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The Relationship Between Bank and Interbank Interest Rates during the Financial Crisis: Empirical Results for the Euro Area

This interest rate configuration also has implications for households deciding on the maturity of their mortgage financing. When short-term rates are low and deemed unlikely to rise, households shorten the maturity of their borrowing, often counting on being able to switch to long-term mortgages when they feel interest rates may rise. As households switch, banks dependent on short-term funding have to hedge their new interest rate exposures. The larger interest rate exposures become, and the more dependent they are on leverage, the higher the probability of destabilising dynamics once expectations change. Households rushing to lengthen the maturity of their. | The Relationship Between Bank and Interbank Interest Rates during the Financial Crisis Empirical Results for the Euro Area David Aristei and Manuela Gallo1 Abstract In this paper we use a Markov-switching vector autoregressive model to analyse the interest rate pass-through between interbank and retail bank interest rates in the Euro area during the financial crisis. Empirical results based on monthly data for the period 2003 1 -2011 9 show that during periods of financial turmoil all the rates considered show a reduction of their degree of pass-through from the interbank rate. Interest rates on loans to non-financial firms are found to be more affected by changes in the interbank rate than loans to households both in times of high volatility and in normal market conditions. Key Words Interest rate pass-through financial crisis interbank interest rate loans interest rate Regime-switching vector autoregressive models Euro area. JEL Classification C32 E43 E58 G01 G21. 1 David Aristei Department of Economics Finance and Statistics University of Perugia via Pascoli 20 - 06123 Perugia Italy e-mail david.aristei@stat.unipg.it. Manuela Gallo Department of Legal and Business Disciplines University of Perugia via Pascoli 20 - 06123 Perugia Italy e-mail manuela. gallo@unipg.it. 1. Introduction The pass-through process from policy-controlled to retail bank rates is important for monetary policy both from the point of view of price stability and from the financial stability perspective. Even if there are additional market and demand factors that affect the definition of bank rates as for example banking competition size of banks level of development of financial markets and even aspects affecting each single customer or credit transaction interbank interest rates are one of the main drivers of the rates charged by banks on loans. The interest rates set by Central Bank affect the interbank rates which are the basis of the process of defining the cost of money lent by banks to .