This study aims at unifying the empirical research on interest-rate pass-through in the euro zone. After endogenously determining structural breaks we select optimal pass-through models, which allow for thresholds and asymmetric adjustment. By applying these models to monetary policy shocks as well as cost-of-funds changes, we show that in post-break periods monetary policy transmission has become faster, that heterogeneity across the euro zone has decreased in some banking markets, and that more competition improves the pass-through predominantly in deposit markets. As national characteristics are still important pass-through determinants, convergence remains incomplete and monetary policy will continue to operate in a heterogeneous euro zone.
How uniform is the monetary transmission process in the euro zone? Given the dominant role of bank finance in the euro zone, banks are important conveyers of monetary policy impulses.1 However, banking markets are often considered to be more resistant to convergence than other parts of the monetary transmission mechanism. As such, divergences in national banking market structures and competition as well as a lack of euro-zone banking market integration can be expected to lead to heterogeneous effects of monetary policy across the euro-zone economies.
Recent literature has therefore focused on empirical analyses of the pass-through of monetary policy impulses to retail banking interest rates in the euro zone.2 Overall, these studies agree that there is a substantial degree of short-run bank interest rate stickiness. Furthermore, all studies find considerable differences in the pass-through not only across different bank lending and deposit rates but also across countries. These differences are typically attributed to the divergent structures of national financial systems. However, the single currency is often perceived to be a unifying force by making the pass-through faster, more complete and more homogeneous over the recent years. Nevertheless, the differences in the results of pass-through studies remain large and can be attributed mainly to four factors: (1) the choice of the exogenous market interest rate, (2) the length and timing of the sample periods, particularly with respect to the treatment of possible structural breaks, (3) the chosen methodology for the pass-through analysis, and (4) the design of the analysis of pass-through determinants.
In this study we provide a unifying analysis of the euro-zone pass-through mechanism by addressing these four issues: First, the pass-through is investigated by using both proxies for monetary policy rates as well as proxies for the bank’s cost of funds. The first approach focuses on the transmission of monetary policy impulses into the financial sector while the second approach highlights the role of competition and market structures. Both approaches can be found in the literature and should therefore be viewed as complementary. Our unifying analysis allows for a direct comparison. Second, we investigate if and when the pass-through has changed between 1993 and 2002 by not postulating, but endogenously searching for structural breaks. Third, we estimate a large variety of pass-through models, including threshold and asymmetric adjustment models. The model finally used for each retail rate in each country is automatically selected according to statistical criteria set a priori. Finally, we investigate the determinants of the size, speed and convergence of the pass-through process.
The results of our study can be summarized as follows: First, the euro-zone pass-through mechanisms have undergone considerable structural changes in the past decade. However, these structural breaks do not necessarily coincide with the introduction of the single currency but have often occurred much earlier. This result contests exogenously setting the break point in January 1999. One would then eventually attribute the observed changes in the pass-through process to the introduction of the single currency, while it may in fact reflect the impact of earlier changes in EU banking market regulation, or expectational effects in the run up to EMU, or the impact of lower money market rate volatility prior to 1999. A second result is that during the post-break period the pass-through of monetary policy impulses has improved with respect to lending but not to deposit rates. We also find that there is no improvement over time in the pass-through of cost-of-funds changes. Furthermore, and in contrast to some earlier studies, we find an incomplete long-run pass-through for most retail rates. Interesting also, the size of the pass-through is typically higher the shorter maturity of the lending rate. However, the grip that monetary policy now has on long-term lending rates, such as mortgage rates, has also improved. Whilst the pass-through mechanism has generally remained heterogeneous across euro-zone countries, the market for short-term corporate lending has become more homogeneous, thus conveying the statistical picture of a more integrated market. Finally, we find that the distinct structural features of national financial markets as well as macroeconomic factors such as interest-rate volatility, structural inflation and growth can explain a considerable part of the pass-through heterogeneity. However, legal and cultural differences remain statistically significant determinants. We therefore conclude that neither structural convergence of financial systems across countries nor a single monetary policy regime can be expected to fully homogenize the euro-zone pass-through in the near future.
The objective of this study is to provide a more uniform analysis of the euro-zone pass-through process. Our study makes a number of contributions to the literature. First, many differences in the results of pass-through studies can be reconciled if the timing of structural breaks is endogenously determined rather than postulated. This is particularly important because we find that structural breaks occur often before the introduction of the single currency. Moreover, changes in structural features such as reduced money market rate volatility may explain the improved pass-through in some countries better than some mysterious “EMU effect”. Secondly, we have shown that it is important to distinguish clearly between the monetary policy and the cost-of-funds approach. Both approaches deliver different results but complementary insights. Thirdly, we have conducted both analyses by selecting an optimal pass-through model for all sub-periods and all national retail interest rates. Forth, we find ample evidence for short-run rigidity of banking product prices, indicating imperfectly competitive markets. Fifth, we have shown that the pass-through has become faster in response to monetary policy impulses but not in response to changes in cost of funds. Sixth, by identifying a number of banking markets with a less than perfect long-run pass-through, our results indicate that market imperfections such as credit rationing are an important feature in European retail banking. Seventh, when using pass-through measures as indicators for euro-zone retail banking market integration, the view that the markets are still fragmented is supported—with the eventual exemption of short-term lending to enterprises. Finally, our analysis of the structural determinants of the pass-through process reveals that some convergence can be achieved by means of nominal, real, and structural convergence. Competition, banking market integration, a stable monetary policy regime, a more homogeneous growth performance etc. are important variables for homogenizing the pass-through and thus monetary transmission in the euro zone. Nevertheless, legal and cultural differences may continue to preclude full convergence.
Our results should remind policy makers that these differences matter for both, monetary policy and integration policy formulation. As monetary policy will have to deal with these differences in the foreseeable future, our results are useful to policy makers as they provide a deeper knowledge of the differential impact of monetary policy on retail lending rates and allow a more precise assessment of the impact of any given shock across individual euro-zone countries and retail products. As our results highlight and quantify the role of structural factors such as competition, banking market integration, and a stable monetary policy regime for producing more homogeneity in euro-zone retail banking markets, they provide guideposts for policy initiatives to promote European financial market integration. Finally, all aspects of our analysis will be of particular relevance in the future when countries with even more different economic and financial structures are becoming members of both, the European Union and the euro zone.
