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Impact of bank competition on the interest rate pass-through in the euro area

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Author Info
Michiel van Leuvensteijn () (CPB Netherlands Bureau for Economic Policy Analysis, P.O. Box 80510, 2508 GM The Hague, The Netherlands.)
Christoffer Kok Sørensen () (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
Jacob A. Bikker () (De Nederlandsche Bank (DNB), Supervisory Policy Division, Strategy Department, P.O. Box 98, 1000 AB Amsterdam, The Netherlands.)
Adrian A.R.J.M. van Rixtel () (Banco de España, International Economics and International Relations Department, Alcalá 48, 28014 Madrid, Spain.)

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Abstract

This paper analyses the impact of loan market competition on the interest rates applied by euro area banks to loans and deposits during the 1994-2004 period, using a novel measure of competition called the Boone indicator. We find evidence that stronger competition implies significantly lower spreads between bank and market interest rates for most loan market products. Using an error correction model(ECM) approach to measure the effect of competition on the pass-through of market rates to bank interest rates, we likewise find that banks tend to price their loans more in accordance with the market in countries where competitive pressures are stronger. Further, where loan market competition is stronger, we observe larger bank spreads (implying lower bank interest rates) on current account and time deposits. This would suggest that the competitive pressure is heavier in the loan market than in the deposit markets, so that banks compensate for their reduction in loan market income by lowering their deposit rates. We observe also that bank interest rates in more competitive markets respond more strongly to changes in market interest rates. These findings have important monetary policy implications, as they suggest that measures to enhance competition in the European banking sector will tend to render the monetary policy transmission mechanism more effective. JEL Classification: D4, E50, G21, L10.

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Paper provided by European Central Bank in its series Working Paper Series with number 885.

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Length: 41 pages
Date of creation: Mar 2008
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Handle: RePEc:ecb:ecbwps:20080885

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Keywords: Monetary transmission banks retail rates competition panel data.

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