting a quicker interest rate pass-through process since the start of Stage Three of EMU. Section 6 addresses this issue in more detail.

5. EMPIRICAL RESULTS
This section examines the interest rate pass-through process in the euro area on the basis of three different empirical methods: VECM (Section 5.1), VAR (Section 5.2) and a univariate ECM (Section 5.3). Broadly speaking, all three frameworks show that the interest rate pass-through process clearly differs between the short- and long-end of the yield curve and across retail bank interest rates in the euro area. The impact of a change in the official interest rate declines with the maturity of market interest rates. Monetary policy fully controls money market rates up to three months. At the same time, government bond yields are not significantly affected by changes in the official interest rate. Retail bank interest rates are found to be sticky in the short term, whereas in the long term a close to complete pass-through of market interest rate developments to retail bank interest rates, most notably lending rates, is observed.

5.1. Vector error-correction model


The VECM results show that the long-term pass-through is typically incomplete for bank deposit rates and complete for bank lending rates (see Table 3). In particular, the bank rate on overnight deposits and deposits redeemable at notice of up to three months do not fully adjust to changes in

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Interest Rate Pass-Through: Empirical Results for the Euro Area Table 3 Interest rate pass-through based on a vector error-correction model
Long-term pass-through 0.32** 0.25** 0.50** 1.08** 0.71** 1.37** 0.88** 0.90** 0.95** Adjustment coefficient 0.04** 0.27** 0.08* 0.03 0.31** 0.07* 0.11* 0.12** 0.21** Complete pass-through? No** No** No** Yes** No** No** Yes** Yes** Yes** LR testa b 3.43 0.17 25.1** 1.17 19.7** 1.02 0.56 0.03

Retail bank rate Deposit rate Overnight Up to 3 months notice Over 3 months notice Maturity up to 2 years Maturity over 2 years Lending rate Up to 1 year to firms Over 1 year to firms Consumer lending House purchase

Notes: Results based on equation (3) using a sample 1996.12001.5. ** and * denote significance of the F-statistic at the 1% and 5% levels, respectively. a 2 w test of long-term restrictions: market rate coefficient 5 1 (normalization) and overnight rate 5 0. b No binding long-term restriction, since market rate is overnight rate. Sources: ECB, Reuters and authors estimations.

the market interest rate developments. Explanations for this finding might be that these segments of the retail bank market are not fully competitive, have a rather inelastic demand and/or that the switching costs of demand and savings deposits are comparatively high. In contrast, the rate on loans to enterprises of up to one year adjusts more than one-to-one to market interest rate developments. This overshooting may, among other factors, be explained by asymmetric information costs without credit rationing, as described in Section 3. If banks increase their lending rates exactly one-for-one with market interest rates they will attract a riskier class of borrowers. Consequently, banks have to increase the lending rate premium charged. The results of the likelihood ratio test show that the imposed restriction of no long-term impact of the official interest rate in the determination of the retail bank interest rate can typically not be rejected. The only exceptions are the rates on time deposits up to two years and short-term corporate loans.

5.2. Vector autoregressive model


Figure 2 summarizes the impulse response results for the official interest rate pass-through. The figure plots how a temporary shock to the overnight rate, as a proxy for the official interest rate, is passed through to market interest rates with a longer maturity. The immediate or one-month pass-through is around 50% at the short-end of the yield curve (up to three months) and well below 50% for the market interest rates with longer maturities. The pass-through after 12 months is close to complete for the one- and three-month money
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G. J. de Bondt
One-month money market rate Six-month money market rate Two-year government bond yield Ten-year government bondyield

Three-month money market rate Twelve-month money market rate Five-year government bond yield

100 80 60 40 20 0 -20 -40

10

11

12

Figure 2 Official interest rate pass-through based on VAR framework ( percentage shares of cumulative official interest rate shock passed through to market interest rate)
Notes: Results based on equation (4a) using a sample 1996.12001.5. See Appendix A for underlying impulse responses including standard errors. Sources: ECB, Reuters and authors estimations.

Bank deposit rates

Bank lending rates

Figure 3 Retail bank rate pass-through based on VAR framework ( percentage shares of cumulative market interest rate shock passed through to bank rate)
Notes: Results based on equation (4b) using a sample 1996.12001.5. See Appendix A for underlying impulse responses including standard errors. Sources: ECB, Reuters and authors estimations.

market interest rate, around 40% for the six-month money rate, 0% for the 12-month money market and negative for government bond yields. The latter suggests that at the long-end of the yield curve an increase in the official interest rate has typically lowered long-term inflation expectations during the period under review, thereby bringing government bond yields down. Figure 3 summarizes the retail bank interest rate pass-through according to an impulse response analysis. The figure plots how a temporary shock to the

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Interest Rate Pass-Through: Empirical Results for the Euro Area market interest rate is passed through to bank deposit and lending rates, respectively. Three main conclusions emerge from Figure 3. The first conclusion is that shocks in the market interest rates are not immediately reflected in retail bank interest rates. In other words, euro area bank interest rates are sticky in the short term, in line with previous country studies. The immediate response of deposit rates to a 1 percentage point shock to the market interest rate varies between around 5 basis points for overnight deposits and deposits redeemable at notice of up to three months and around 35 basis points for deposits with an agreed maturity of over two years. The immediate pass-through of a 1 percentage point shock in the market interest rate to a bank lending rate varies between around 15 basis points for consumer lending and 50 basis points for loans to enterprises of over one year. Second, the pass-through of a market interest rate shock is higher in the longer term. After 12 months the pass-through for deposits rates varies between 15% (overnight deposits) and 68% (time deposits), and for bank lending rates between 44% (consumer lending) and 76% (loans to enterprises up to one year and loans to households for house purchase). After 36 months the pass-through is far from complete for the overnight deposits and deposits redeemable at notice of up to three months, but almost fully complete (around 90%) for time deposits and loans. The exception is loans to enterprises up to one year that shows, in line with the VECM outcome, a pass-through of around 145%. This overshooting of the bank lending rate suggests a move towards riskier borrowers during the period under review. The third conclusion, closely related to the other two conclusions, is that the interest rate pass-through process clearly differs across instruments. The interest rates on overnight deposits and deposits redeemable at notice of up to three months are sticky compared to other bank deposit rates. The interest rate on consumer lending is sticky compared to the other bank lending rates.

5.3. Univariate error-correction model


Four conclusions emerge from the estimation results of equations (5a) and (5b), as summarized in Tables 4 and 5, respectively. Overall, the results confirm the findings based on the VECM and VAR frameworks. First, changes in the official interest rates are completely passed through to market interest rates at the short-end of the yield curve in the euro area, i.e. up to three months. No significant statistical relationship exists between the official interest rate and government bond yields, suggesting a credible monetary policy. The declining impact of the change in the official interest rate to market interest rates as the maturity rises is in line with Perez-Quiros and Sicilia (2002). They find that the impact of monetary policy shocks on bond yields declines with the maturity of the bonds. Second, the immediate pass-through of market interest rates to retail bank interest rates is found to be incomplete. The proportion of a given market
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G. J. de Bondt Table 4 Official interest rate pass-through based on a univariate errorcorrection model
Market rate a2 Adjustment Immediate Final Final speed pass-through pass-through pass-through in months complete? complete? b2 (1 a2)/b1 a2 5 1 b2 5 1 0.90** 0.68** 0.62** 3.12** No** No** No** No** No** No** No** Yes** Yes** No** No** No** No** No**

Retail bank rate

Money market rates 1-month deposits 0.63** 3-month deposits 0.45** 6-month deposits 0.35** 12-month deposits 0.28** Government bond yields 2 years 0.17 5 years 0.01 10 years 0.05

Notes: Results based on equation (5a) using a sample 1996.12001.5. ** and * denote significance of the F-statistic at the 1% and 5% levels, respectively. Sources: ECB, Reuters and authors estimations.

Table 5 Retail bank interest rate pass-through based on a univariate errorcorrection model
Immediate Final Adjustment Complete passCointegration speed passpassrelation? through through in months through? a2 b2 (1 a2)/b1 b2 5 1 b1 5 0 0.02 0.05 0.35** 0.32** 0.35** 0.24** 0.54** 0.13** 0.26** 0.41** 0.35** 0.87** 0.98** 0.76** 1.53** 0.92** 0.93** 0.94** 15.3** 8.7** 23.8 4.8** 3.0** 8.7** 3.9** 10.2** 2.8** No** No** Yes** Yes** No** No** Yes** Yes** Yes** Yes** Yes** No** Yes** Yes** Yes** Yes** Yes** Yes**

Retail bank rate Deposit rate Overnight Up to 3 months notice Over 3 months notice Maturity up to 2 years Maturity over 2 years Lending rate Up to 1 year to firms Over 1 year to firms Consumer lending House purchase

Notes: Results based on equation (5b) using a sample 1996.12001.5. ** and * denote significance of the F-statistic at the 1% and 5% levels, respectively. Sources: ECB, Reuters and authors estimations.

interest rate change that is passed through within one month is found to be typically around 30% during the sample period. The highest immediate passthrough is found to be 54% in the case of the interest rate on lending to

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Interest Rate Pass-Through: Empirical Results for the Euro Area enterprises over one year. This may be explained by a relatively elastic loan demand, since firms have access to alternative sources of funds, such as trade credit (Kohler et al., 2000) and the corporate bond market (de Bondt, 2002). Third, the final pass-through of market interest rates to retail bank interest rates is typically complete or even well above 100%, as in the case of loans to enterprises of up to one year. The final pass-through is clearly incomplete for the interest rates on overnight deposits and deposits redeemable at notice of up to three months. The fourth and final conclusion is that the average speed for retail bank interest rates to fully adjust to market interest rate changes is typically between 3 and 10 months. Exceptions to this finding are the slow speed of adjustment between 1 and 2 years for the interest rate on overnight deposits and deposits redeemable at notice of over 3 months. The latter finding is biased because this deposit rate is actually a German interest rate, while a euro area market interest rate is considered. This also explains why for this deposit rate no cointegration relation with the market interest rate is found. In all other cases a long-term equilibrium relationship exists between the retail bank interest rate and the comparable market interest rate. Regarding lending rates, the speed of adjustment of around 9 months as found for the interest rates on lending to enterprises with a maturity up to 1 year and on consumer lending is much slower than for the other lending rates which show a mean adjustment speed of around 3 months. This difference might be explained by the fact that the asymmetric information costs are higher for unsecured lending than for secured lending.

6. EMPIRICAL RESULTS BASED ON STAGE THREE OF EMU


This section examines the hypothesis of a change in the interest rate passthrough since the introduction of a common monetary policy by applying the three empirical methods to a sub-sample starting in January 1999 (EMU sample). The tentative conclusions, albeit robust across the three empirical frameworks, are that the monetary policy control at the short-end of the yield curve has become immediately complete at the euro area level since the introduction of the euro. In addition, a quicker retail bank interest rate passthrough has been observed since the common monetary policy in the euro area. The quicker pass-through can, among other factors, be explained by less collusion among banks, which, in turn, may be affected by the fact that the ECB monetary policy reacts to euro area conditions and have contributed to less variability in money market interest rates (Bagliano et al., 2000). It is also shown that asymmetric information costs, as reflected in credit risk concerns, may significantly explain the slower speed at which bank lending rates adjust to market interest rate developments compared with deposit rates.
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G. J. de Bondt

6.1. Vector error-correction model


Table 6 summarizes the interest rate pass-through process on the basis of a VECM using a sample starting in January 1999. The most striking difference between the results of Table 6 and Table 3 of the full sample is that the adjustment coefficients have generally increased since the introduction of a common monetary policy, suggesting a quicker interest rate pass-through. The long-term pass-through is found to be around 20% for the rate on overnight deposits and deposits redeemable at notice of up to three months, and around 80% for the other deposit and lending rates. The exception is the rate on loans to households for house purchase for which a complete longterm pass-through is found. The likelihood ratio tests show that the binding restriction that the official interest rate is not part of the cointegration relation between the bank and market rate cannot be rejected in all cases at the 1% confidence level.

6.2. Vector autoregressive model


Figures 4 and 5 provide an overview of the interest rate pass-through process since January 1999 based on the VAR approach. Broadly speaking, the picture emerging from Figures 4 and 5 is similar to that of Figures 2 and 3: monetary policy controls the short-end of the yield curve, retail bank interest rates are sticky in the short term, the pass-through is close to complete in the long term, and striking Table 6 modela Interest rate pass-through process based on vector error-correction
Long-term pass-through 0.18** 0.24** 0.74** 0.77** 0.85** 0.85** 0.84** 0.62** 1.18** Adjustment coefficient 0.48** 0.26** 0.58* 0.16 0.78 0.37** 0.34 0.22** 0.22** Complete pass-through? No** No** No** No** No** No** No** No** Yes** LR testb c 6.38* 1.71 2.90 3.63 2.16 2.18 0.09 0.28

Retail bank rate Deposit rate Overnight Up to 3 months notice Over 3 months notice Maturity up to 2 years Maturity over 2 years Lending rate Up to 1 year to firms Over 1 year to firms Consumer lending House purchase

Notes: Results based on equation (3) using a sample 1999.12001.5. ** and * denote significance of the F-statistic at the 1% and 5% levels, respectively. a 2 w test of long-term restrictions: market rate coefficient 5 1 (normalization) and overnight rate 5 0. b No binding long-term restriction, since market rate is overnight rate. Sources: ECB, Reuters and authors estimations.

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Interest Rate Pass-Through: Empirical Results for the Euro Area


One-month money market rate Six-month money market rate Two-year government bond yield Ten-year government bond yield 120 100 80 60 40 20 0 -20 -40 -60 1 2 3 4 5 6 7 8 9 10 11 12 Three-month money market rate Twelve-month money market rate Five-year government bond yield

Figure 4 Official interest rate pass-through based on VAR framework since January 1999 ( percentage shares of cumulative official interest rate shock passed through to market interest rate)
Notes: Results based on equation (4a) using a sample 1999.12001.5. See Appendix B for underlying impulse responses including standard errors. Sources: ECB, Reuters and authors estimations.

Bank deposit rates

Bank lending rates

140 100 80 60 40 20 0 1 4 7 10 13 16 19 22 25 28 31 34 100 80 60 40 20 0 120 100 80 60 40 20 0 1 4 7 10 13 16 19 22 25 28 31 34

140 120 100 80 60 40 20 0

Figure 5 Retail bank rate pass-through based on VAR framework since 1 January 1999 ( percentage shares of cumulative market interest rate shock passed through to bank rate)
Notes: Results based on equation (4b) using a sample 1996.12001.5. See Appendix B for underlying impulse responses including standard errors. Sources: ECB, Reuters and authors estimations.

differences in the pass-through process exist across retail bank instruments. There are, however, two striking differences between both sets of charts. First, the immediate pass-through of changes in the official interest rate to money market interest rates up to three months has increased from around 60% to 80%, suggesting a strengthening of the monetary policy control at the short-end of the yield curve.
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G. J. de Bondt The second difference relates to the extent by which market interest rate shocks are immediately passed through to retail bank interest rates. The share of the immediate pass-through of a market interest shock to the interest rate on deposits redeemable at notice of over three months, time deposits and on loans to households for house purchase has increased since the introduction of the euro by around 15 percentage points. The main difference with respect to the long-term pass-through is that the interest rate on lending to enterprises up to one year no longer overshoots, in line with the VECM outcome.

6.3. Univariate error-correction model


Table 7 summarizes the official interest rate pass-through process since January 1999. For the EMU sample official interest rates are immediately completely passed through to money market interest rates up to three months. This suggests that the monetary policy control of the short-end of the yield curve at the euro area level has increased since January 1999. This is not a surprising finding given the fact that in this period a common monetary policy was in place in the euro area. A significant incomplete immediate pass-through for the money market rates with a longer maturity and no statistical relationship between the official interest rate and government bond yields have been found, in line with the full sample results. Table 8 summarizes the retail bank interest rate pass-through process since the introduction of the euro and compares the results based on the EMU sample with the estimated coefficients based on the full sample. Comparing Table 7 Official interest rate pass-through since January 1999 based on a univariate error-correction model
Final Adjustment Immediate speed in pass-through pass-through Immediate Final complete? complete? pass-through pass-through months a2 b2 (1 a2)/b1 a2 5 1 b2 5 1 0.94** 0.73** 0.14** 2.66** Yes** Yes** No** No** No** No** No** Yes** Yes** No** No** No** No** No**

Retail bank rate

Money market rates 1-month deposits 0.90** 3-month deposits 0.61** 6-month deposits 0.37** 12-month deposits 0.31** Government bond yields 2 years 0.12 5 years 0.16 10 years 0.34

Notes: Results based on equation (5a) using a sample 1999.12001.5. ** and * denote significance of the F-statistic at the 1% and 5% levels, respectively. Sources: ECB, Reuters and authors estimations.

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Interest Rate Pass-Through: Empirical Results for the Euro Area

Table 8

Retail bank interest rate pass-through since January 1999 based on a univariate error-correction model
Pass-through EMU sample Pass-through coefficient full sample 5 EMU valuea Final b2 6.12* 1.61 0.04 9.06** 4.28* 24.0** 0.68 5.13* 8.54** Speed (1 a2)/b1 19.1** 7.93** 0.55 34.1** 10.8** 37.0** 2.22 7.86** 0.58

Retail bank rate Deposit rate Overnight Up to 3 months notice Over 3 months notice Maturity up to 2 years Maturity over 2 years Lending rate Up to 1 year to firms Over 1 year to firms Consumer lending House purchase

Chow test Immediate Final Speed Complete Cointegration LR Immediate a2 b2 (1 a2/b1) b2 5 1 b1 5 0 Break 1999.1 a2 0.04** 0.01 0.35** 0.38** 0.47** 0.19* 0.55** 0.08 0.46** 0.18** 0.26** 0.72** 0.76** 0.65** 0.88** 0.80** 0.61** 1.04** 1.6** 4.1** 0.8** 1.1** 1.0** 2.8** 2.5 6.3** 2.6** No** No** No** No** No** Yes* Yes* No** Yes** Yes** Yes** Yes** Yes** Yes** Yes** No** Yes** Yes** 24.6** 15.4** 53.0** 53.2** 28.1** 38.7** 9.5* 3.8 18.7** 1.27 1.23 0.01 1.73 6.60* 1.49 0.02 1.63 36.1**

Notes: Results based on equation (5b) using a sample 1999.12001.5. ** and * denote significance of the F-statistic at the 1% and 5% levels, respectively, unless stated otherwise; LR denotes log likelihood ratio statistic. a F-statistic. Sources: ECB, Reuters and authors estimations.

61

G. J. de Bondt the findings based on the EMU sample with the results from the full sample, three observations emerge. The first observation is that Chow breakpoint tests, analysing a structural break for the error-correction model at January 1999, indicate a significant change in the pass-through process since 1 January 1999 in all cases with the exception of the interest rate on consumer lending. The impact of the introduction of the euro is, for all retail bank interest rates, reflected in a quicker speed of adjustment, which in most cases is statistically significant. The mean adjustment lag since January 1999 is typically 1 month for deposit interest rates and 3 months for bank lending rates. Exceptions are the interest rate on deposits redeemable at notice of up to 3 months and on consumer lending with an adjustment speed of 4 and 6 months, respectively. Second, the proportion of a given market interest rate change that is immediately passed through to the interest rate on mortgages and on deposits with a maturity of over two years has significantly increased since the start of Stage Three of EMU by around 20 and 10 percentage points, respectively. This suggests a rise in the prevailing competitive forces and/or a fall in switching and asymmetric information costs in these segments of the retail bank market. A third difference between both sets of findings is that for the period since 1 January 1999 the final pass-through to interest rates on loans to enterprises up to one year is no longer more than 100%. At the same time, for the interest rate on consumer lending an incomplete long-term pass-through is found for the period since the introduction of the euro, suggesting a certain degree of credit rationing in this segment of the credit market during this period. More generally, for all retail bank interest rates, except the mortgage interest rate, the final pass-through found for the EMU sample is lower than for the preEMU sample. In several cases this effect is statistically significant.

6.4. Explanations for the observed differences in the retail bank interest rate pass-through
6.4.1. Quicker interest rate pass-through since the euro Prima facie, three likely explanations emerge for the observed quicker retail bank interest rate pass-through process since January 1999. First, one could argue that the observed change around January 1999 relates to the reversal in the direction of the change in market interest rates and therefore is in favour of an asymmetric interest rate pass-through, e.g. bank lending rates are quicker adjusted upward in an environment of rising interest rates than adjusted downward when interest rates fall. In the course of 1999 the declining pattern in interest rates as observed since January 1996 reversed into a rise in interest rates, which continued more or less up to the end of 2000, after which market interest rates started to decline again. Although the period of rising market interest rates is a substantial part of the EMU sample, an asymmetric pass-through argument cannot explain why the

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Interest Rate Pass-Through: Empirical Results for the Euro Area speeding up is not only found for lending rates, but also for deposit rates for which the opposite effect is expected. The second and more likely economic explanation is that the prevailing competitive forces in most segments of the retail bank market have increased since 1999, both from a supply and from a demand perspective. The developments towards a rise in the prevailing competitive forces in the different segments of the retail bank market, in turn, may have been triggered by the introduction of a common monetary policy (see third explanation below). As regards the supply side, the ongoing restructuring of the banking sector seems to have promoted higher efficiency in the banking markets and more competitive pricing. A declining role of traditional banking, e.g. granting long-term loans and funding them by short-dated deposits, as reflected in an increasing use by banks of non-deposit or market-based funding sources is observed in the EMU sample (see Figure 6). As regards the euro area interbank market, which plays an important role in the overall banking activity in the `-vis the domestic euro area, an increasing use of cross-border transactions vis-a ones exists since the introduction of the euro. In addition, notwithstanding the steady decline in the number of credit institutions, new (foreign) players have become active in the retail bank credit market. Euro area banks also face more and more competition from other financial intermediaries such as insurance companies and pension funds (ECB, 2002). Turning to the demand side, there are also indications that competition has increased as bank customers have become more sensitive to the interest rates on bank loans and deposits compared with those charged by other banks and by financial markets. This may be related to the higher stability of nominal interest rates in an environment of price stability, which facilitates the comparison of prices across different suppliers, and to an increase in the
Deposit funding (left-hand scale) 35 Alternative funding (right-hand scale) 53 52 34 51 50 33 49 32 48 47 31 1997 1998 1999 2000 2001 2002 46

Figure 6

Deposit and alternative funding of MFI loans in the euro area (in per cent of balance sheet total)

Note: Alternative funding defined as deposits from resident MFIs and from non-residents (interbank and foreign deposits) and securities other than shares issued by MFIs. Source: ECB.
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G. J. de Bondt availability of alternative non-bank sources of finance, at least for some enterprises. For example, the commercial paper and corporate bond markets in the euro area have become deeper and more liquid in recent years (de Bondt, 2002). In addition, money market mutual funds, which offer marketbased returns, have grown considerably during the EMU sample. The third and final explanation, closely related to the competition argument, is that the price-setting behaviour by euro area banks may have changed due to the shift from national central banks to the ECB. Bagliano et al. (2000) theoretically show that in particular for German bank lending rates a strong impact of the change towards a common monetary policy at the euro area level is expected, since German banks, from January 1999, face a monetary policy which has responded to the euro area instead of German conditions. Empirical results for Germany using the univariate ECM are indeed in favour of this hypothesis (see the table in Appendix C). German bank lending rates adjust significantly quicker to changes in market interest rate developments since January 1999. For the other euro area countries the impact of the introduction of a common monetary policy is ambiguous. On the one hand, the other euro area countries may experience less money market interest rate variability from external conditions than before, suggesting a quicker interest rate pass-through. On the other hand, a larger ECB responsiveness to their country or local shocks than their national central banks did before 1999 under the EMS may result in a slower passthrough. Preliminary results at the euro area country level for four lending rates and one time deposit rate, point in the direction of a quicker adjustment speed since the introduction of a common monetary policy. In 34 out of 36 cases the adjustment speed of retail bank interest rates to changes in the short- and long-term market interest rates has increased since January 1999 (de Bondt et al., 2002). 6.4.2. Quicker bank deposit than lending rate pass-through The generally slower speed of adjustment of bank lending rates compared with bank deposit rates may relate to credit risk considerations due to asymmetric information costs (Wong, 1997; Winker, 1999). The spread between yields on long-term BBB-rated corporate bonds and government bonds with a comparable maturity can provide an indication of the degree of prevailing corporate credit risk as viewed by corporate bond market participants. This proxy for long-term corporate credit risk is added as an additional explanatory factor in the univariate error-correction model specification for the long-term corporate lending rate: Dbrt a1 a2 Dmrt a3 Dcrt b1 brt1 b2 mrt1 b3 crt1 et 6

Estimates of equation (6) show that the immediate adjustment of the longterm corporate bank lending rate to a change in the market interest rate remains around 55%, but that the adjustment speed substantially increases

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Interest Rate Pass-Through: Empirical Results for the Euro Area Table 9 Long-term corporate bank lending rate pass-through taking account of credit risk based on a univariate error-correction model
Immediate pass-through Market rate a2 0.55** (0.08) 0.58** (0.09) Credit riska a3 Adjustment coefficient b1 0.18 (0.11) 0.37* (0.18) Final pass-through Market rate b2 0.80** (0.10) 0.66** (0.07) Credit riska b3 Adjustment speed (1 a2)/b1 2.5 0.37* (0.18) 1.1*

a1 0.46 (0.31) 0.96 (0.50)

R2 0.70 0.72

0.15 (0.13)

Notes: Estimates of equation (6) using a sample period 1999.12001.5. ** and * denote significance at the 1% and 5% levels, respectively; standard errors are reported in parentheses. a Long-term corporate credit risk is approximated by the long-term BBB-rated corporate bond spread. Sources: ECB, Merrill Lynch, Reuters and authors estimations.

due to a larger adjustment coefficient (see Table 9). The adjustment speed on the basis of the model with a credit risk factor is found to be 1 month instead of 21 months. The coefficient estimates for the corporate bond spread suggest 2 that, following a 100 basis point change in the BBB-rated corporate bond spread, banks immediately adjust the long-term corporate lending rate with around 15 basis points and in the long term by around 35 basis points. Another observation is that the final pass-through for deposit rates is typically lower than for lending rates. This may be explained by a lower interest rate elasticity of the demand for deposits than of loans as shown by money and loan demand studies for the euro area. For money demand in the euro area Calza et al. (2001) find a semi-elasticity with respect to the opportunity cost of M3 between 0.6 and 0.9. As regards the demand of firms and households for loans in the euro area, Calza et al. (2003) find a semielasticity with respect to the short-term interest rate of 0.4 to 1.0 and to the long-term interest rate of 1.8 to 3.1. However, it should be kept in mind that these interest rate elasticities are based on total deposits and loans, whereas this study examines specific components of total deposits and loans.

7. CONCLUDING REMARKS
This study empirically analyses for the first time the interest rate pass-through process at the euro area level. The bank and market interest rates considered have, in contrast to previous studies, a comparable maturity to avoid distortions from yield curve effects and to accurately capture the marginal pricing costs of banks. Besides the pass-through of changes in market interest rates to retail bank interest rates, the pass-through of official interest rates, approximated by
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G. J. de Bondt the overnight interest rate, to market interest with longer maturities is examined. Notwithstanding the fact that the empirical findings presented in this paper have to be interpreted with more than usual caution because the sample period is short and the interest rate cycles covered are limited, three main conclusions emerge from the empirical results presented. These results are fairly robust across the three different empirical methods applied. First, monetary policy fully controls the short-end of the yield curve, i.e. money market interest rates with a maturity of up to three months. The passthrough of official interest rates to money market interest rates up to three months has become immediately complete since January 1999, in line with the introduction of a common monetary policy in the euro area. The impact of changes in official interest rates on market interest rates is found to decline with the maturity of the market instrument. No significant statistical relationship has been found between official interest rates and government bond yields, suggesting a credible monetary policy. Second, the immediate pass-through of market interest rates to retail bank interest rates is incomplete, in line with previous cross-country studies. The proportion of a given market interest rate change that is passed through within one month is found, at its highest, to be around 50%. The passthrough is higher in the longer term and notably for bank lending rates close to 100%. The most sticky retail bank interest rates in the euro area are the interest rates on overnight deposits and deposits redeemable at notice of up to three months with a long-term pass-through of at most 40%. The third and final conclusion is that the empirical results suggest a quicker retail bank interest rate pass-through process in the euro area since the introduction of the euro. For all retail bank interest rates the mean adjustment speed has become quicker since January 1999. The mean speed at which bank rates finally adjust to market interest rate developments since the introduction of the euro is found to be typically around one month for deposit rates and around three months for lending rates. A likely factor underlying this speeding up is the tendency towards a rise in the prevailing competitive forces in the different segments of the euro area retail bank market during the first years of Stage Three of EMU. The latter, in turn, may have been triggered by the introduction of the euro and/or the common monetary policy. This is a topic for further research. Another field of future research is the role of credit risk in the determination of bank lending rates. Tentative results as presented in this paper in this respect may form a starting point for this. The possibility of an asymmetric interest rate pass-through process in the euro area also warrants future research, as soon as a more extended EMU interest rate cycle becomes available.

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APPENDIX A. IMPULSE RESPONSE ANALYSIS OF INTEREST RATE PASS-THROUGH


Official interest rate pass-through (response of the market interest rate to a one standard deviation innovation of the official interest rate)

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Notes: Dotted lines denote 95% confidence interval based on analytical standard errors of estimated VAR models of interest rate pairs using a sample 1996.12001.5. Sources: ECB and authors estimations.

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APPENDIX B. IMPULSE RESPONSE ANALYSIS OF INTEREST RATE PASS-THROUGH SINCE JANUARY 1999
Official interest rate pass-through since January 1999 (response of the market interest rate to a one standard deviation innovation of the official interest rate)

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Interest Rate Pass-Through: Empirical Results for the Euro Area Retail bank interest rate pass-through since January 1999 (response of the retail bank rate to a one standard deviation innovation of the market interest rate)

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Notes: Dotted lines denote 95% confidence interval based on analytical standard errors of estimated VAR models of interest rate pairs using a sample 1999.12001.5. Sources: ECB and authors estimations.

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APPENDIX C. RETAIL BANK INTEREST RATE PASS-THROUGH IN GERMANY


Table A.1 German retail bank interest rate pass-through based on a univariate error-correction model
Market interest rates with a comparable maturity Immediate Final passpassthrougha throughb a2 b2 Adjustment speed (in months) (1 a2)/b1

Retail bank interest rate Bank deposit rate 1996.12001.5 Up to 3 months notice Over 3 months notice Maturity of 1 month Maturity of 3 months 1999.12001.5 Up to 3 months notice Over 3 months notice Maturity of 1 month Maturity of 3 months Bank lending rate 1996.12001.5 Up to 1 year to firms Over 1 year to firms Consumer lending House purchase 1999.12001.5 Up to 1 year to firms Over 1 year to firms Consumer lending House purchase

3 months 12 months 1 month 3 months 3 months 12 months 1 month 3 months

0.16** 0.27** 0.43** 0.45** 0.04 0.32** 0.42** 0.42**

0.31* 0.75** 0.72** 0.83** 0.22** 0.78** 0.71** 0.82**

11.4* 2.3** 1.1** 1.0** 2.7** 2.1** 1.0** 1.0**

12 months 58 years 35 years 35 years 12 months 58 years 35 years 35 years

0.12* 0.57** 0.04 0.69** 0.02 0.56** 0.08 0.75**

1.05** 1.26** 0.82** 1.06** 0.89** 1.14** 0.83** 0.98**

6.8** 4.9* 10.5** 1.0** 4.3** 1.9** 10.2 0.3**

Notes: Results based on equation (5b). ** and * denote significance at the 1% and 5% levels, respectively. a In all cases the immediate pass-through is statistically different from 1. b In all cases the final pass-through is statistically different from 1 for deposit rates, but not for lending rates. Sources: Bundesbank and authors estimations.

ACKNOWLEDGEMENTS
Comments by John Fell, Hans-Joachim Klockers, Manfred Kremer and an anonymous referee are appreciated. All views expressed are those of the author alone and do not necessarily reflect those of the ECB or the Eurosystem.
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G. J. de Bondt Address for correspondence: European Central Bank, Kaiserstrasse 29, D60311, Frankfurt am Main, Germany. Tel.: 49 69 1344 6477; fax: 49 69 1344 6514; email: gabe.de_bondt@ecb.int

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