**How Banks Fund Themselves Affects the Reach of ECB Rate Decisions, Study Finds**
A recent working paper from the European Central Bank (ECB) highlights the significant impact that the funding structures of euro area banks have on the transmission of interest rate changes to businesses and households. The study reveals that banks that primarily rely on short-term money market funding tend to adjust their lending and deposit rates more rapidly and persistently following changes in ECB policy rates. In contrast, banks that depend more on long-term bond funding exhibit a slower response.
The research underscores the crucial role of bank lending as a primary source of finance for companies within the eurozone. Consequently, variations in how banks react to ECB decisions can influence borrowing costs, investment decisions, production levels, and ultimately, inflation rates. When the ECB adjusts its policy rates, commercial banks play a pivotal role in determining the rates they charge for new loans and the interest they offer on deposits. The process through which these changes are transmitted is known as interest rate pass-through, and the findings suggest that this process is not uniform across different banks.
Using aggregate data from the euro area spanning from 2001 to 2023, alongside detailed ECB data from 266 individual banks between July 2007 and April 2023, the researchers focused primarily on new loans to non-financial corporations and overnight deposits. Their analysis revealed that while ECB policy changes do affect borrowing rates for companies, the response is neither immediate nor complete. On average, only about 40% of a policy rate change is reflected in rates on new loans to companies immediately after the change, with this figure increasing to approximately 80% after three months. Deposit rates, particularly for household overnight deposits, tend to respond even more slowly and to a lesser extent.
The study illustrates that the effects of ECB rate decisions can vary significantly depending on the type of financial product involved. Banks that rely heavily on short-term money market funding are more likely to pass on changes in ECB policy rates to their lending rates more effectively and for a longer duration. This is because short-term funding, which is borrowed for relatively brief periods, experiences cost changes more rapidly in response to shifts in central bank interest rates. Therefore, when the ECB raises rates, banks that depend on this type of funding face a quicker increase in their own borrowing costs, prompting them to raise lending rates more aggressively.
Conversely, banks that primarily utilize bond funding are less immediately affected by changes in policy rates. Bonds typically provide financing for longer durations at fixed rates, which do not adjust as quickly in response to shifts in short-term policy rates. As a result, these banks tend to increase their lending rates more gradually and by smaller amounts following an ECB policy change.
The research also identified a notable relationship between the type of loans banks offer and their funding structures. Banks with a greater share of long-term bond funding are more likely to issue loans with fixed interest rates. Fixed-rate loans maintain the same interest rate for an agreed period, while floating-rate loans can fluctuate as market rates change. This creates an "asset-liability-management channel," indicating that the way banks fund themselves is linked to the characteristics of the loans they provide. Banks with stable, longer-term funding are better positioned to offer fixed-rate loans, as their funding costs are less susceptible to short-term market fluctuations.
The study found that the weakest response to ECB rate changes was observed in banks that combined a high proportion of bond funding with a significant share of long fixed-rate loans. This suggests that both sides of a bank's balance sheet can contribute to a reduced sensitivity of lending rates to monetary policy changes.
To assess the broader implications of these findings for the euro area economy, the researchers employed a small economic model. The model indicated that when bank rates do not fully and immediately align with ECB policy rates, the overall effects of monetary policy on economic output and inflation are diminished compared to scenarios where perfect pass-through is assumed. This suggests that economic models presuming immediate and complete adjustments in bank lending rates may overestimate the impact of monetary policy.
The paper argues that evaluations of monetary policy should consider not only the ECB’s policy rate but also the funding structures of banks and the maturity of their loans. The researchers found that differences in funding models create a structural source of variation among banks, even within the same monetary union, independent of national differences. Banks that utilize more money market funding tend to see policy changes reflected in their rates more quickly and robustly, whereas those with more bond funding and longer-term assets exhibit a more gradual adjustment.
However, the study does not claim that funding structures directly cause differences in pass-through in every situation. The analysis primarily focuses on conventional monetary policy surprises and does not delve into targeted credit measures or central bank balance sheet policies, except where they influence banks' funding conditions. The researchers also acknowledge that their approach may not fully capture how relationships could evolve in different economic environments, such as periods of negative interest rates. They suggest that future research could explore the maturity of both sides of bank balance sheets in greater detail and examine how pass-through dynamics change across varying monetary policy regimes.
In conclusion, the study emphasizes that banks’ funding structures are a crucial determinant of how swiftly and effectively ECB monetary policy reaches the broader economy. Understanding these differences can enhance assessments of current financial conditions and inform expectations regarding the effects of future policy decisions.