The key chart
Changes in EA policy, market, wholesale and retail rates (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
The key message
This is the first in a series of three posts analysing the Bank Lending Channel (BLC) and its role in the transmission of ECB monetary policy. The focus here is:
What is the BLC and how does it work?
The BLC is one of the “downstream effects” of the transmission mechanism that relate to changes in the cost and volume of bank financing for NFCs and HHs.
Its importance to the transmission of ECB monetary policy reflects the fact that the euro area (EA) is largely a “bank-centred” economic region (especially Italy, Germany and Spain).
They are two key elements to the BLC: (1) bank funding costs and (2) the “interest rate channel”. In terms of the former, theory and experience tells us that the marginal cost of wholesale funding typically reflects changes in policy rates relatively quickly. In contrast, retail deposit rates adjust more slowly, thereby containing the rise in bank funding costs during a period of higher interest rates. Clearly then, the funding mix plays an important role in determining the effectiveness of overall policy (see the second post in this series) and its impact at the country level (see the third post in this series).
Increases in market rates are transmitted via bank funding costs to lending rates for new bank loans via the interest rate channel (as well as by the repricing of outstanding variable rate loans). Banks typically apply a mark-up on top of their funding costs (c.190bp and 200bp for NFC and HH loans respectively). It is reasonable to expect a more rapid pass through of policy and market rates to the costs of NFC (market) debt, then NFC (bank) loans, then HH loans.
Practice has followed theory in the EA since June 2022.
There was a rapid pass though from the policy rate (300bp) to the market rate (288bp) between June 2022 and February 2023. The pass through to NFC and HH deposits with agreed maturity was incomplete but more rapid in the NFC sector (240bp) than in the HH sector (163bp).
The very limited pass through to the cost of overnight deposits is particularly noteworthy, both in terms of historic precedent (“Passing Through II”) and the implications for policy effectiveness (“Passing Through III”).
In terms of the interest rate channel, the pass though has been more rapid in the case of NFC loans than for HH loans but remains incomplete so far in both cases.
In short, the BLC is working in practice in the same was as theory would suggest through both bank funding costs and the interest rate channel. There are important differences, however, between current experiences and those of previous hiking cycles and important differences in the BLC at the country and sector levels that create challenges for policy makers, banks and investors alike. The next two posts address these issues in turn.
Passing Through II
This series of three posts (“Passing Through II – Passing Through IV”) analyses the BLC and its role in the transmission mechanism of ECB monetary policy. They focus on three questions:
- What is the BLC and how does it work?
- How do the current working of the BLC compare with previous hiking cycles?
- What are the key challenges for policy makers, bankers and investors?
What is the BLC and how does it work?
The ECB likes to divide analysis of the monetary policy transmission process into two parts –upstream and downstream effects.
Upstream effects relate to how the steering of ST money market conditions affects risk-free rates and sovereign yield curves.
Downstream effects relate to how policy decisions affect the cost and volume of bank financing for NFCs and HHs.
The focus here is on one important downstream effect – the Bank Lending Channel – and its two key elements, namely funding costs and the interest rate channel.
Bank credit as a percentage of total private sector credit (Source: BIS; CMMP)
The importance of the BLC in the transmission of ECB monetary policy reflects the fact that the euro area (EA) is largely a “bank-centred” economic region (see chart above). Bank credit accounts for 55% of total private sector credit in the EA, compared with 46% for all advanced economies. Bank credit plays a particularly important role in Italy (65% total), Germany (65% total) and Spain (59% total), but less so in France (49% total) and the Netherlands (39% total).
Funding costs are the first key element of the BLC. The marginal cost of wholesale funding typically reflects changes in policy rates relatively quickly. In contrast, retail deposit rates adjust more slowly, thereby containing the rise in bank funding costs during a period of higher policy rates. Clearly then, the funding mix plays an important role in determining the effectiveness of overall policy and its impact at the country level.
The interest rate channel is the second key element of the BLC. Increases in market rates (eg 3m EURIBOR, or 12m EURIBOR in Spain) are transmitted via bank funding costs to bank lending rates for new loans via the interest rate channel, as well as by the repricing of the outstanding stock of variable rate loans. Banks typically apply a mark-up on top of their funding costs. Over the past twenty years, the mark up on the composite cost of borrowing indicator (CCOB) for NFCs and HHs (for home purchases) has been 193bp and 200bp respectively. Note that it is reasonable to expect a more rapid pass through of policy rates to the cost of NFC (market) debt, then NFC (bank) loans, then HH loans.
Changes in policy rates, market rates and selected bank funding costs (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
In terms of funding costs and the interest channel, practice has followed theory in the EA since June 2022.
The MRO (policy rate) and 3m EURIBOR (market rate) rose 300bp and 288bp between June 2022 and February 2023 (and further again in March). In other words, there was a rapid pass though from the policy rate to the market rate. The NFC and HH composite interest rates (CIR) for deposits with agreed maturity rose 240bp and 163bp over the same period. As expected, the pass through to wholesale deposits has been more rapid than to retail deposits.
That said, the limited pass through to the cost of overnight deposits is noteworthy both in terms of historic precedent (the subject of Passing Through III) and the implications for policy effectiveness (the subject of “Passing Through IV”).
Trends in market rates and the NFC and HH composite cost of borrowing indicators (%) (Source: ECB; CMMP)
In terms of the interest rate channel, the so-called “pass through” has been more rapid in the case of NFC loans than for HH loans (see chart above). The NFC CCOB has increased 202bp since June 2022, to 3.85%. The HH CCOB for house purchase has increased by 127b to 3.24% over the same period (see chart below).
Changes in policy rates, market rates and NFC and HH composite cost of borrowing indicators (ppt) between June 2022 and February 2023 (Source: ECB; CMMP)
Note that in both cases, the lagged effect of pass through to lending rates so far, means that the spread over 3m EURIBOR has narrowed sharply to 121bp and 60bp respectively. This is not unusual (see chart below).
Spread between NFC and HH CCOB and 3m EURIBOR (ppt) (Source: ECB; CMMP)
Another way of thinking about this, however, is that is the full average mark up over the past twenty years was applied to the 3m EURIBOR rate in February 2022, the NFC CCOB would rise from 3.85% to 4.57% and the HH CCOB would rise from 3.24% to 4.64%.
Conclusion
The BLC is working in practice in the same was as theory would suggest through both bank funding costs and the interest rate channel. There are important differences, however, between current experiences and those of previous hiking cycles and important differences in the BLC at the country and sector levels that create challenges for policy makers, banks and investors alike. The next two posts address these issues in turn.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.