The way euro area banks fund themselves can significantly affect how quickly and fully changes in ECB interest rates reach businesses and households, according to a recent working paper by the European Central Bank.

The study shows that banks relying more heavily on short-term money market funding tend to adjust lending and deposit rates more strongly and persistently after a policy rate change, while those relying more on longer-term bond funding tend to respond more slowly.

The findings are significant because bank lending is a major source of finance for companies across the euro area, meaning differences in how banks respond to ECB decisions can affect borrowing costs, investment, production and ultimately inflation.

When the ECB changes its policy rates, the effect is passed on through commercial banks, which decide how much to charge for new loans and how much interest to pay on deposits.

The extent and speed of that adjustment is known as interest rate pass-through, and the paper argues that it is not uniform across banks.

The research uses euro area aggregate data from 2001 to 2023, alongside ECB data covering 266 individual banks between July 2007 and April 2023.

The bank-level analysis focuses mainly on new loans to non-financial corporations, meaning businesses outside the financial sector, as well as overnight deposits.

At the euro area level, the researchers found that ECB policy changes do reach company borrowing rates, but the adjustment is neither immediate nor complete.

Only around 40 per cent of a policy rate change was reflected in rates on new loans to companies immediately, rising to about 80 per cent after three months.

Deposit rates, particularly those paid on household overnight deposits, responded more slowly and by a smaller amount.

The results therefore suggest that the same ECB rate decision can have very different effects depending on whether it reaches a loan, a deposit or another financial product.

The differences become even clearer when looking at individual banks.

Banks that depend more on short-term money market borrowing tend to pass changes in ECB policy rates through to their lending rates more strongly and for longer.

Money market funding is borrowing over relatively short periods, meaning its cost can change rapidly when central bank interest rates move.

As a result, when the ECB raises rates, banks heavily dependent on this type of funding face a quicker increase in their own borrowing costs and have a stronger incentive to raise lending rates.

Banks that rely more on issuing bonds, by contrast, are less immediately affected because bonds generally provide funding for longer periods at rates that do not reset as quickly when short-term policy rates change.

The study found that these banks therefore tend to increase lending rates more gradually and by less following an ECB policy shock.

The researchers also identified a second factor involving the type of loans banks provide.

Banks with a larger share of longer-term bond funding also tend to issue more loans where the interest rate is fixed for longer periods.

A fixed-rate loan is one where the borrower’s interest rate remains unchanged for an agreed period, while a floating-rate loan can change as market rates move.

This creates what the paper describes as an asset-liability-management channel, meaning that the way banks fund themselves and the loans they issue are connected.

A bank with stable, longer-term funding is better placed to offer loans with fixed rates because its own funding costs are less exposed to short-term market movements.

The study found that the weakest response to ECB rate changes came from banks combining a high proportion of bond funding with a high share of long fixed-rate loans.

In other words, both sides of a bank’s balance sheet can make its lending rates less sensitive to monetary policy.

The researchers then used a small economic model to assess what the findings mean for the wider euro area economy.

The model suggested that when bank rates do not fully and immediately follow ECB policy rates, the effects of monetary policy on economic output and inflation are smaller than they would be under an assumption of perfect pass-through.

This means that economic models which assume bank lending rates move immediately and completely with ECB decisions could overstate the impact of monetary policy.

The paper argues that assessments of monetary policy should therefore take account not only of the ECB’s policy rate itself, but also of banks’ funding structures and the maturity of their loans.

The researchers found that differences in funding models create a structural source of variation between banks, even within the same monetary union and independently of national differences.

Where banks make greater use of money market funding, policy changes tend to feed into their rates earlier and more strongly.

Where banks have more bond funding and longer-term assets, the adjustment tends to be more gradual.

The authors also caution that the study does not establish that funding structures themselves directly cause differences in pass-through in every circumstance.

The analysis focuses on conventional monetary policy surprises and does not directly examine targeted credit measures or central bank balance sheet policies, except where those measures affect banks’ funding conditions.

The researchers also say their approach does not fully capture how the relationship could change in different economic environments, such as periods of negative interest rates.

They suggest that future research could examine the maturity of both sides of bank balance sheets in greater detail and explore how pass-through changes across different monetary policy regimes.

The study concluded that banks’ funding structures are a major determinant of how quickly and completely ECB monetary policy reaches the economy, and that accounting for those differences can improve assessments of both current financial conditions and the likely effects of future policy decisions.