chapter  8
29 Pages

Impact of bank competition on the interest rate pass-through in the euro area JACOBA. BIKKER, MICHIEL vA NLEUvENSTEIJN, CHRIS TO FFERKOK

This chapter analyses the impact of loan market competition on the interest rates applied by euro-area banks to loans during the 1994-2004 period, using the PCS indicator. We find evidence that stronger competition implies significantly lower spreads between bank and market interest rates for most loan market products, in line with expectations. This result implies that stronger competition causes both lower bank interest rates and a stronger pass-through of market rate changes into bank rates. Evidence of the latter is also presented by our error correction model for bank rates. Further, banks compensate income losses from increased loan market competition by offering lower deposit rates. Our findings with respect to the loan market rates have important monetary policy implications, as they suggest that measures to promote competition in the European banking sector are likely to render the monetary policy transmission mechanism more effective.

8.1. Introduction This chapter discusses the effects of bank competition on bank loan interest rates, and their responses to changes in market rates, as well as on deposit rates. Given the prominent role of the banking sector in the euro area’s financial system, it is of significant importance for the European Central Bank (ECB) to monitor the degree of competitive behaviour in the euro-area bank loan market. A more competitive banking market is expected to drive down bank loan rates, adding to the welfare of households and enterprises in a financially stable environment. This is particularly true for competitive edges resulting from efficiency gains. At the same time, competition may increase instability through two channels: by exacerbating both the problem of depositor (investor) coordination on the liability side and the risk of panics; and by increasing incentives to take risks, and thus raising the probability of failure (vives, 2010). Further, in a more competitive market, changes in the ECB’s main policy rates are assumed to pass through more strongly and more quickly into banking rates, enhancing the monetary policy transmission mechanism.