Interest rate setting by universal banks and the monetary policy transmission mechanism in the euro area pot

Interest rate setting by universal banks and the transmission mechanism in the euro area
1
Interest rate setting by universal banks and
the monetary policy transmission mechanism in the euro area
Gabe de Bondt, Benoît Mojon and Natacha Valla*
6 November 2002
Preliminary Draft
Abstract
This paper empirically analyses the pass-through of changes in market interest rates to retail bank
interest rates in euro area countries. The results confirm earlier findings that retail bank rates adjust
sluggishly to market rates. Differences in the degree of this pass-through persisted after the
introduction of the euro, both across the five segments of the retail bank markets analysed and across
the ten euro area countries considered. First, the sluggishness is not generally due to an ability of
“universal” banks to fund loans by deposits rather than securities. Second, estimation results of linear
and state dependent error correction models show that retail bank interest rates adjust to changes in
funding (lending rates) or opportunity costs (deposit rates), which are approximated by a weighted
average of short and long-term market interest rates. Furthermore, it is found that the introduction of
the euro has speed up the adjustment of retail bank interest rates to market interest rates. One possible
factor behind this evolution is in the evolution could be related to competitive forces in the different
segments of the retail bank market.
Keywords: retail bank interest rates; market interest rates; euro area countries
JEL classification: E43; G21
European Central Bank, Kaiserstrasse 29, D-60311, Frankfurt am Main, GERMANY. E-mail addresses:
, , and We thank Jesper Berg, Francesco
Drudi, Michael Ehrmann and Oreste Tristani for their reflexions on a previous draft, Hans-Joachim Klockers for his
comments and Rasmus Pilegaard for excellent data assistance. All views expressed are those of the authors alone and do not
necessarily reflect those of the ECB or the Eurosystem.
Interest rate setting by universal banks and the transmission mechanism in the euro area
2
1. Introduction
The level of interest rates is one of the main determinants of savings and investment decisions. When

making these decisions, euro area households and firms are mainly confronted with retail bank interest
rates. In 2000, the amounts outstanding of loans to non-financial corporations of the euro area were
seven times as large as debt securities. Moreover, traditionally deposits are larger than money mutual
funds (Agresti and Claessens, 2002; ECB’s Report on Financial Structures, 2002). It is also clear that
the response of bank retail rates to changes in the interest rates on the refinancing operations
controlled by the central bank is a major link in the transmission of the ECB monetary policy.
A growing literature has shown the sluggishness of retail banks interest rates in the euro area. As
shown in Table 1 (reproduced from De Bondt 2002), the complete pass-through from changes in the
money market rates to retail bank rates takes at least several months
1
. These results are usually based
on reduced form regressions of retail bank rates on the money market rate. While this modelling
approach provides a good summary evaluation of this sluggishness, it falls short of explaining its
determinants. To remedy this gap, this paper estimates semi-structural equations of interest rate setting
by euro area banks, which we see as being in their majority “universal”.
2
Our study covers five
categories of euro area retail bank rates, four loans (short-term and long-term loans to firms,
mortgages and consumer credit), and one time deposits interest rates. We use time series of retail rates
and market rates from ten of the twelve euro area countries as well as for the euro-area aggregate.
“Universal” banks, which we define by opposition to “specialised” banks, should in principle enjoy
economies of scope. In particular, the rates on loans granted by universal institutions may depend on
the cost of raising deposits rather than issuing securities. Such a deposit-based funding of loan
activities could imply that retail bank rates remain little responsive to market conditions once deposit
rates are accounted for. On the contrary, specialised banks without branches collecting deposits would
set their retail loan rates on the basis of their market-based funding.
Within our framework, this ability of continental European banks to avoid market funding using
deposits instead is one possible explanation for the retail rates sluggishness.

1

This is in sharp contrast with the U.S., where, as shown in Sellon (2001), the spread between the prime lending rate and the
federal funds rate has been constant, implying a complete instantaneous pass-through, for nearly a decade.
2
Indeed, banks in the euro area benefit from a very broad range of authorised operations. This became formally true with the
second European Banking Directive (1989), which formalised a tendency that had already emerged earlier on in key euro
area countries. The functional separation of banking activities indeed gradually disappeared since the mid-1970s: 1974 in
Spain, 1975 in Belgium, 1989 for the Netherlands, 1984 in France, 1990 in Italy. Moreover, in Germany and Austria,
universal banking had been the grounding principle of banking activities ever since the beginning of the 20th century.
Overall, there is a long tradition of universal banking across euro area countries. We note that universal banking may
refer not only to household lending, deposit-taking and investment financing, but also brokerage, equity holding,
portfolio management and trading. Moreover, the multiplication of mergers and acquisitions has led to the creation of
conglomerates involving banks, insurance and securities companies that have strengthened the universal character of
European banks (see Cybo-Ottone and Murgia (2000)). However, given the scope of our paper, we shall stick to a
“narrow” definition of universal banking and refer to the set of “traditional” retail banking activities.
Interest rate setting by universal banks and the transmission mechanism in the euro area
3
Another explanation for the sluggishness of retail bank rates is that funding costs are not entirely
indexed to the money market rate. First, banks may try to limit interest rate risk on long-term loans by
increasing the maturity of the funding of such loans. Second, in the presence of adjustment/menu
costs, uncertainty about the persistence of changes in money market rates may induce banks to define
a target retail rate as a function of long-term rates, as a smooth indicator of future changes in money
market rates.
Our initial tests reject the idea that retail bank rates on deposits have, conditionally on the level of
market interest rates, a significant influence on retail bank rates on loans. We then show that the
dynamics of each retail bank interest rate can be specified separately within an error correction model
(ECM). In the long run, banks set their retail prices in line with their marginal costs, i.e. the funding
costs of loans and the opportunity costs of deposits. Both the funding and opportunity costs are
modeled as a weighted average of the three-month money market rate (MMR) and the 10-year
government bond yield (BR). This way, the marginal cost of retail bank instruments are more
accurately captured than in previous studies, which typically examined only the short-term market

interest rate. Nevertheless, it can not be ruled-out that our empirical findings are distorted by maturity
mismatches or yield curve effects, since it is unclear whether our freely estimated weighted average of
the short and long-term interest rates have a comparable maturity with the underlying retail bank
instrument.
3
In the short run, changes in retail bank rates depend on changes in the MMR and in the
BR and on the deviation from the long-run equilibrium relationship between the retail bank interest
rate and short- and long-term interest rates.
The stability of the baseline linear ECM before and after the introduction of the euro is then tested and
we assess whether more general state dependent models are preferable to the linear specification. A
break in January 1999 is found in the estimated linear ECM in about half of the cases. One possible
explanation for this break may be associated to the evolution of the competitive forces in the different
segments of the retail bank market since the introduction of the euro. For instance, the time deposit
and mortgage markets have seen some new entrants, in particular internet banks. In addition, for non-
financial corporations, non-bank sources of finance, in particular debt securities, have increased in
recent years (De Bondt, 2002c).
This paper has three key contributions. First, it shows that the sluggishness in the response of retail
rates to market rates is not due to the possibility of banks to fund their loans through the issuance of
deposits. Second, it shows that retail bank interest rates in euro area countries adjust to changes in
marginal funding or opportunity costs, approximated by a weighted average of short and long-term

3
At the euro area level De Bondt (2002a) examines the adjustment of retail bank interest rates to market interest rates with a
comparable maturity.
Interest rate setting by universal banks and the transmission mechanism in the euro area
4
interest rates. The weight of market rates in the equilibrium target of retail bank rates, which has been
largely ignored in the literature on the pass-through, is found to be an important factor behind the
sluggishness of the response of bank rates to market rates. Third, we find that in a large number of
national retail markets, the introduction of the euro has affected bank pricing.

The paper is structured as follows. Section 2 presents available evidence on interest rates pass-through
process in individual euro area countries. The theoretical model of bank pricing is presented in section
3. Section 4 provides an overview of the data. Section 5 discusses the empirical results and Section 6
concludes.
2. The pass-through to retail bank interest rates: literature review(s)
While recent studies on the retail bank interest rate pass-through stress the sluggishness in the
adjustment of retail bank rates, they usually do not provide explanations for it. Against this
background, we discuss how the complementarities across bank’s activities can explain the lack of
responsiveness of bank rates to market conditions.
2.1. An incomplete interest rate pass through in individual euro area countries
Table 1 summarises the main findings of interest rate pass-through studies performed for individual
euro area countries. All studies show cross-country differences in the interest rate pass-through,
although no clear pattern in those differences seems to emerge .
Studies from the mid-1990s broadly show that changes in official and/or money market rates are not
fully reflected in short-term bank lending rates to enterprises after three months, but that the pass-
through is higher in the long term (BIS, 1994, Cottarelli and Kourelis, 1994, and Borio and Fritz
1995). Recent cross-country studies by Kleimeier and Sander (2000 and 2002), Donnay and Degryse
(2001), Toolsema et al. (2001), and Heinemann and Schüller (2002) confirm this finding. Hofmann
(2000) and Mojon (2000) also find short-term sluggishness in short-term bank lending rates to
enterprises, but assume a priori a complete long-term pass-through.
As regards long-term bank lending rates to enterprises and households, all studies, except BIS (1994),
typically show that the pass-through tends to be less complete than for short-term bank lending rates to
enterprises. This finding may be driven by the fact that the funding costs are approximated by money
market interest rates, which may not always be the most appropriate marginal funding costs, in
particular for long-term loans to enterprises and mortgages.
Furthermore, changes in and convergence of financial structures among euro area countries is a
potential determinant of the interest rate pass-through. For instance, Mojon (2000) concludes that
Interest rate setting by universal banks and the transmission mechanism in the euro area
5
deregulation has significantly affected the interest rate pass-through process for deposits, but not for

loans.
2.2. Bank studies on the interest rate pass-through
The industrial organisation literature typically examines the link between bank interest rate margins
and the market structure of the banking system using bank data. (Hannan and Berger, 1991, Neumark
and Sharpe, 1992, Angbazo, 1997, Hannan, 1997, Wong, 1997, and Corvoisier and Gropp, 2001). The
main lesson of these banking structure studies is that the pricing behaviour of banks may depend on
the degree of competition and contestability in the different segments of the retail bank market. For
instance, Corvoisier and Gropp (2001) conclude that for demand deposits and loans increasing bank
concentration in individual euro area countries during the years 1993–1999 may have resulted in less
competitive pricing by banks, whereas for savings and time deposits the opposite seem to be the case.
2.3 Loans pricing by universal banks
The vast empirical literature that has tested the existence of economies of scope is largely
inconclusive. However, the complementarities across bank activities can explain the sluggishness of
retail bank rates.
One factor of retail bank rate sluggishness that has not received much attention is the ability of banks
to exploit the complementarity of their activity. In a universal banking environment, the way banks set
retail interest rates pertains to the general - and overall inconclusive - debate on complementarities and
scope in banking. A widespread belief suggests that banks tend to expand the scope (and possibly
scale) of their activities because of the allegedly increased competition in traditional banking
activities
4
. Unfortunately, the economic benefits from expanding scope seem are not overwhelmingly
echoed in the data (Berger et al 1993). The enormous literature estimating costs and production
functions of banks remains relatively inconclusive on the issue (see the survey in Clark (1988) and
Altunbas (2001) and Bikker (2001)). Regressing three different measures of bank profits on bank-

4
Because they need to improve their cost efficiencies to operate more effectively, scale expansion would be justified. In
parallel, by squeezing margins, tougher competition would force banks to seek profits outside familiar territories. This
argument, however, is not strongly supported empirically. In addition, cost efficiency arguments suppose a focus on

“core” competencies. They are therefore difficult to reconcile with scope expansion (Hamel and Prahalad (1990)). A
more appealing argument relates to the strategic benefits that may arise from increasing scope (and size). Milbourn, Boot
and Thakor (1999) suggest that banks may enlarge the scope of their activities because it enhances the reputation of their
management and/or increases the wealth of shareholders. In addition, strategic benefits may also arise if (i) current
operations are sufficiently profitable to finance the fixed costs associated with scope expansion, (ii) uncertainty about the
core competencies required to successfully run new operations is sufficiently high, and (iii) expected competition in the
prospective market is low enough so as to make the effort worthwile. By stressing the role of informational uncertainty
and learning for a wider scope to be optimal, this argument suggests that unless very specific conditions are met, it does
not pay, on average, to be diversified. See also Berger. and Humphrey (2000) and, for European studies, Altunbas (2001)
and Bikker (2001).
Interest rate setting by universal banks and the transmission mechanism in the euro area
6
specific and country specific variables, Steinherr (1994) singles out the significantly larger influence
of costs, competition and regulation on the profits of universal banks relative to those of specialised
institutions. However, those results do not say much on the disaggregation of those three factors by
activity.
Overall, estimating complementarities and economies of scope is subject to a range of practical
problems. Among the issues identified in Berger, Hunter and Timme (1993), two are of direct interest
to us. First, data on specialized banks are scarce. This issue is particularly fierce when using a narrow
definition of universal banking as we do here. In particular, banks in the euro area tend to produce the
entire array of retail banking outputs.
5
Second, the data used to evaluate economies of scale
correspond to a point which is far from the efficiency frontier. In that sense, scope economies may be
mistaken for X-efficiencies.
6
However, for our purpose, the prevalence of universal banks in the euro area may affect the
transmission of market interest rates to retail banking conditions even if economies of scope are not
large. In particular, the multi-business nature of universal banks may help them to manage interest rate
risk and dampen the effect of fluctuations in market conditions. To that respect, specialized institutions

may either add a portfolio of liquid securities and/or recourse to money market instruments and central
bank liquidity. Universal banks have another option. As they handle both loans and deposits, they may
in principle shelter lending activities from market conditions not only by spreading risk across loan
markets segments, but also by “using deposits” as an input to producing loans. By doing so, banks
should buffer the impact of market conditions on retail loans rates, and create a causal link from
deposit rates to lending rates.
The question as to whether deposits are inputs or outputs for universal banks has been raised in the
intermediation literature. On the one hand, they have been considered as inputs for the production of
loans, i.e. as a source of liquidity, which is then redistributed under various maturities to agents in
need of financing. Alternatively, we may argue that deposits are also an output, as retail banks are
service producers to depositors. Without clinching the matter, Sealey and Lindley (1977) view
deposits as an intermediate input which is produced by banks (they offer means of payments and a
remuneration to depositors), and then used in the production of loans. Hughes and Mester (1993a, b)
estimate a variable cost function with a fixed level of deposits. Their estimate of this function’s
derivative with respect to deposits being negative, they conclude that deposits are inputs. The “user
cost methodology” proposed by Hancock (1991) is also insightful. Hancock regresses bank profits on

5
They all tend to be away from the zero-output, which creates extrapolation problems.
6
The relevant literature suggests that there has been a systematic bias in earlier measures of scope and scale economies for
banking activities, because this distance from the efficiency frontier, and to some extent the risk attitude of banks’
managers, were both overlooked (Hughes and Mester (1993a, b)). The cost and revenue efficiency of evolving financial
institutions has also been empirically investigated ,see e.g. , Berger, Hunter and Timme (1993).
Interest rate setting by universal banks and the transmission mechanism in the euro area
7
the real balances of all items of its balance sheet without earmarking loans and deposits as being ex
ante outputs or inputs. The input/output distinction emerges endogenously from the sign of the
regression coefficients. Positive estimates correspond to outputs, while negative estimates correspond
to inputs. She finds that loans and deposits are outputs, while cash (time deposits and borrowed

money) is an input.
As a result, retail interest rates in loans markets may depend on retail pricing for deposits, a
phenomenon less likely to emerge when banks are specialised. Hence it appears that the dominance of
universal banking in the euro area could be a factor for the sluggishness of retail bank rates.
3. A model of bank pricing
From a static point of view, the links between market and retail interest rates has an immediate
interpretation in terms of bank profit maximizing and pricing. An equilibrium relationship between
retail and market rates may be obtained in a simple static Monti-Klein bank where banks hold money
market instruments and longer term assets.
7
A “universal” bank with some monopoly power chooses
the volumes of loans L and deposits D that maximise its profits given by
[1] ),( LDCDrBrMrLr
d
b
s
l
−−++=π
C(.) is a well behaved cost function. M is the bank’s net position on the interbank market and B its net
longer term assets holdings (“bonds”) which, given mandatory reserve requirements a, satisfy the
balance sheet condition:
[2] (1- a)D – L = M+B
s
r and
b
r are the interest rates prevailing in the money and bonds markets. They are taken as given by
the bank. Money market instruments and bonds are held with proportions k and (1-k), that is
[3] M = k [(1- a) D + L]
[4] B=(1-k)[(1- a) D + L]
Rewriting profits accordingly, the first order conditions for the supply of loans and the demand for

deposits yield a pricing rule for each market i (i = deposits, various loans), for given inverse demand
and supply functions )(Lr
l
and )(Dr
d
:

7
More elaborate profit-maximizing oligopoly models have exploited large detailed datasets, see Steinherr and Huveneers
(1994).
Interest rate setting by universal banks and the transmission mechanism in the euro area
8
1
]
1
1][')1([]5[
−
−+−+=
i
ibsi
Crkkrr
ε
where
i
ε represents the price elasticity of the demand for loans (i =loans) and the supply of deposits
(i=deposits).
Under perfect competition with complete information, ∞→
i
ε , price equals marginal cost and its
derivative with respect to marginal costs equals one. This derivative typically falls below one when the

demand for loans (supply of deposits) is not fully elastic with respect to the bank lending (deposit)
rate, or if banks have some degree of market power (Laudadio, 1987). A wide range of factors
influences market power. Entry into the banking sector may be restricted by regulatory agencies,
thereby creating room for monopoly power and administrated pricing (Niggle, 1987). Market power
and an inelastic demand for retail bank products may also result from the existence of switching costs
(Klemperer, 1987, and Sharpe, 1997) or asymmetric information costs. The former is expected to be
particularly relevant for bank deposit rates and the later for bank lending rates. Moreover, beyond the
static framework of the model, bank rates may fluctuate around the target rate presented in Equation
[5] because of adjustment costs.
Overall, the resulting pricing equation [5] highlights the key role played by long term rates when the
longer term assets held by banks are taken into account when they maximise profits. [5] states that
retail rates are set as a weighted average of market interest rates, corrected for market structure and
banking costs.
The interdependence between the deposit and lending activities in which a universal bank is involved
appears via the cost structure of banking activities. If the markets for deposits or loans are segmented,
the properties of the cost function determine whether developments in one market have an impact on
retail rates in other markets. In particular, the cost function is defined on both deposits and loans and
should not be separable in those arguments for a bank engaging simultaneously in various lending and
deposit markets. In particular, the equilibrium volume of deposits chosen by the bank will depend on
the rate prevailing in that market, so that the marginal cost of loans in [5] can be explicitly written as
)),((' LrDC
dl
and is in general not a linear function of
d
r .
8
While in [5] the relationship between
lending rates and market rates is linear, the impact of
d
r on

l
r is going to be linear only in the specific
case where '
d
C is itself a linear function of
d
r , i.e. if BArC
dd
+=' where A and B may be functions
of quantities and cost parameters. As a consequence, we concentrate on a linear specification including
both market rates but leaving deposit rates out of the information set.
9
This is coherent with the fact

8
It would be linear for example with a quadratic cost function and a linear demand for deposits.
9
This step is warranted by the results of Granger causality tests presented below, suggesting that A=0.
Interest rate setting by universal banks and the transmission mechanism in the euro area
9
that a baseline Monti-Klein bank considers retail interest rates to be independent from each other
across markets.
4. Data
National retail bank markets provide independent observations to investigate bank pricing. Indeed,
these markets remain segmented in spite of the institutional changes and the market consolidation that
financial intermediaries went through in the last two decades. In contrast to the increasing integration
of securities markets and wholesale finance services across countries (Pagano et al. 2002), the
consolidation of the banking sector took mostly place within national borders. This national
segmentation explains, among other factors, why the pass-through of changes in market interest rates
to retail bank interest rates is different across euro area countries (see Table 1)

10
.
The analysis is carried out on 46 retail interest rate series for all euro area member states except
Luxembourg and Greece, the euro area and the associated MMR and BR. All series have a monthly
frequency - except for France, where the model is estimated on quarterly data - and are available from
the ECB national retail interest rate database.
11
They correspond to five main financial instruments that
reflect different segments of the banking sector. They include interest rates on short (10 series) and
long-term (6 series) loans to firms, mortgages to households (10 series), consumer credit (7 series) and
time deposits (9 series). One should note that from January 1999, the MMR is the EURIBOR for all
countries.
Each of those five categories may differ across countries by their main characteristics, namely habitat,
maturity, the average size of each transaction, and risk. The rates on short-term loans are reported,
when specified, for maturities ranging from up to three months (Spain) to up to 18 months (Italy).
Long-term loans to enterprises refer to investment credit of over one year. Consumer loans include
overdrafts (e.g. Ireland), but usually correspond to a weighted-average of short-term credit lines,
personal loans, and longer-term installment credit. Housing and mortgage loans typically have a
longer maturity, specified over 18 months (Italy) to three (Spain) to five years (Germany, Portugal).
Finally, we restrict our analysis of deposits to the interest rate on time deposits, which are the only
deposit rates that are available for a large enough number of countries.
We estimate the models on sample periods that excludes the turbulent years of the early 1990s, when
interest rates have been quite volatile, as they had to respond to a number of shocks, notably exchange

10
It is worth stressing that, while the levels of retail bank rates, and their spread with respect to market rates are not directly
comparable, the pass-through from market rates to retail bank rates is more comparable.
11
The series we use and a detailed description of their characteristics is available at www.ecb.int.
Interest rate setting by universal banks and the transmission mechanism in the euro area

10
rate crises. This clearly appears in Charts 1 and 2. For most countries, the ERM crises of the early
nineties led either to out-liers (Ireland, Belgium, France, Italy) or to periods of high volatility of
market rates (Spain, Portugal, Finland). We trust that such turbulence can never take place in EMU.
Hence, for these countries, the sample period of estimation starts in 1994:4. For Germany and the
Netherlands the estimation sample starts in 1991:1. In Austria, which also was part of the core ERM,
the estimation starts in 1995:7 because retail bank rates are not available before.
12
Nevertheless, it can
not be excluded that our results are distorted by a change in yield curve effects.
Two final observations on the data are worth noting. First, Charts 1 to 4 indicate a clear downward
trend in all the market and retail bank interest rates in the period prior to EMU. In addition to the
upturn, which took place after April 1999, the other main episode of rising interest rates corresponds
to the winter 1994 crash on bond markets which was triggered by the February 1994 increase in the
Fed funds rate. Second, the well-known hierarchy in the mark-ups across retail bank markets, i.e.
largest on consumer credit, lowest on mortgages with loans to firms in between, is widely observed
across countries.
5. Empirical estimations
5.1 Do lending rates depend on market rates?
The first step in our empirical analysis is to check whether banks insulate lending rates from market
conditions thanks to the funds collected as deposits. We look at this issue by investigating the extent to
which deposit rates have a predictive power with respect to lending rates. For that purpose, we
implement Fisher tests on the coefficients of market rates and deposit rates in equations of lending
rates such as:
∑ ∑∑∑∑
=
=
−
=
−−

=
−
=
−
+++++=
n
i
t
n
i
iti
n
i
itiiti
n
i
iti
n
i
itit
brmmrddxx
1
1
1
1
1
22212211 εγγββα
where x, mmr, br, d1, d2 are retail loan rate, the short-term and long-term market rates, interest rates
on deposits (time deposits, savings accounts or current accounts depending on the country), while
i

l is
alternatively the interest rate on loans to firms (short and long), consumption credit and mortgages.
We test which interest rate Granger causes each of our four lending rates.
Results shown in Table 2 reveal that deposit rates are not relevant for interest rates on loans in a clear
majority of cases (25 out of 32 across the four types of loans). The 7 observations where the lags of at
least one deposit rate are relevant are concentrated in Austria (all markets but mortgages) and to some
extent in Belgium. In terms of markets, cases are concentrated in loans to firms, both short and long.

12
In the case of France where our data is quarterly, however, the full sample is extended to 1991:1 – 2001:4 (1998:1 onwards
for the EMU-sample).
Interest rate setting by universal banks and the transmission mechanism in the euro area
11
By contrast to this very occasional relevance of deposit rates, the coefficients for short and/or long
term market rates contain quasi systematically valid information for lending rates. On the basis of
those properties, we vastly reject the buffer role of deposits for the pricing of loans and consider that
banks in continental Europe follow market conditions in spite of being universal. We therefore focus
go ahead with a specification of loans pricing based on market rates only.
5.2
Presentation of the empirical model
After finding that lending rates usually do not depend on deposit rates, we present the error correction
form of the model presented in section 3. All specifications proposed below introduce, in addition to
the MMR, the long-term market interest rate as an explanatory variable for the behavior of retail
interest rates. This approach has two merits. First, the long-term interest rate inherently influences the
funding cost of banks. As suggested in section 2, the latter depends on the structure of the bank’s
assets, which include short and long term market instruments as well as loans.
13
Moreover, we expect
that banks consider that the funding costs of a loan depend on its maturity. For example, mortgages are
funded with the issuance of long-term bonds while short-term loans to firms are funded with the

issuance of certificates of deposits.
In practice, the funding cost of loans would depend on both short-term and long-term market interest
rates, with a stronger impact of the latter for long-term loans. The second merit is that long-term
market rates contain information about market expectations of the level of future short-term interest
rates.
We choose to provide an empirical characterization of those issues within an ECM that relates each
retail interest rate to the short and long-term market rates. This approach is a simple and intuitive way
to relate the adjustment of retail bank interest rates to changes in the funding or opportunity costs in
the banking sector. In particular, the ECM approach gives a view on long-term relationships between
retail bank prices and market interest rates, on the adjustment dynamics of the former, and finally has a
say over their stochastic properties and the equilibrium conditions between them.
The advantage of our approach over an analysis of cointegrating relationships between retail and
market rates following Johansen (1988) is its very intuitive interpretability as a marginal cost price
model of bank pricing. Under imperfect competition, intermediaries impose a mark-up over expected
refinancing conditions when setting their retail interest rates (Rousseas, 1985, and De Bondt, 2002a).

13
We note that the latter also depends on the structure of the banks’ liability, which comprises short and long-term market
instruments as well as deposits. However, the interest rate on deposits is a mark down over the opportunity cost of raising
alternative liabilities, i.e. issuing debt securities at market rates. Overall, the reasoning developed in section 3 may be
applied to net holdings of money market instruments and long-term bonds, assuming them to be perfect substitutes on the
asset and the liability side of the bank balance sheet.
Interest rate setting by universal banks and the transmission mechanism in the euro area
12
This mark-up is related to the multiplicative term
1
]
1
1[
−

−
i
ε
in equation (5). Given the various
maturities of the supplied financial instruments, those conditions are reflected by both short and long-
term market interest rates. In addition to be intuitive, the specification is appropriate to discriminate
between the short-run dynamics (first difference terms) and the adjustment towards the long-run
equilibrium relation (in level terms). This can be done here without reducing the specification unless
we want to impose specific testable restrictions.
14
Overall, we do distinguish the long-term relationship
between retail and market rates (i.e. the drift of retail rates along a linear combination of market rates)
from the short-run dynamics. In the short-run, changes in market rates are transmitted to changes in
retail bank rates through the lagged differenced terms in [1]. The long-run rigidities that relate retail
rates to market rates are reflected by the correction term towards equilibrium. For this interpretation,
we rely on the fact that market interest rates are (weakly) exogenous to retail bank interest rates and
may themselves depart from their long-run equilibrium value.
Baseline specification
Our baseline specification is a symmetric linear error correction model (ECM) relating each retail
interest rate on loans as shown in [1] to both long-term bond rates and short-term money market
interest rates.
[6]
tt
j
jtj
j
jtj
j
jtjttt
ectrlilir εργβαβα ++∆+∆+∆+∆+∆=∆

∑∑∑
=
−
=
−
=
−
2
1
2
1
2
1
00
where
[6’] )(
1
1
1
CCBBlAAirect
t
t
t
t
++−=
−
−
−
t
r refers to the retail interest rate (which is alternatively the rate on short-term, long-term loans to

enterprises, consumption credit, mortgages),
t
i the three-months money market rate and
t
l the
interest-rate on government bonds and ∆ is the first difference operator.
For time deposits, we have
[6’’]
1
1
1
)(
−
−
−
−−+=
t
t
t
t
rCCBBlAAiect

14
If we were to give a structural economic interpretation to unit roots that may not be statistically rejected, a fully-fledged
cointegration analysis of the system formed by all rates would have been the way to go. More than one cointegration
relationship is needed to give a role to expectations, structures and policy regimes as determinants of the interest rate
pass-through. Since any linear combination of cointegration relations would also be stationary, cointegrating vectors
could not be given a direct interpretation as meaningful economic relations, and identifying restrictions have to be
imposed. To our view, imposing such restrictions would be too strong.
Interest rate setting by universal banks and the transmission mechanism in the euro area

13
Equation [6] relates the changes in the retail rate to its own lags, the changes in the long and the short-
term market rates and the error-correction term
t
ect , where
t
ect is a stationary deviation from the
average equilibrium relationship between the specific retail rate and the market interest rates. The error
correction mechanism would imply that ρ is negative so that the retail rate adjusts back to its long run
equilibrium.
The latter is defined as a weighted average of the three-month money market rate and the government
bond rate as shown in [6’]. The coefficients AA and BB can have two interpretations. As explained
above, they either reflect the notional funding / opportunity cost, or the optimal adjustment to current
and expected changes in short-term rates in the presence of adjustment costs. As to the term CC, it
jointly reflects (i) the bank marginal cost, which is not related to market rates (C’(.) in (5)), and (ii)
market conditions (reflected by elasticities in (5)). CC is therefore not only a measure of the mark-up
but also an indicator of bank costs in a given market. It may be habitat specific – related inter alia to
instrument-specific market structure, risk and maturity - or country specific institutions, on account,
for example, of institutional or regulatory factors. Finally, adjustment costs would also explain the
short-run dynamics of the model and justify why the retail bank rate does not stay permanently at its
target equilibrium level
15
. Overall, adjustment costs are often invoked to explain the existence of
nominal rigidities
16
.
Results over the full sample
This section examines how well the baseline single equation error-correction specification performs
relative to the conventional modelling strategies that consist in considering only one (short-term)
market interest rate. We then describe the four key ingredients of the retail bank interest rate pass-

through we shall consider: (i) the long-term pass-through, (ii) the immediate pass-through, (iii) the
mark-up, and (iv) the speed at which retail rates converge back to their equilibrium relationship with
short and long-term market rates (MMR and BR). The estimated coefficients are summarised in
Tables 3, 4 and 5.
Our baseline specification (1) is estimated with OLS. We arbitrarily choose to estimate the model with
two lags, as this specification seems to fit the data satisfactorily. We focus on the error correction
term, the mark-up and coefficients on the short and long-term market rates. Standard Chow tests are
conducted on the equation residuals obtained over the whole sample to test for a breakpoint on January

15
Such adjustment costs are not systematically observed on all bank retail rates. Sellon (2001) shows, since 1995, the spread
between the prime bank rate and the Fed funds target is constant, which indicate an instantaneously adjustment of the
base rate to all changes in the money market rate.
16
See Rotemberg (1982) for a model of nominal price adjustment with quadratic adjustment costs. The price setting by banks
is also influenced by the competition regime banks are in. For instance, Neuman and Sharpe (1992) showed it across
local deposits markets within the US. Similar type of results for European national retail bank markets were discussed in
section 2. The effects of structural features of European national retail bank markets on bank’s pricing will be further
investigated in a follow up to this paper.
Interest rate setting by universal banks and the transmission mechanism in the euro area
14
1999. The equation is then fit separately for the whole sample and for the EMU sub-sample in order to
spot differences in the estimated equations, as those would indicate a structural change in the
relationship. The results of those tests are presented in Table 3.
(i) The long-run equilibrium
Overall, our results confirm the existence of a long-term “rigid” structure that pulls back retail interest
rates towards a linear combination of short and long-term market rates. In particular, the long-run
pass-through, reflected by the weights to each market rate in the long run relationship, varies across
markets and countries. However, the sum of those coefficients comes close to one in most cases –we
shall qualify the few exceptions below – which we see as a satisfactory/intuitive feature of our long-

run relationship. For deposit rates, the sum of long-term coefficients is systematically smaller than
one, indicating that those rates are less responsive to market conditions than the interest rates on bank
loans. From a country perspective, Germany is the only country where the overall pass-through is
found to be below unity in every retail market segment except consumer credit. In general, the sum of
coefficients tends to be above one in markets with shorter-term maturities (short-term loans to firms
and consumption credit). At the country level, this is the case for all markets in France, Belgium
(except short corporate loans), Italy and Portugal.
We also observe a clear pattern for the relative contribution of long and short-term market rates. First,
the BR does enter the equilibrium mark-up relationship in a large majority of cases. Its level is
estimated not significant, so that the level of the retail rate depends only on the level of the MMR,
only for about third of the retail rates of short maturity. This is the case in Germany, Ireland, Italy and
Portugal for short-term corporate loans, and Belgium, Germany and Ireland for time deposits. Second,
the BR has a predominant role, i.e. a larger weight than BR in the equilibrium relationship, for longer-
term loans in most countries, and for all credit markets in Austria, France and Belgium. Noticeably,
Ireland appears to be an atypical case, as the long-term interest rate is never relevant.
Overall, the data confirm a significant role of the BR in the determination of retail bank interest rates
of short and long maturity. Hence, the models of retail bank interest rate pass-through that fullly
ignoring the BR, as typically done in previous interest rate pass-through studies, seems to be mis-
specified. While they provide a summary of the effects of the interest rate controlled by the central
bank on retail bank rates, they can not decompose what in this pass-through relates to a “maturity
component” and a “structural component”. While the latter should depend on the market structure and
the habitat of this particular loan/deposit product, the former should depend on the monetary policy
regime.
(ii) Market-specific immediate pass-through, with country-specific patterns
The immediate, i.e. within one-month pass-through, from short and long-term market interest rate
changes to retail bank interest rates differs across retail bank products, as shown by Charts 8. On the
Interest rate setting by universal banks and the transmission mechanism in the euro area
15
corporate side, banks adjust their short-term loan rates more sluggishly than longer-term loans rates.
(on average around 50% for long-term rates against 25% for short loans). A possible explanation is

that asymmetric information costs may be more severe for short-term loans to enterprises. Among
loans to households, the immediate pass-through is larger for mortgages than for consumer credit (on
average around 40% against 20%). More or less the same range is found for the immediate pass-
through of time deposit rates. At the country level, the immediate pass-through is relatively high in
Belgium, Finland and the Netherlands with an immediate pass-through between 50% and 100%. The
same range is found for mortgages and time deposits in Germany.
(iii) Market rather than country-specific costs/mark-ups
The estimated constant CC reflecting costs and mark-ups clearly differ across the retail bank products
considered for a given country, as illustrated by Chart 7. For bank lending rates, asymmetric
information costs or credit risk considerations may explain, among other factors, these differences. In
particular the estimated constant for consumer lending is high compared with the other bank lending
rates, suggesting high asymmetric information costs in this segment of the credit market in euro area
countries. The level of CC for mortgages is much lower and shows much less cross-country
differences, because of the lending practice against collateral. An explanation for the difference in the
constant on short and long-term loans to enterprises might be that the information and monitoring
costs of banks are higher for short-term loans (De Bondt, 1998). Borrowers with severe information
asymmetries will borrow relatively more with a short maturity because of the larger information costs
associated with long-term debt. On average, the lowest “mark-ups” are found for time deposits since
credit risk considerations play not at all a role for deposits. In other words, time deposits are more
homogeneous retail bank products than loans. Of course, also the degree of competition and
contestability of the different segments of the retail bank market may help in explaining these
differences.
(iv) Error-correction coefficients
The speed at which banks adjust to the equilibrium relationship between retail bank interest rates and
short and long-term market interest rates clearly differs across retail bank products (see Charts 8).
Long-term bank rates on loans to enterprises typically adjust between 20% to 50% of a deviation from
the long-term equilibrium relationship each month, except in Germany and Ireland where this
adjustment is slower. The estimated error-correction coefficient are found to be between 10% and 20%
in the case of the bank rate on short-term loans to enterprises, except in the Netherlands where the
adjustment speed is quicker. An adjustment speed of between 10% and 20% is also generally found

for the bank rate on mortgages and consumer credit. The exceptions are a slower adjustment to
equilibrium in the mortgage markets in Spain and Portugal and a quicker one in the consumer credit
Interest rate setting by universal banks and the transmission mechanism in the euro area
16
markets in Spain, Finland and Portugal. For time deposit rates, the error-correction coefficients are
found to vary between 20% and 50%, with the exception of Austria and the Netherlands where the
adjustment to equilibrium is slower.
Did EMU have an impact on the pass-through?
(i) Assessing stability
To assess the stability of our baseline specification, we calculate recursively the coefficients of the
model parameters. The estimated coefficients appear to be stable over time in [27] cases out of [42]
17
,
where they remain within the confidence bands. In addition, Chow tests for a structural break in
January 1999 support the view that our data exhibit pre- and post-1999 specific properties. The Chow
statistics, as reported in Tables 2 to 5 (11
th
columns), suggest that across all model specifications, a
break is detected rather frequently. Overall, the household sector has been more stable than the
corporate loans sector. Furthermore, a structural break is most often detected when the retail rate has a
short maturity (short-term loans to firms and deposits). At the country level, the instability of the
parameters is more frequent in Spain, Finland and Portugal, suggesting that the changes that have
taken place after 1999 have been factored-in by banks in their setting of retail rates in those countries.
In light of our discussion above, this may be related to a change in their cost of financing, or
alternatively in the expectations content of long term interest rates. Those results suggest that an
investigation of the model over the EMU sub-sample may be insightful.
(ii) The baseline model under EMU
Four main facts emerge from those estimation results. First, our estimates confirm that the role played
by the long-term market rate in the long-run adjustment of bank rates is non-negligible both across
countries and markets. However, while this is salient over the whole period, the weights assigned by

banks to the long-term market rate are overall much smaller under EMU. This could be related to the
fact that long-term interest rates are not expected to fully reflect the volatility of short-term market
interest rates when monetary policy is credible and inflationary expectations are stable. In turn, our
results suggest that the direct impact of short-term market rate movements onto retail rates has
increased. Second, the speed of adjustment of retail rates to changes in the short-term market rate, as
reflected in the strength of the error-correction force ρ, has become significantly faster after January
1999. A possible explanation for this would be an increase in the prevailing competitive forces in the
retail bank market. Furthermore, we observe that the long-term constant has had a tendency to increase
after 1999 for two categories of loans: short-term loans to firms and consumer credit.

17
5/10 for short-term loans to firms, 1/6 for long-term loans to firms, 2/9 for mortgages, 1/7 for consumer credit and 5/8 for
time deposits. Cusum-test charts to be added.
Interest rate setting by universal banks and the transmission mechanism in the euro area
17
• The comparison of the average 1990s and EMU coefficients suggests that the strongest changes in
long-term coefficients have taken place in the market for short-term loans to firms and consumer
credit, where the long-term market rate has consistently less importance under EMU across
countries. At longer maturities, the evidence is milder but points to a smaller role of the long-term
market rate since the advent of EMU.
• As to the immediate pass-through of short-term interest rate movements follows a rather country-
specific pattern. It is remarkably strong in Belgium, where the compounded reaction of retail rates
to short and long term market rates is close to or (well) above 100%. As expectable, the relative
impact of long and short market rates depends on the maturity of credit: while the impact of the
money market rate on short-term loans to firms and consumption loans dominates, the bond rate
has a stronger impact for long corporate loans and mortgages.
• Turning to the strength of the error correction term, we observe that it exhibits a clear change
across samples. The speed of adjustment or force that pulls retail rates back towards their long-
term equilibrium level, as measured by the size of the error-correction coefficient, is
systematically much stronger across countries and markets over 1999-2001.

18
While adjustment
tends to be faster for the price of short-term loans to enterprises, the differences that can be drawn
across our observations relate to countries rather than loan specifics. In general, adjustment is the
fastest in Spain and Finland (short and long loans to firms, consumer credit)
• Another salient fact concerns the behaviour of the cost/mark-up constant, which should however
be interpreted with caution. We observe that the cost/mark-up constant follows a market-, and
possibly maturity- rather than country-specific pattern. On the one hand, the cost/mark-up constant
that corresponds to short-term loans to firms and consumer credit appears to be higher for a
majority of countries under EMU than on average over the 1990s (this is not the case in Ireland
and the Netherlands for the former, and Finland for the latter). The picture is less clear in the case
of mortgages and long-term loans to enterprises.
19
An overall picture of the simulated pass-
through is provided in the simulations of Charts 10.
6. Conclusion

19
For the former, CC goes up in Austria, Spain, Finland, Ireland, Italy and Portugal, and down in Belgium, Germany and the
Netherlands. For the latter, it goes up in Spain, Ireland, Italy, down in Belgium and Germany. However, it could be the
case that the term CC captures a trend in the level of the bank rate that would have been orthogonal to our explanatory
variables. On obvious source for such a trend would be inflation developments. A check of the model on interest rate
series specified in real terms remains coherent with the results we present here. In particular, CC in general increases by
slightly less for loans to firms, and slightly more for households loans. Results are available upon request.
Interest rate setting by universal banks and the transmission mechanism in the euro area
18
This paper complements the empirical literature on the interest rate pass through. It provides insights
on two specific aspects of nominal bank pricing that had been left unexplored: complementarity across
banking activities, and the adjustment to longer term measures of market rates. In principle, given the
diversification of euro area banks activities, complementarities between loans and deposits could be

fully at work when they set retail rates. We find that this idea is not supported by aggregate interest
rate series covering four loans markets in 10 countries of the monetary union. By contrast, maturity
matters, and retail rates pricing is found to reflect the conditions for both short and long term market
instruments. Overall, the sluggishness in the response of bank retail rates to changes in money market
conditions can not be attributed to the universal nature of banking sectors in continental Europe, but
rather to a longer term view of their “equilibrium” funding and opportunity costs related to their
balance sheets.
Interest rate setting by universal banks and the transmission mechanism in the euro area
19
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Interest rate setting by universal banks and the transmission mechanism in the euro area
22
Appendix on state dependent pricing
20
A.1. State dependent models
While it provides a simple and intuitive benchmark that can easily be compared across markets and
countries, the baseline specification is not fully satisfactory. Ideally, we would like to singularize the
regime shift to EMU, and characterize precisely the mechanism by which this effect operated. In this

appendix, we first check whether the EMU break which is observed in the estimation of the baseline
model can be explained by the change in the underlying trend in the market rate that coincided with
the beginning of EMU. We then test whether the EMU break is due to the change in the volatility of
market rates brought about by the new monetary policy regime.
(i) Asymmetry
We first investigate asymmetry to assess whether the 1999 break can be attributed to the start of
market rate rises that coincided with EMU. Indeed, at first glance, the interest rates profile (Charts 1 to
4) reveals that EMU coincides with a change in the sign of interest rate changes. While policy and
money market rates have followed a downward trend in the mid / late 1990s, 1999 has coincided with
the start of an interest rate cycle, with short-term rates rising between end-1999 and mid-2000. This is
especially obvious in countries like Portugal or Spain. As such, this reversion may suggest a break in
the behavior of banks that could be misleadingly attributed to the start of EMU in 1999. Such a
structural change, if detected, would not imply per se that the transmission has structurally changed. It
would only indicate that no such up-trending sequence of interest rate rises could be observed in the
earlier part of the sample, and that our baseline model is unable to capture the asymmetric adjustment
of banks. Such asymmetries would correspond for instance to the exploitation of monopolistic power
by banks in order to preserve margins
21
.
In order to explore such asymmetry in the dynamics of retail rates, we augment the ECM [6] with an
asymmetry generator. We estimate a natural extension of the linear model, allowing for sign

20
Conditional responses of retail bank rates depending on whether short-term interest rates are rising or falling have already
been examined in the literature. The response of bank rates to changes in official rates and/or money market rates seems
to be sometimes asymmetric (Borio and Fritz, 1995, and Mojon, 2000) or to depend on whether bank interest rates are
below or above equilibrium levels as determined by cointegration relations (Hofmann, 2000, and Kleimeier and Sander,
2000 and 2002b). See Scholnick (1996) for an analysis of an asymmetric interest rate pass-through process in Malaysia
and Singapore.
21

Mester and Saunders (1995) show that the prime rate of US banks adjusts faster upward than downward. Using a sample
of national retail bank interest rates, Mojon (2000) shows that the pass-through to credit rates is larger in the upturns of
the interest rate cycle than in its downs turns.
Interest rate setting by universal banks and the transmission mechanism in the euro area
23
asymmetry in the error correction mechanism
22
.
ρ
takes one of two values depending on whether the
deviation from equilibrium term is positive or negative – that is, depending on whether the retail
interest rate is above or below its long-run equilibrium value for given market rates. The estimated
relation can be represented as
[A.1.]
0
2
0
1
2
1
2
1
2
1
00
<>
=
−
=
−

=
−
++∆+∆+∆+∆+∆=∆
∑∑∑
tt
j
jtj
j
jtj
j
jtjttt
ectectrlilir ρργβαβα
This specification allows for sign (but not amplitude) asymmetry via the parameters
1
ρ and
2
ρ
respectively.
(ii) Volatility
Turning to the mechanisms by which the shift to EMU may have affected the pricing of private loans
and deposits, we suggest two possibilities. The first exploits the simple idea that the adjustment of
retail bank rates depends on uncertainty about market interest rates. After 1999, the new monetary
policy regime has certainly homogenised the underlying money market rate volatility across member
states (see the charts 5 for the MMR and charts 6 for the BR), and most likely induced some
convergence among the – still country-specific – nominal bond yields. In particular, the role of
volatility may be reflected in the strength of the error-correction coefficients and imply a different
long-term weighting in the pricing rule of banks. To condition our model on volatility, we estimate
another extension of [6] whereby the adjustment back to equilibrium is a function of the volatility of
the MMR or of the BR. This volatility dependent model is given by
[A.2.]

tt
j
jtj
j
jtj
j
jtjtit
ecthrlilr
t
)*(
110
2
1
2
1
2
1
0
0
−
=
−
=
−
=
−+∆=
++∆+∆+∆+∆∆
∑∑∑
ρργβαβ
α

with
[A.2.’]
t
t
t
h ηη
*
=
and η
t
is the residual of a simple auto-regressive distributed lag model of either the MMR or the BR:

22
Boshen and Mills (1995) were the first to our knowledge to estimate this intuitive state dependant adjustment to retail bank
rates, in the case of Australian credit rates. Hoffman (2000) implemented other asymmetric models of retail rates
adjustment in six euro area countries. His model however does not include the long rate in the equilibrium relationship.
Moreover, his estimation strategy proceeds in two steps. He first estimates the long run equilibrium and then tests for the
relevance of the asymmetric adjustments. This forces the long run equilibrium to be independent from the short-run
adjustment.
Interest rate setting by universal banks and the transmission mechanism in the euro area
24
[A.2.’’]
t
j
jtj
j
jtjtt
j
jtj
j

jtjt
lillii ηβαηβα +∆+∆∆+∆+∆∆
∑∑∑∑
=
−
=
−=
=
−
=
−=
2
1
2
1
2
1
2
1
or
A.2. Results
(i) Are these changes due to EMU or is the retail bank rates adjustment asymmetric?
The cyclical path of interest rates historically observed over our sample period suggests that the
reversal observed in January 1999 came after a time of gradual but continuing decline in money
market rates during the years of nominal convergence. As our baseline was shown to be unstable in a
significant number of observations, we conjecture here that changes in the pass-through may be
associated with an asymmetric adjustment of retail interest rates. One could postulate, as suggested
earlier, that banks preserve their margins by slowing-down the adjustment of lending (resp. deposit)
rates when they are below (resp. above) their equilibrium value, and vice versa.
23

The asymmetric model is accepted (i.e. we can reject the baseline linear model) in a significant
number of cases (the results are reported in Table A.1.). However, the asymmetry does not always
lend itself to be interpreted as a smoothing of interest rate margins by banks. In about a third of the
cases where the asymmetric model is preferred to the baseline model, the adjustment back to
equilibrium is faster when bank margins are above their long-term equilibrium. However, no
systematic pattern emerges from the data. At the country level, the adjustment tends to be slower when
lending rates are below equilibrium in Germany, Belgium and Italy, while the reverse is true in
Finland, Spain.
Generally, asymmetry does not alone address the model instability. This is true for corporate loans at
all maturities. In addition, accounting for asymmetric effects on loans to households eliminates the
model instability in Finland, but retains it in Austria (consumer credit) and Portugal (mortgages) and
becomes unstable in Italy (mortgages). Finally, concerning deposits, the asymmetric specification
becomes stable in Belgium and Portugal, but remains unstable in Austria and Spain, and becomes so in
Italy as well. To conclude, retail rates adjustment do exhibit an asymmetric behaviour, but this
phenomenon as such does not explain the underlying changes that have occurred under EMU.
(ii) Is the EMU impact due to a change in the uncertainty of the market rate dynamics?
One mechanism by which the pass-through could have changed under EMU relates to the volatility of
market interest rates. Volatility is of interest in two respects from the point of view of bank retail rates
setting. It is synonymous to uncertainty about the path of short-term refinancing conditions. If in
addition, the response of long market rates to short-term rate fluctuations are taken into account,

23
We reckon that the sign of the variation of long-term interest rates in response to changes short-term market rate also
matters, as it directly affects the long-term relationship. We are currently investigating the issue.
Interest rate setting by universal banks and the transmission mechanism in the euro area
25
swings in the short-term rate blur the predictability of refinancing conditions at all maturities. Overall,
our “GARCH-inspired” specification (A.2.) suggests that volatile market rates do affect the adjustment
speed of retail rates towards equilibrium. The extent to which this is the case is measured by the size
of ρ1*h, h being the volatility of the unpredictable part of the market rate, see (A.2.’) and (A.2.’’). As

shown in Charts 5 and 6, most euro area countries have seen the underlying volatility of their short and
long-term market rates reduced under EMU. This is particularly true in Spain, Italy and Portugal and
to some extent Ireland. The variance observed in the early sample is remarkably high for long-term
market rates in those countries, in contrast with remaining cases. Results are shown in Table A.2
Controlling for the variance of the short-term market interest rates is more relevant for bank rates of
shorter maturity, essentially short-term corporate loans and time deposits. The effect of volatility is
strong but contrasted across countries. Short-term rate volatility decreases the speed of adjustment in a
majority of cases. By contrast, the volatility of the bond rate is associated with a speed-up of the
adjustment of long term corporate rates in all countries except Italy – implying that the lower
variability of BR coincided with a slow down in the adjustment of long-term corporate loans rates to
equilibrium. However, since it concerns longer-term market rates, this faster adjustment at times when
the BR was most volatile may be related to the nominal convergence that was particularly strong in
Spain, Italy and Portugal in the mid-1990s.
Those results suggest that the lower volatility of short-term market rates that prevailed under the single
monetary policy have speeded-up transmission, and MMR changes are reflected more fluidly in retail
financing conditions in the late sample. However, the underlying behavior of long-term market rates
needs to be investigated further, as the role of changes in the underlying BR volatility seems to depend
on the contemporaneous pattern of short-term market rates.