Popa-radu-i6070269-Economic Studies-Interest Rate Pass-through in Czech Republic 2004-201

8/11/2019 Popa-radu-i6070269-Economic Studies-Interest Rate Pass-through in Czech Republic 2004-201

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The interest pass-through in the Czech Republic

2004-2014

RaduPopa i6070269

Maastricht University

School of Business and Economics

Master of Economic Studies

Supervisor: Prof. dr. Bertrand CandelonJune 2014

Abstract

This paper examines the impact of the policy rate on deposit and loan rates in Czech Republicbetween 2004 and 2014. An error correction model, will be used if cointegration is found.Alternatively, a first difference ARDL model will be used if no cointegration is found. Bankrates will be regressed to the policy rate and to the money market rate with which they have the

highest correlation. Lastly, a rolling regression will be utilized in order to find structural breaksendogenously and observe the gradual impact of the crisis on the pass-though.

For the period leading up to 2009, loans to non-financial corporations have a full pass-through,mortgages follow with a long run pass-through of 70%, and no significant impact is found forconsumer credit loans, credit cards and household overdrafts. The impact of the crisis has beenmore pronounced for the household sector, making the pass-through insignificant for householdloans. However the pass-through for non-financial corporations has been less affected by thefinancial crisis, but has substantially diminished since the end of 2012, as the policy rate hasreached the zero lower bound.


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Contents

1. Introduction..................................................................................................................................... 2

2. Literature review ............................................................................................................................. 3

2.1 Determinants of the interest rate pass-through................................................................................ 3

2.2 Interest rate pass-through in the Czech Republic............................................................................ 6

2.3 Impact of the financial crisis.......................................................................................................... 9

3. Methodology ................................................................................................................................. 10

4. Data description............................................................................................................................. 11

4.a) Money market rates .................................................................................................................... 13

4.b) Government bond yields............................................................................................................. 14

4.c) Household deposits..................................................................................................................... 15

4.d) Non-financial corporations deposits............................................................................................ 17

4.e) Household loans ......................................................................................................................... 19

4.f) Non-financial corporations loans................................................................................................. 21

5. Results........................................................................................................................................... 22

5.a) Money market rates................................................................................................................. 22

5.b) Government bonds.................................................................................................................. 23

5.c) Household deposits................................................................................................................. 25

5.d) Non-financial corporations deposits........................................................................................ 27

5.e) Household loans...................................................................................................................... 295.f) Non-financial corporations loans............................................................................................. 31

6. Conclusion .................................................................................................................................... 32

Bibliography ......................................................................................................................................... 35

Appendix .............................................................................................................................................. 38

Appendix A Unit root test results................................................................................................... 38

Appendix B Cointegration test results- monetary approach............................................................. 41

Appendix C Bond correlation........................................................................................................... 43

Appendix D Cointegration test results -cost of funds method............................................................ 44

Appendix E Results monetary approach......................................................................................... 45

Appendix F Results cost of funds approach.................................................................................... 51

Appendix G Rolling regression cost of funds approach................................................................... 55


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1. Introduction

One of the most important tools of a central bank is the interest rate channel through whichchanges in the policy rate are transmitted to bank rates of households and firms. Bernanke andBlinder (1992) have proven that monetary tightening decreases availability of credit andnegatively impacts credit. Gertler and Gilchrist (1994) have focused specifically on small firms,

showing inventory investment is sensitive to higher policy rates. Therefore analyzing the impactof central banks on lending and deposit rates is vital in order to be able to gauge the efficiency ofcentral bank policy on the real economy.

Yet the recent financial crisis has cast a large doubt on the power of central banks to steer theeconomy and jump start a recovery. While much of the focus has been on Western Europe andthe Euro area, the impact that the crisis has had on monetary policy in Eastern and CentralEurope has mostly been neglected by mainstream academia. Therefore, this paper will extendthis type of analysis to the Czech Republic, focusing on the period between 2004 and 2014. Thelatest study on the interest rate pass-through in the Czech Republic was published in 2009,therefore this paper will bring novel data about the developments of the interest rate pass-throughin the aftermath of the financial crisis.

Given the I(1) nature of interest rates, cointegration will be tested using the Johansen tracestatistic in order to see whether a long run relationship exists. If cointegration is found, an errorcorrection model will be employed, otherwise an ARDL model of first differences will be used.Bank rates will be regressed to the policy rate, in accordance with the monetary policy approachused by Sander and Kleimeier (2004), and to the money market rate with the highest correlation,following the cost of funds approach supported by De Bondt (2005). Due to the possibleexistence of a structural break in the data, results will be estimated for the period prior to August2008 and afterwards. Finally, a rolling regression with a window of 50 months will be used, thus

presenting the gradual evolution of the pass-through since 2009 and finding additional structuralbreaks endogenously.

The paper will be structured as follows: section 2 will present a literature overview of the theorybehind the determinants of the interest rate pass-through, the evolution of the interest rate pass-through Czech Republic and an analysis of how the financial crisis has impacted the pass-through in Western Europe. Section 3 will present the methodology. Section 4 will begin with adescription of the macroeconomic environment in Czech Republic over the past 10 years,followed by a summary of the analyzed deposit and loan rates. Section 5 will present the resultsfor the monetary policy approach, including a graphical presentation of the long run coefficient

for the rolling regression. Graphs and detailed tables for the cost of funds approach are availablein the appendixes. Finally, section 6 will present the conclusions.


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2. Literature review

2.1 Determinants of the interest rate pass-through

As banks can gain funding from money markets, consumer deposits or capital markets, yields are

expected to equalize of between the different markets as any opportunity to access funds at alower costs will be exploited, thus driving yields up. Therefore money market rates can beregarded as a proxy for the cost of funding. As a result, a change in the policy rate should impactthe interest banks charge to customers as they maintain a constant mark-up over market rates.

On the other hand, consumers to place their savings in money market funds, bank deposits orgovernment bond yields. Thus money market rates represent an opportunity cost for savers. In amodel with perfect competition and no switching costs, the demand elasticity of deposits wouldbe 1 as yields across different asset markets equalize, thus entailing a complete pass-throughfrom monetary policy to deposit rates.

De Bondt (2005) describes the transmission mechanism from policy rate to interest rates forconsumers and firms in a two stage manner. In the first stage, the central policy rate impacts theshort term money market rates. The two-week repo acts as an opportunity costs for banks, it isexpected that money market rates will not exceed the policy rate. While variations occur on adaily basis due to liquidity shortages in the market and reserve requirements, in the long run,money market rates and the policy rate move together. In the second stage, long term rates inmoney market are impacted, therefore a proportionate transmission of the policy rate implies aparallel shift in the yield curve. If one of the factors affecting the yield curve changes, such asinflationary expectations, liquidity premiums for long term maturities or market segmentation;then the transmission of the policy rate will not be proportionate.

As opposed to the cost of funds approach, the monetary approach focuses solely on therelationship between the policy rate and retail lending rates, thus assuming a constant yieldcurve. Such an estimation method is preferable due to its simplicity and is extremely useful ifcointegration between money rates and lending/deposit rates is not found.

De Bondt (2005) uses the marginal cost pricing model br= 0 + 1*mrwhere bris the bank rate,0is the constant markup,1is the demand elasticity of deposits or loans and mris the market rate.A demand elasticity of 1 would occur in a model with perfect competition, no switching costsand information asymmetries, thus entailing a complete pass-through from monetary policy todeposit rates. Nevertheless, such a situation does not occur in reality, therefore many deposit andloan rates have a pass-through lower than 1

The degree of competition between banks is very important determinant in the elasticity ofdeposits. If there are relatively few banks, they can collude and will not feel pressure to adjustrates rapidly. On the other hand, if there are a large number of banks, once one bank will adjusttheir rates, others will have to follow suit for fear losing customers to the competition. VanLeuvensteijn, Kok Sorensen et al. (2008) analyze the impact of competition on the interest rate


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pass-through for 8 Euro area countries for the period 1994-20061. They measure competitionwith the Boone indicator, which measures the elasticity of profits to marginal costs 2. Theirfindings show that higher competition leads to lower spreads between money market rates andlending rates. Furthermore, the impact of competition lowers deposit rates, as banks compensatelost revenue from lending by cutting interest rates paid on deposits. Overall, a higher degree ofcompetition is associated with a larger and more rapid pass-through for both lending and deposit

rates.

When cost of funding goes up, banks have the incentive to pass on the additional costs tocustomers. On the other hand, when costs fall, banks will postpone decreasing lending rates asthey can benefit from a higher margin. Mojon (2000) looks at interest rates for the six largesteconomies of the Eurozone between 1979-1998. He shows that the pass-through is higher whenmoney market rates increase, while rates adjust slower when money market rates are decreasing.This downward rigidity leads to an asymmetric speed of adjustment for lending rates.Furthermore, the impact of regulation, as measured by Gual, (1999), is shown to be significantonly when money market rates are decreasing, therefore reducing this downward rigidity. The

opposite effect is observed for deposits ie deregulation increases the pass-through when moneymarket rates are increasing. Therefore, a higher degree of competition is expected to minimizethe asymetry of the pass-through for both lending and deposit rates.

If companies rely heavily on financial markets, ie bonds issuance, in order to raise funds, theywill be less impacted by developments in the money market. Furthermore, the development ofmoney market funds and mutual funds has increased competition for traditional deposits andimproved alternatives for savers. The process of financial disintermediation implies a lowerdependency on banks for funding and a higher reliance on capital markets. Access to directfinance outside of the bank sector is expected to increase the pass-through as it puts more

pressure on banks to offer competitive rates to clients. Singh, Razi et al., (2008)analyze theinterest rate pass-through in developed and developing Asian countries, controlling for financialmarket developments across countries. They have found a positive correlation between the sizeof equity and bond markets and the size and speed of the interest rate pass-through. Furthermore,more developed financial markets also improve the pass-through to short term and long termgovernment bond yields.

Ozdemir and Altinoz (2012) use the z-score as one of the determinants for the size for interestpass-through in 25 emerging country economies between 2004 and 2008. The z-score is definedas the sum of the mean return on assets and ratio of equity to assets by the standard deviation of

return on assets for banks in the respective country. Therefore, a higher z score reflects a higherbuffer against future losses and a healthier banking sector. The authors find a positiverelationship, thus a 1 point increases in the z-score improves the pass-through by 15%.

1The countries analyzed are: Austria, Belgium, France, Germany, Italy, the Netherlands, Portugal and Spain2The market share of more efficient banks is expected to increase as competition increases. A larger negative valueindicates a higher market share of companies with lower marginal costs, and thus a higher degree of competition


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The bank finance structure also impacts the extent to which it transfers changes in policy toconsumers. A bank which would be highly reliant on external funds from money market willimmediately feel the pressure from a change in the policy rate. On the other hand, a bank whichhas a substantial amount of long term deposits will not have such a pressure to reprice its loansas its deposits will adjust their interest rates less frequently. Gambacorta (2005) looks at theimpact of monetary policy on Italian banks between 1986-2001, showing that more liquid banks

are less responsive to a monetary policy shock. Furthermore, banks with higher levels of capitalwill be less affected by monetary policy as they can access alternative sources of funding such ascapital markets. Jimborean (2009) analyzes data from individual commercial banks from 10Central European countries between 1998-20063. By separating banks depending on their loan todeposit ratio, the author finds that lending growth for banks with a high deposit to loan ratio isnot impacted by a monetary policy shock. Weth (2002) looks at the maturity mismatch betweenloans and deposits, showing that banks which have a larger proportion of short term deposits tofund long term loans, will have a higher pass-through.

While large firms have access to capital markets to obtain funding, SMEs and households are

highly reliant on bank financing, therefore lending rate need to not fully adjust. Therefore, thepass-through for corporate loans is expected to be closer to 1 due to competition from financialmarkets and higher credit-worthiness of large firms. For example, Sander and Kleimeier (2004)show that the interest rate pass-through in 8 Central European countries between 1993 and 2003is 91% for short term corporate loans, 107% for long term corporate loans, but only 59% forconsumer loans. Furthermore, Van Leuvensteijn, Kok Sorensen et al. (2008) show that anincrease in the Boone indicator, a measure of competition, has a the highest impact on short-termcorporate loans, while mortgage loans, followed by consumer credit, present a lowerresponsiveness to changes in competitiveness.

Furthermore, switching costs, both administrative and informational, also act as a deterrent forcustomers for customers to move to another bank in order benefit from a higher deposit rate.Kim, Kliger et al. (2003) show that contractual penalties for loans impose high costs for endingthe relationship prematurely, thus locking in customers for years. Therefore lower switchingcosts increase the elasticity of demand, making it more likely for rates to adjust faster.

Due to asymmetric information, banks are not able to exactly determine the probability of defaultfor firms. Banks will charge higher risk premiums when increasing rates in order to cover theadverse selection (attracting lower quality borrowers) and moral hazard (borrowers use loans forventures with higher returns, and thus higher risks, in order to be able to pay back higher

interest).Stiglitz and Weiss (1981) showed that banks will not raise rates proportionally and willration credit only to eligible client, if they believe that profits of higher interest rate income willbe outweighed by defaults .On the other hand, a pass-through higher than one implies that banksare willing to lend to riskier ventures and are not involved in credit rationing.

3Countries analyzed are Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, SlovakRepublic and Slovenia.


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Sander and Kleimeier (2004) analyze the impact of money market volatility and inflation rateson the pass-through. Money market volatility has a negative impact as it makes it hard for banksto differentiate white noise from long run trends in the money market rates. Therefore banks willchoose to implement larger adjustments at longer intervals. On the other hand, higher inflationhas a positive impact on the pass-through as shown by Mojon (2000). During periods of highinflation, with a 1% higher inflation decreases the pass-through by 6% as price adjustments for

firms occur more frequently, therefore banks can pass on higher costs with greater ease. Last butnot least, higher economic growth is expected to improve the pass-through as shown by Sanderand Kleimeier (2004). According to their estimates, 1% higher GDP growth improves the pass-through by 17%.

2.2 Interest rate pass-through in the Czech Republic

Sander and Kleimeier (2004) account for differences between effectiveness of monetary policyby focusing on the financial structure(bank concentration, foreign bank ownership), financialdevelopment (credit to GDP, non-performing loans, stock market capitalization) andmacroeconomic developments such as volatility of money market rates and inflation. WhileGDP growth and financial development are not significant, inflation has a positive sign,therefore a higher rate of inflation is expected to increase the size and speed of the pass-through.On the other hand, money market volatility as measured by standard deviation of 1-monthmoney market rate has a negative coefficient. They find an average pass-through for loansincreasing from 78% for period 1993-1997 to 95% for the period 1999-2003. The pass-throughfor deposits is lower, starting at 44% for the period 1993-1997 and increasing to 66% between1999-2003. Out of the sample of countries, Czech Republic dummy is not statisticallysignificant, therefore results are in line with other countries analyzed.

gert, Crespo-Cuaresma et al. (2007) use the monetary and cost of funds approach to analyze the

pass-through in 5 Central European countries between 1995 and 2005. The monetary approach isestimated by using a bivariate error correction model linking the market rate to the policy rate isestimate using both Dynamic Ordinary Least Squares and Autoregressive Distributed Lag model.Overall stock of deposits in Czech Republic has a coefficient of 80% for maturity less 1 yearand70% for maturity higher 1year. Lending rates for the total stock of loans with maturities up to1year have a pass-through of 66%, while total household loans have a statistically insignificantpass-through. Looking at the period between 2001 and 2005, the pass-through for non-financialcorporations loans is 87% for loans with maturity up to 1 year and 98% for loans with a maturitybetween 1 and 5 years. A cointegration relationship is found only for Czech Republic between2001 and 2005, supporting the cost of funds approach two stage approach. The coefficientsyielded through this estimation method are consistent with the monetary policy approach: 73%for deposits up to than 1 year and90% for non-financial corporate loans with maturities between1 and 5 years.

Tieman (2004) also look at the period 1995-2004, focusing on Czech Republic, Hungary,Poland, the Slovak Republic, and Slovenia. The author employs a bivariate Error Correctionmodel, following the monetary policy approach. Adding to gert, Crespo-Cuaresma et al.


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(2007), data is also available for new loans for the period 2001-2004. Stock of short termdeposits have a pass-through of 79%, while long term deposits have a lower long term pass-through of 49%. Regarding loans, short term maturities exhibit a higher responsiveness tochanges in the policy rate as the pass-through is 104% for newly issued short term loans, whilefor long term loans the coefficient declines to 83%.

The following table from Coricelli, gert et al. (2006) provides a useful overview of the pass-through in Central and Eastern European countries, as measured by studies 1998 and 2004.

Long-Run Interest Rate Pass-Through Estimates for the CEECs

Type of rate Average long-run pass-through

Short-term deposit rate 0.72

Long-term deposit rate 0.69

Short-term lending rate 1.01

Long-term lending rate 0.91Consumer lending rate 0.51

Housing/mortgage lending rate 0.73

Horvth and Podpiera (2012) look at the pass-through in Czech Republic between January 2004and December 2008, applying panel cointegration technique to a panel of bank data. They allowfor heterogeneity in both the speed of adjustment and the size of the pass-through. The resultswere obtained by analyzing bank data and presenting median values of the pass-through out ofthe sample. They used a single equation bivariate error correction model, regressing bank rateson the money market rate with the highest correlation. Compared to previous studies, short termdeposits show an improvement, coming closer to a full pass-through with a full coefficient of93%. On the other hand, long term deposits are below the CEEC average with a pass-through of47%. Regarding mortgage loans, the pass-through is significant with a coefficient of 62%, butslightly lower compared to CEEC average. Lastly, loans for non-financial corporations bellow 30mio CZK exhibit a full pass-through for all maturities, while loans above 30 mio CZK have acoefficient of around 80%. This is counterintuitive as we would expect larger loans to have alarger pass-through due to higher credit-worthiness of borrowers and larger elasticity of demandgiven existence of other financing alternatives.


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HouseholdsShort-term pass-

through

Long-term pass-

through

Speed of

adjustment

Deposits

With agreed maturity of upto two years

0.70*** 0.93*** - 0.61***

(0.09) (0.02) (0.09) With agreed maturity of overtwo years

0.68 0.47*** - 0.28*

(0.63) (0.06) (0.14)

Loans

Lending for house purchase - 0.13 0.62*** - 0.34***

(0.23) (0.03) (0.11)

Non-financial corporations - Loans up to CZK 30 mil

Floating rate and initial ratefixation of up to one year

0.70** 0.94*** - 0.50***

-(0.15) (0.06) (0.11)

Initial rate fixation of overone year

0.52 0.95*** - 0.49***

(0.44) (0.09) (0.20)

Non-financial corporations - Loans over CZK 30 mil

Floating rate and initial ratefixation of up to one year

0.90*** 0.81*** - 0.53***

(0.30) (0.03) (0.10)

Initial rate fixation of overone year

0.9 0.78*** - 0.77***

(2.20) (0.08) (0.27)

Furthermore, their dataset allows them to study what the determinants are for differences in thepass-through within banks. While banks react heterogeneously in the short run, in the long runtheir coefficients are homogenous. They find that banks which rely heavily on deposit funding asopposed to non-deposit funding will tend to have a lower pass-through as they will smoothen thetransition to their customers and rely more on relationship lending. Credit risk, as measured by

non-performing loans, has a positive effect on the interest rate pass-through. Therefore bankswhich experience higher credit risk will not have the adequate resources to smoothen thetransmission of a policy shock to their customers. Other indicators such as bank size, capitaladequacy and liquidity do not affect the interest rate pass-through.

Babeck-Kucharukov, Franta et al. (2013) extend the analysis to 2009, find that the pass-through short term deposits has remained constant, while that for long term deposits has


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increased to 73%. Mortgages have also increased, having a long term coefficient of 92% asopposed to 62% before. Regarding non-financial corporations, the crisis has had a negative effectfor loans with an interest rate fixation period below 1 year and a positive effect for loans with ahigher interest rate fixation period. This effect has been more pronounced for smaller loans(around 20% in both directions), while for larger loans it has only been around 1-2 percentagepoints.

The main conclusions from surveying the data are: corporate loans have higher pass-throughthan consumer loans, as expected given that corporations have access to other sources of fundingsuch as capital markets. Long term deposits have a higher pass-through than short term deposits,while current account and saving accounts show a very low pass-through. Lastly, a large degreeof heterogeneity is observable within countries, with Czech Republic having a slightly lowerpass-through than other countries in the region.

2.3 Impact of the financial crisis

Beckmann, Kleimeier et al. (2013) look at the impact of banking crises on the interest

rate pass-through. They use a database set up by Laeven and Valencia (2013)which coversbanking crisis from the 1980s onwards. Given that the current financial crisis is still developing,the results do not allow for estimation post crisis. Nevertheless, they find that the long run pass-through in France, Germany, Ireland and UK has not been affected by the crisis. On the otherhand, for Italy, Portugal and Spain the financial crisis has decreased long run pass-through by 30to 70 percentage points. Regarding deposit rates, the impact has been even larger as the pass-through has declined from a full pass-through to insignificant for Spain and Portugal. UK andGermany have also been impacted, falling by around 20 percentage points for Germany and 60for UK.

ECB (2013) analyzes the impact of financial fragmentation on the pass-through after thecrisis. Due to sovereign debt crisis and the slowdown of economic activity, the decreases in thepolicy rate could have not been passed down to firms as banks require higher premium over thepolicy rate in order to be compensated for the higher risk of default. Furthermore, since thebeginning of the crisis, the spread between lending rates has increased, especially for smallerloans designated for SMEs, showing the flight to quality of banks. This situation was especiallypronounced in Spain and Italy, both countries severely affected by recession and sovereign debtcrisis. In addition to this, changes from the policy rate were transmitted quite uniformly for thepolicy rate cuts between October 2008 and May 2009, but much more heterogeneously andincomplete for those between November 2011 and July 2012. For example, short term lending

rates to household increased in Spain and Ireland over the period even though the policy rate fell.Overall, they find that the increase in sovereign bond yields spread to German bonds as well asother macroeconomic factors such as high unemployment, increased probability of default fornon-financial companies are responsible for the discrepancies within countries.

Al-Eyd and Berkmen, (2013) extend the traditional ECM model by including variableswhich capture changes in macroeconomic environment which might affect the pass-through andexplain the recent divergence between core and periphery countries. When controlling for factors


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such as CDS spreads for financial companies, spread of bank bonds to the policy rate and asset tocapital, the pass-through is unchanged compared to pre-crisis period. Therefore the heterogeneitybetween core and periphery countries and elevated lending rates can be explained bydevelopments related to macroeconomic environment rather than traditional determinants of theinterest rate pass-through such as competition or bank finance structure.

3.MethodologyAccording to the monetary approach, the long run relationship between the policy rate and bankrates is = + +. As stationarity is an issue with interest rate time series, unit roottests augmented Dickey Fuller (ADF), Phillips Perron (PP) and Kwiatkowski-Phillips-Schmidt-Shin (KPSS) will be performed. Cointegration between two variables means thatdespite fluctuations in the short run, these values will not deviate from equilibrium for anextended period of time. Cointegration will be tested using the Johansen trace statistic and theoptimal lag length will be determined by the Akaike Information Criterion with maximum

number of lags set to 4.

If cointegration is found, then an error correction model used to estimate the pass-through asshown below

= + , + ,

+ +

where BR is the retail bank rate for deposits or loans, P is the monetary policy rate and the errorterm is = ,. The short run impact of a policy rate shock is ,,

the long run impact is ,

,

and the speed of adjustment is .The advantage of the ECM

is that it gives the possibility to differentiate between short run and long run dynamics, thusgiving a complete picture of the interest rate pass-through.

If no cointegration relationship is found, then an ARDL model will be estimated as shown below

= +, , + ,

In this case, the short run impact of a policy rate shock is , , the long run impact is

,

and the speed of adjustment is ,as defined by Sander and Kleimeier (2004). A

speed of adjustment lower than 1 shows that the impact of a change in the policy rate istransmitted to market rates within one month.

Given the possible existence of a structural break since the onset of the crisis, the Johansen tracestatistic may wrongly indicate lack of cointegration due to the misspecification of the modelTherefore, cointegration tests will also be performed for period before August 2008 andafterwards and the ECM will be estimated separately for pre-break and post break period. Thedate was chosen as it was the first month when the Czech National Bank started cutting its policy


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rate in response to the financial crisis in Europe, therefore it provides the first signal of thechange in the macroeconomic environment.

Lastly, a rolling regression with a period of 50 months will be conducted in order to gauge howthe long run coefficients have changed since 2008. A period of 50 months was chosen in order togive a clear estimate of the pass-through before the crisis and show the gradual impacts of the

economic crisis. If cointegration is found in at least two of periods analyzed (full period, beforeor after crisis), then an error correction model will be employed. Otherwise, an ARDL modelwill be used. The results will be presented by graphing the long run impact along with its 95%confidence interval.

Additionally, the cost of funds method will be used to measure the pass-through. Given the shortmaturity of the policy rate, it may not be a useful indicator to measure to opportunity costs forbanks in the case of loans with longer maturities. Therefore the cost of funds approach definesthe pass-through from the policy rate to bank rates as a two stage process: initially from thepolicy rate impacts market rates, and afterwards, from market rates to bank rates. For example,De Bondt, Mojon et al. (2005) find that bank will set rates for long term loans such as mortgagesin accordance to long term liabilities such as government bonds. Therefore the market ratesanalyzed will be interbank money rate rates with maturities of 1 day, 1 month, 3 months and 1year and government bonds with maturities of 2 years, 5 years and 10 years. The market ratewith the highest correlation will be chosen and the same methodology as the monetary approachwill be used to measure the pass-through from market rates to the bank rate.

4. Data description

The period between 2004 and 2006 is characterized by high GDP growth fuelled byincreasing household and business debt. Growth in the EU helped boost Czech exports as well as

foreign direct investment. Furthermore, low oil prices helped inflation fluctuate around 2% level.Therefore the policy rate remained around the 2% level, supporting economic growth. During2007 as international tensions started to mount due to the developing financial crisis in theUnited States, the Czech Republic was not affected as GDP continued to grow at an acceleratedpace, along with exports and household debt. However, increasing oil prices along with a VATtax hike put pressure on the inflation rate, thus forcing the Czech National Bank to increase thepolicy rate by an entire percentage point during 2007 from 2,5% to 3,5%(CNB 2008). Anotherincrease followed in February 2008, yet as inflationary pressures fell and the economicslowdown of developed countries in EU started to affect Czech economy, the Czech NationalBank decided to decrease the policy rate in August 2008to 3,5%. By the end of the year, the

policy rate fell further to 2,25%. The performance of the economy was disappointing in 2009registering the first year of negative economic growth with a record high government deficit anda drastic fall in exports, even though the Central Bank further eased monetary policy, loweringthe policy rate to 1%(CNB 2009).


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2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

GDP growth 4,7 6,8 7,0 5,7 3,1 -4,5 2,5 1,8 -1,0 -0,9

Loan growth households 33,0 32,6 29,5 34,4 21,2 11,7 7,5 5,8 4,0 3,7

Loan growth non-financial corporations

8,0 15,6 19,6 19,5 12,3 -8,2 0,0 5,3 2,5 -1,6

Non-performing loans 6,3 5,0 4,2 3,4 3,1 4,8 6,7 7,0 6,5 6,6

Export growth 16,0 16,5 17,5 13,6 10,5 -15,7 19,1 13,5 5,3 -1,5

Government deficit -2,8 -3,2 -2,4 -0,7 -2,2 -5,8 -4,7 -3,2 -4,2 -1,5

Unemployment 8,3 7,9 7,1 5,3 4,4 6,7 7,3 6,7 7,0 6,9

Inflation 2,6 1,6 2,1 3,0 6,3 0,6 1,3 2,1 3,5 1,4

Policy rate 2,3 1,9 2,2 2,9 3,5 1,5 0,8 0,8 0,5 0,1

All figures are percentages

Property prices started falling as well, as growth in mortgages subsided and supply of new

residences outstripped demand. Nevertheless, the high profitability of the banking sector,comfortable deposit to credit ratio and low proportion of foreign currency loans were importantfactors in important factors in maintaining the viability of the banking sector. Furthermore, thecapital to asset ratio of banks remained constant around 11% during the crisis, showing thesoundness of Czech banks.

During 2010, the economy started rebounding slowly, yet high energy prices and low demand forexports were drags on growth. The fall in economic activity significantly impacted corporationswhose default rates increased, leadings to cuts in production and increases in unemployment.Following a contraction of 8% in 2009, loans to non-financial corporations were stable, while

loans for households increased at 7,5%, showing a slow-down from previous year level of 12%(CNB 2011).

After decreasing the policy rate to 0,75% in May 2010, the CNB kept the rate stable until June2012 in an effort to boost the economic recovery. Nevertheless, the recovery lost steam during2011, as net export and changes in inventory were the only drivers of growth. Due to lowdomestic demand, firms which focus on internal market such as construction, real estate andservices posted disappointing results. Furthermore, low wage growth and high unemploymentwere a drag on consumption and led to only a moderate increase in lending to households. On theother hand, non-performing loans stabilized around 7% and the banking sector maintained a solid

capitalization ratio, showing signs that the worst had passed for the financial sector(CNB 2012).


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Slow growth in EU started to impact exporting companies, which had been shielded from theimpact of the crisis, thus the Czech Republic fell into a recession again at the beginning of2012.The economy continued to experience negative economic growth until the third quarter of2013, mainly due to fiscal consolidation efforts and falling investment of firms. As a result, thepolicy rate was decreased thrice in 2012 to 0,05%. Furthermore, the CNB announced it willintervene in foreign exchange markets in order to keep the koruna close to CZK 27/EUR level inorder to prevent appreciation and support exports. Fortunately, external demand and householdconsumption picked upin first quarter of 2014, pushing GDP growth to 2,5% (CNB 2013).

4.a) Money market rates

First of all, the pass-through from the policy rate to money market rates will be analyzed.Interbank rates are obtained as monthly averages from the website of the Czech National Bank,focusing on the main maturities: overnight, 1 month, 3 months and 1 year. Czech money marketrates follow closely the policy rate for maturities below 1 year before the financial crisis. Giventhat around 80% of the market is traded on short maturities overnight or 1 week, these rates aremost significant. Furthermore, due to the low liquidity of longer maturities, these interest ratesare much more sensitive to shifts in the market and are characterized by higher volatility. Allrates spike in October - November 2008 after the fall Lehman Brothers, showing the largeamount of market unrest at the period. Accordingly, the Czech National Bank expanded its repo

maturity to 3 months and implemented a full allotment policy (CNB 2008). As can be seen fromthe graph below, there was a spike in volumes for repo operations, helping money market ratesfall back to normal levels.Gersl and Lesanovska (2013) analyze the increase in the spread ofPRIBOR 3M from policy rate during the financial crisis and find that high counterparty non-performing loan, as well as low bond market liquidity and volatility in EURIBOR money marketare the main determinants for the higher spread. Following November 2008, overnight ratefollowed closely the policy rate, while the spread between maturities above 1 week narrowed

-8,0

-6,0

-4,0

-2,0

0,0

2,0

4,0

6,0

8,0

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Quarterly GDP growth

Euro area (12 countries) Czech Republic Germany


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0

2

4

6

8

10

12

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

10 year bond yields

Czech Republic Germany Hungary Poland

significantly until February 2009. Nevertheless, given the extremely low volumes at highermaturities (around 1% for maturities above 1month for 2008 and 5% for 2009 and 2010), thesedevelopments are not particularly significant for the market(CNB 2012). Money market ratescontinued to decrease with the policy rate, stabilizing in May 2010 as the Central Bank set thepolicy rate at 0,75% and falling again in 2012 after the last round of policy rate cuts. They havesince remained at levels between 0.15% for overnight to 0.55% for 1 year maturity.

4.b) Government bond yields

Additionally, the pass-through from the policy rate to government bond yields will be measuredin order to see how debt instruments with longer maturities are impacted. Government bond

yield data is obtained from Czech National Bank and Bratislava Stock Exchange and is based ona basket of government bonds with an average residual maturity for 2 years, 5 years and 10 year.The average maturity of Czech government bonds has varied around 6,5 years since 2006, witharound half of outstanding debt above 5 years. Government bond yields moved with the policyrate between 2004 and 2008, with the spread between 2 and 5 year maturities tightening aspolicy rate increased. Bond yields spiked in June 2008 and again in March 2009 for 2 and 5years maturities and in June 2009 for 10 years maturity.

0

10.000

20.000

30.000

0

1

2

3

4

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Money market rates

Liquidity providing repo (rhs) 1 day (%)

1 month (%) 3 months (%)

1 year (%) Policy rate


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15

0%

5%

10%

15%

20%

0

1

2

3

4

5

6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Government bond yields

Bank holdings of government debt (rhs) 2 years maturity

5 years maturity 10 years maturity

Policy rate

Claeys and Vaek (2012) show that 50% of variance of Czech bond yields over German bondscan be explained by external developments ofbond markets, with Hungary and Poland havingthe largest impact. As 30% of government debt is held by investors, external perceptions on thecredit worthiness of Czech Republic as well as risk aversion in the markets may move yieldsbeyond their fundamentals during periods of unrest. This can also have a positive impact onyields. For example, a dip in yields can be observed for all maturities at the end of 2001 as the

European Central Bank introduced Long Term Refinancing Operations. Overall, Czech bondsare now seen by international investor as a safe asset offering an attractive yield, given the lowdebt to GDP ratio of the Czech Republic (46% in 2014). This was also reflected by the Standardand Poor decision to upgrade Czech government debt by two notches from A to AA- (Reuters2011)

Furthermore, due to the high deposit to credit ratio of commercial banks and slow growth oflending, Czech banks have increased their government bond yields holdings since the onset ofthe crisis, driving down yields. Regulatory measures have also supported domestic banks holdingdomestic bonds as they do not have to keep additional capital and can be used as collateral forCNB repo operation, therefore they can be used as a liquidity buffer in times of unrest. ( CNB2012). Overall, Czech bond yields have been responsive to the decrease in the policy rate, fallingalong with its changes and maintaining a constant spread of around 1% between maturities.

4.c) Household deposits

I will also analyze the price behavior of interest for deposits, both for households and non-financial corporations. At April 2014, the majority of funds were held in overnight and currentaccounts, reflecting a need for liquidity and a low incentive to save. Households split theirremainder of their funds between agreed maturity deposits and redeemable at notice accounts.Nevertheless, the situation was quite different in 2004, when funds for households were splitevenly between overnight and agreed maturity deposits. While agreed maturity and redeemablenotice deposits remained stable, all growth in households funds went to overnight deposits.


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16

0

200.000

400.000

600.000

800.000

1.000.000

1.200.000

1.400.000

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Household outstanding amounts

Overnight With agreed maturity total Redeemable at notice total

Furthermore, at the end of 2008 as market tensions began to rise, households shifted from agreedmaturity deposits to redeemable at notice due to higher uncertainty regarding the future and needfor easy access to liquidity.

In order to facilitate an easy understanding of the data, deposits for agreed maturity will be splitbetween interest rate fixation period shorter than 1 year and longer than 1 year. The interest rateabove 1 year will be constructed by using the weighted average of new amounts with maturitiesabove 1 year. Until 2009 interest rates above 1 year show very high volatility, while broadlyfollowing the movement of the policy rate with a large delay until mid 2010. On the other hand,deposits below 1 year followed closely movements of policy rate, maintaining a constant spread

of around 0,75% between 2004-2009. As the policy rate started decreasing, the spread becameclose to zero as rates fell in sync. Since May 2010 when the policy rate stabilized at 0,75%, bothrates in household deposits have been driven mainly by competition from small banks andbuilding societies which offer higher rates than large and medium banks (on average 1,5%higher, CNB 2011-2012), therefore interest rates of new amounts have shown a large degree ofvolatility and a high spread above the policy rate.


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17

Regarding deposits redeemable at notice, their rates show very low responsiveness to thepolicy rate, therefore a very low pass-through is expected. The rates over 3 months havefluctuated around 1%, while rates for maturities up to 3 months show a similar pattern around the2% level.

4.d) Non-financial corporations depositsFor non-financial corporations, a detailed breakdown is not available between maturities,therefore only the three main categories will be considered: overnight, agreed maturity depositsand redeemable at notice deposits. Regarding outstanding amounts, deposits redeemable atnotice have a very small share for the entire period, while overnight and agreed maturity depositsamounts are almost equal at the beginning of 2004. While agreed maturity deposits remainedrelatively stable until the end of 2008, overnight deposits increased by around 40 bio CZK (1.8

0

1

2

3

4

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Agreed maturity - Households

Up to 1 year maturity Over 1 year maturity Policy rate

0

1

2

3

4

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Redeemable at notice & Overnight - Households

Policy rate Up to 3 months - HH Over 3 months - HH Overnight


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18

bio EUR). Due to market tensions and decreasing interest rates, outstanding amounts for agreedmaturity deposits started falling at the end of 2008, leading to an increase of 60% for overnightaccounts increased between 2009 and 2014.

Regarding interest rates, overnight deposits are least responsive, fluctuating around 0,5%until beginning of 2006. Afterwards rates started rising to a maximum of 1,2% in June 2008,falling again to an equilibrium level of 0,5% in March 2009. Deposits redeemable at noticefollow changes in the policy rate with a delay of around 3 months. The interest rate onredeemable deposits switched from having a spread of around 1% below the policy rate tohaving a positive spread which increased up to 1,9% in the beginning of 2013, four months afterthe Central Bank lowered to its historical low of 0,05%. The spread has since fallen and seems

to have stabilized at around 1%, which is comparable to interest rates offered in the householdsector for redeemable deposits above 3months. Interest rates for deposits with an agreed maturityshow a much smaller spread to the policy compared to household agreed maturity deposits,therefore showing a higher degree of competition for funds in the corporate sector and a higherelasticity of demand given the larger number of alternatives available to corporates. Once theCzech National Bank started implementing a looser monetary policy in August 2008, the spreadbetween agreed maturity interest rate and policy rate became even smaller, close to 0%, untilfinally in June 2012 when the policy rate was lowered to 0,5% the spread became positive asrates on agreed maturity deposits could not be lower than those offered for overnight deposits.

0

100.000

200.000

300.000

400.000

500.000

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Outstanding amounts - Non financial corporations

Overnight Agreed maturity Redeemable at notice


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19

4.e) Household loans

Household loans are divided into three main categories: loans for house purchase, consumercredit and other loans. Mortgages represent the largest share of outstanding loans given theirgood quality of collateral and high ticket per loan. Given the low debt level of Czech householdsat the beginning of the 2000s, (30% of GDP in 2004), there was a lot of potential for expandingprivate lending. Therefore in the period preceding the crisis, mortgages increased by 35%annually, while consumer credit and other loans grew at around 25%. As the financial crisis hitCzech Republic, growth loans to households started slowing down, with mortgages stabilizing at

around 6% growth in early 2011, while consumer credit stopped growing in September 2009.Overall, loan growth has been supported almost exclusively by mortgages over the past fouryears, showing that banks are less willing to lend out money to households for loans with nopurpose attached or without collateral, as the increase in unemployment and stagnation in wageshave affected the credit-worthiness of households.

Share of household loans

Consumer creditLending for

house purchaseOther

31.1.2004 22% 67% 11%

30.4.2014 16% 73% 11%

0

1

2

3

4

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Non-financial corporations - deposits

Overnight Agreed maturity Redeemable at notice

Policy rate Agreed maturity households


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20

Keeping in line with methodology used for deposit rates, loans will be separated depending ontheir interest rate fixation period: below 1 year and above 1 year. The interest rates for interestrate fixation period above 1 year will be constructed using weighted average of interest based onnew amounts.

Mortgages with higher interest rate fixation periods adjust slower to changes in the policy rateand only partially. If the policy rate is decreasing, floating mortgages are preferable as they aremore susceptible to changes in the policy rate. Given the fact that rates have stayed low for sucha long period, longer maturities (1-5 years) have also been impacted, therefore it is profitable forhouseholds to lock in these low rates for an extended period of time.

On the other hand, consumer credit and credit cards show very low responsiveness to changes inthe policy rate, given their high risk premium and poor collateralization. Credit card interest rates

-5%

5%

15%

25%

35%

45%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Growth rate - Household loans

Total loans Consumer credit Lending for house purchase Other

0

10.000

20.000

30.000

0

2

4

6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Mortages - Households

Over 1 year rate IRF - new amounts Floating rate and up to 1 year IRF - new amounts

Over 1 year IRF Floating and up to 1 year IRF

Policy rate


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21

fluctuate around 20%, with the exception of 2009 when rates peak at 24%, afterwards returningto the previous level. Consumer credit with an IRF above 1 year falls from 2004 to August 2006to a low of 12%, afterwards fluctuating with no clear trend up to 15%. Overdrafts have a verysimilar evolution to fixed rate credit card interest rates, showing no distinct trend over theanalyzed period. Floating interest rates for consumer credit show the highest volatility out of thethree series, having a delayed response to changes in the policy rate of around 14 months.

Nevertheless, they have decreased by 5% from their peak, showing some responsiveness to thefall in the policy rate since 2008.

Between 2004 and 2006, the majority of new loans (80%) were floating rates as these had thelowest rates. In the period following, until 2006, loans were split with around a third of new

amounts having floating rates, while the remainder had interest rate fixation periods above 1year. Even though floating rates have been lower than fixed rates since 2012, most of the growthin new loans has occurred in loans with fixed interest rates

4.f) Non-financial corporations loans

For loans above 30 mio CZK, no division is available based on interest rate fixation period,therefore only total amounts will be analyzed. For loans below 30 mio CZK, , loans will bedivided depending on their interest rate fixation periods. Out of the interest rate analyzed so far,loans for non-financial corporations have the highest responsiveness to changes in the policyrate. Nevertheless, since August 2008 the spread against the policy rate has increased as the

default rate of companies started increasing, therefore banks became more risk adverse andcharged a higher risk premium. Loans over 30 mio CZK have a lower interest rate than loans upto 30 mio CZK as larger firms have a lower probability of default and they have access toalternative sources of finances, therefore they exhibit a higher elasticity of demand.

0

1

2

3

4

5

10

15

20

25

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Consumer credit, overdrafts and credit cards

Consumer credit - Floating rate and up to 1 year IRF Consumer credit - Over 1 year IRFOverdrafts - HH Credit cardsPolicy rate (rhs)


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22

5. Results As expected, interest rates are I(1), therefore looking at a cointegration relationship isfeasible as all rates have the same degree of integration.

5.a) Money market rates

Looking at the entire period, the long run pass-through is not significant, while it becomes

complete for sub-periods between 2008-2012. During 2004 the Czech National increased thepolicy rate twice and decreased twice during 2005, therefore rolling estimates up to 2009show aninsignificant pass-through. Nevertheless, the pass-through steadily improved, becomingcomplete by the end of 2011 and decreasing afterwards to 70% as policy rate approached thezero lower bound.

The 1 month money market rate shows a lower degree of volatility, dipping from 90% before thecrisis to 60% at the end of 2008. Afterwards it stabilizes around 100% and, following a peak atthe beginning of 2013, it falls to 75%.

0

25.000

50.000

75.000

0

2

4

6

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Non-financial corporations loans

Loans over 30 mio CZK - new amounts (rhs) Loans up to 30 mio CZK - new amounts (rhs)

Over 30 mio CZK - total Loans up to 30 mio CZK -Floating rate and up to 1 year IRF

Loans up to 30 mio CZK - Over 1 year IRF Policy rate


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23

The 3 month and the 1 year money market rates show very similar evolution to the 1 month pass-through. They exhibit a drop in the pass-through to 60% during the unrest of 2008 and after June

2012 as policy rate is approaching zero lower bound, but for the rest of the analyzed period thepass-through is complete for 3 month rates and at 80% for 1 year rates. These results are in linewith gert, Crespo-Cuaresma et al. (2007)who find a complete pass-through from policy rate toshort term money market rates (1month) and long term (12 months) for the Czech Republicbetween 1995 and 2005.

To conclude, money market rates have been weakened by the financial crisis between 20% and40%, thus overnight and 1 month maturities now have a comparable pass-through around 70-75%, while 3 month and 1 year maturities have stabilized around 60%.

5.b) Government bonds

Government bond yields with a 2 year maturity have a pass-through of 90% at the beginning ofthe analysis, but this falls to 60% as the policy rate decreases between 2009-2013. Government

-1,5

-1

-0,5

0

0,5

1

1,5

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Overnight - ECM

0

0,5

1

1,5

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

1 month - ARDL

0

0,2

0,4

0,6

0,8

1

1,2

1,4

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

1 year - ARDL

0

0,2

0,4

0,6

0,8

1

1,2

1,4

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

3 months - ARDL


25/59

24

bond yields with a 5 year maturity have a pass-through of 50% at the beginning of the period,climbing up to 70% at the end of 2008, but becoming insignificant afterwards.

The regression is significant only for the period before the crisis, with a coefficient of 65%. Thiscan also be observed from the graph of the long run coefficient which becomes insignificantfrom the end of 2008.

Singh, Razi et al. (2008) show that the pass-through to 3 month T-bill rates in developedcountries4is close to 1 in the long run, while long term bonds with maturities between 3 and 5

years have a long run pass-through between 65% (Germany) and 81% (US). Therefore results forCzech Republic before the crisis are in line with pass-through in developed countries.Government bonds with higher maturities are less responsive to changes in the policy rate andhave been affected to larger extent by the financial crisis. Furthermore, as the policy rateapproached the zero lower bound, the pass-through becomes insignificant for all maturities as

4The countries analyzed are :UK, Australia, Canada, the US and Germany

-2

-1,5

-1

-0,5

0

0,5

1

1,5

2

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

10 year maturity - ARDL

-1

-0,5

0

0,5

1

1,5

2

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014


-1,00

-0,50

0,00

0,50

1,00

1,50

2,00

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014



26/59

25

government bond yields are driven by other factors beyond the policy rate. Therefore the impactof the crisis on the long run pass-through has been much more pronounced regarding governmentbonds as opposed to money market rates.

5.c) Household deposits

Up to 2009, the pass-through for overnight deposits shows very large standard errors, but is still

significant. Nevertheless, from 2009 the long run impact is stable and significant throughout theentire period with a coefficient of 18%. The immediate impact is only significant in the periodprevious to the crisis, as well as the adjustment speed, showing a slowdown in the transmissionof policy rate to overnight rates. The pass-through weakens again from 2013 when the last roundof policy cuts was instituted by the Czech Central Bank, as rates for overnight deposits remainedstable despite the lower policy rate.

When regressing the overnight rate to the 2 year government bond yield, the long run coefficientis significant only for the full period at 7%, but loses significance when analyzing the sub-periods or running the rolling regression. Therefore the monetary approach is more suited for the

estimation of the pass-through.

Deposits with maturity less that 1 year are more responsive to changes in the policy rate, havinga long run pass-through of around 80%-85% up to the end of 2012, with the exception of a dropat the end of 2008 which was due to market unrest. The long run coefficient becomesinsignificant from April 2013. The adjustment speed is 0,35 before crisis, showing that the

impact of the policy change in fully implemented in 3 months, but it becomes insignificant afterthe crisis. Implementing the cost of funds approach, the pass-through from 3 month moneymarket rate is slightly higher (71% vs 66% for the entire period), but given their standard errors,the results are not significantly different. Therefore the cost of funds approach yields consistentresults with the monetary approach.

On the other hand, deposits with maturities above 1 year are not impacted at all by changes in thepolicy rate throughout the analyzed period, with short run, long run and adjustment speeds being

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Overnight deposit - ECM


27/59

26

insignificant. The pass-through from the 10 year government bond yields is also not significant,showing that deposits rates are not related to longer maturities either.

Given the very low volumes of deposits with higher maturities, the interest rate is quite sensitiveto changes in new amounts, therefore a high degree of volatility and low responsiveness isexpected. Furthermore, as banks seek long maturities in the context of uncertainty in market,

they are willing to pay a high premium above the policy rate in order to secure long termfunding, therefore changes in the policy rate are not reflected in these rates.

Even though the long run pass-through is significant for maturities up to 3 months from thebeginning of 2009, the long run impact is quite low at around 8%. As was seen with depositswith agreed maturities, the coefficient ceases to become significant after 2013 as the policy rate

reached the zero lower bound. When employing the cost of funds method, the pass-through from2 year government bond yields is not significant, therefore the monetary policy approach ispreferred for measuring the pass-through.

For deposits redeemable at notice with maturities above 3 months, the long run coefficient ofaround 25% period preceding the crisis. Afterwards it decreases quite abruptly becominginsignificant by the end of 2008. Since 2013, the long run pass-through has been improving asrates fell slightly as the policy rate was decreased. The cost of funds approach yields an 11%pass-through from 5 year government bond yield, showing that the policy rate has a largerinfluence on deposit rates.

-1,5

-1

-0,5

0

0,5

1

1,5

2

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Agreed maturity over 1 year - ARDL

-1,5

-1,0

-0,5

0,0

0,5

1,0

1,5

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Agreed maturity - less than 1 year - ARDL


28/59

27

Deposits with short maturities such overnight and redeemable at notice have a lowresponsiveness to changes in the policy rate. Preceding the crisis, deposits with agreed maturity

with maturities below 1 year had an almost complete pass-through, while those with maturitiesabove 1 year have an insignificant pass-through. Overall, the pass-through weakened during theturmoil of 2008 and has become insignificant from the end of 2012 as the policy rate approachedthe zero lower bound. Deposits redeemable above 3 months are the only exception, showingimprovement since 2013, yet they represent only a small fraction of funds held by population.Lastly, the monetary approach seems better suited to describe the pass-through as deposit ratesshow a higher responsiveness to changes in the policy rate as opposed to other money marketrates or government bond yields

5.d) Non-financial corporations deposits

The long run pass-through for overnight deposits is significant and stable at 29% for the entireperiod. The adjustment speed is 0,25 for the entire period, increasing to 0,75 when analyzing theperiod before the crisis showing a faster transmission from policy rate to overnight deposits.Analyzing the rolling regression graph, the long run coefficient is stable at around 35% since2009, but falls to 0% the end of 2012 as rates remained at the 0,25% level while the policy ratefell to 0,05%. The long run pass-through measuredwith the cost of funds shows a similarevolution as the market rate chosen in overnight which has a high correlation with the policyrate.

-0,4

-0,3

-0,2

-0,1

0

0,1

0,2

0,3

0,4

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Redeemable at notice - less 3

months - ARDL

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

1,0

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Redeemable at notice over 3

months - ARDL


29/59

28

Unlike other rates, agreed maturity depositsshow a lower pass-through before the crisis ascompared to the period after the crisis. The pass-through steadily improves from 80% at the

beginning of 2008, stabilizing at 100% since mid-2011. The pass-through falls at the beginningof 2013 to 60% as the policy rate stabilizesatthe 0,05% level. Furthermore, the adjustment speedalso improves in the period following the crisis with a coefficient of 0,7, compared to 0,5 for theentire period.As in the case of overnight deposits, the results from the cost of funds approach arevery similar as the chosen money market rate is overnight one.

The long run pass-through for deposits redeemable at notice starts out at around 60% for periodbetween January 2004 August 2008, but falls sharply until January 2009 to a minimum of10%.For the next four years it stabilizes around 30%, decreasing again to levels shown duringthe crisis from the end of 2013.The cost of funds approach measures the pass-through from the 2year government bond yield, showing a much weaker pass-through.

-0,1

0

0,1

0,2

0,3

0,4

0,5

0,6

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Overnight - ECM

0

0,2

0,4

0,6

0,8

1

1,2

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Agreed maturity - ECM


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29

Comparing to household deposits, the pass-through for overnight and deposits redeemable atnotice is higher by 10%-30% for the entire analyzed period. On the other hand, deposits with

agreed maturity have similar pass-through preceding the crisis, but are much more resilient since.Unlike household deposits that have become insignificant, agreed maturity deposits forcorporations still have a 60% pass-though.

5.e) Household loans

Floating mortgages have long run pass-through of 75%, yet very high standard errors. Fromanalysis of rolling regression output, it is observable that the long run coefficient quicklybecomes insignificant and remains so until the end of the analyzed period. The situation is quitesimilar for mortgages above 1 year, starting out with a pass-through of 70% but becominginsignificant by the end of 2008.Given that mortgages with interest rate fixation above 1 year

make up 50% of overall new loans, the disruption of the pass-through from policy rate tomortgage rates is quite worrying in assesing the impact of the central bank on real economy.

The cost of funds approach calculates the pass-through from 10 year government bond yeilds tomortgages and shows much weaker results. Despite their long maturities, mortgages are pricedmore in accordance to development of the policy rate, rather than instrumetns with longermaturities.

-0,6

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

1,0

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Redeemable at notice - ARDL


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30

The pass-through for consumer credit loans is insignificant for both short run and long runimpact. This is expected as these types of loans have a very high unit costs, low elasticity of

substituion with other financial goods and a high credit risk. Therefore banks price such loanswith a high margin above policy rate.

Credit cards and overdrafts are in a similar situation as they have high unit price per ticket, poorcollateral and high credit risk. Therefore results not significant for either of the sub-periodsanalyzed. When calculating the pass-through using the cost of funds methodology, consumer

credit loans, credit cards and overdrafts have the highest correlation with 10 year governmentbond yields but still have an insignificant pass-through.

-2,5

-1,5

-0,5

0,5

1,5

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Mortgage less 1 year - ECM

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

1,0

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Mortgages over 1 year - ARDL

-3

-2

-1

0

1

2

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Consumer credit less 1 year - ARDL

-2

-1

0

1

2

2004-2008

2005-2009

2006-2010

2007-2011

2008-2012

2009-2013

2010-2014

Consumer credit over 1 year - ARDL


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5.f) Non-financial corporations loans

Before the crisis, loans below 30 mio CZK exhibited a full pass-through with a long run

coefficient of 106%. Looking at the two different interest rate fixation periods, floating rates aremuch more responsive to changes in the policy rate and the pass-through becomes insignificantonly at the end of 2011. On the other hand, loans with interest rate fixation period start out with alower long run pass-through (85% vs 95% for floating rates) and decreases much faster,becoming insignificant from the beginning of 2009.

While in the period preceding the crisis, loans over 30 mio CZK had a lower pass-through (86%)compared to loans up to 30 mio CZK (106%), these loans have maintained a substantial pass-through from the beginning of the crisis. The pass-through weakened by 30% starting in 2009,finally becoming insignificant as the policy rate was approached the zero lower bound in at theend of 2012.

-1

-0,5

0

0,5

1

1,5

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Overdrafts

-2

-1

0

1

2

3

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Credit cards

-0,5

0

0,5

1

1,5

2

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Loans up to 30 mio CZK - up to 1

year - ECM

-1

-0,5

0

0,5

1

1,5

2

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Loans up to 30 mio CZK - over 1

year - ARDL


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32

Overdrafts for non-financial corporations start with a long run pass-through of 70%, falling to60% at the beginning of 2009. Since 2013, the pass-through has become insignificant.

Compared to the monetary policy approach, the cost of funds approach yields similar results forloans over 30 mio CZK which are regressed to the 1 year money market rate, but less significantresults for loans up to 30 mio CZK and overdrafts which are regressed to the 2 year government

bond yield.

6. Conclusion

The purpose of this paper is to analyze to what extent the policy rate set by Czech NationalBank impacts interest rates for deposits and loans. An error correction model was used when

cointegration was found, allowing both long run and short run dynamics to be analyzed. Forhousehold deposits, only overnight rates were cointegrated with the policy rate for the entireperiod, while agreed maturity deposits and deposits redeemable up to 3 months werecointegrated in the period prior to August 2008. Out of the household loan rates, onlymortgages with floating rates are integrated for the full period. For non-financialcorporations, both loans up to 30 mio CZK and over 30 mio CZK are found to becointegrated for the entire period. This is not surprising given that these loans also exhibitedthe highest pass-through. In the absence of cointegration, a first differenced ARDL modelwas employed.

The monetary policy approach analyzes the pass-through from the policy rate to bank rates,while the cost of funds examines at the pass-through from market rates to bank rates. Out ofthe two methods employed, the monetary approach has yielded most consistent results,showing that banks price their products in accordance to the policy rate.

By analyzing separately the periods before August 2008 and afterwards, the impact of thecrisis on the pass-through can be identified. Furthermore, a rolling regression method was

-0,2

0

0,2

0,4

0,6

0,8

1

1,2

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Overdrafts - ARDL

-0,5

0

0,5

1

1,5

2004-

2008

2005-

2009

2006-

2010

2007-

2011

2008-

2012

2009-

2013

2010-

2014

Loans over 30 mio CZK - ECM


34/59

33

also used in order to examine the impact of the crisis in a gradual manner and detect theexistence structural breaks endogenously.

For the period before 2009, the pass-through to money market rates was complete for moneymarket rates and varied between 60% and 80% for government bond yields. Overnight andredeemable at notice deposits had a low pass-through between 8% and 17% for households

and 30% and 50% for non-financial corporations. Agreed maturity deposits for non-financialcorporations and households had a pass-through of around 80%.

Since the onset of the crisis, the pass-through to money market rates has decreased, butremained significant, stabilizing around 60%, showing that interbank money market rates arestill influenced by the decisions of the Central Bank. With the exception of householddeposits redeemable at notice over 3 months, the long run pass-through for overnight andredeemable at notice deposits has become insignificant over the past two years. On the otherhand, the pass-through for agreed maturity deposits strengthened in the aftermath of thecrisis, as can be seen from the table below. Since June 2012 as the policy rate approached

the 0,05% level, the pass-through slumped, becoming insignificant for households and 60%for non-financial corporations While the pass-through was slightly weakened during themarket unrest of 2008, the impact of the policy rate to influence deposit rates hasconsiderably deteriorated since it has approached the zero lower bound.

HouseholdsNon-financial

corporations

DepositsPre

breakPost

breakPre

breakPost

break

Overnight0.16** 0.13** 0.07 -0.03

-(0.07) -(0.04) (0.11) (0.33)Agreed maturity upto 1 year

0.49** 0.68**0.5** 0.98**

(0.16) -(0.23)

Agreed maturity over1 year

0.25 -0.30(0.17) -(0.06)

(0.42) -(0.28)

Redeemable at notice- up to 3 months

0.08 -0.010.57** 0.26

(0.05) (0.02)

Redeemable at notice- Over 3 months

0.26** 0.04-(0.15) (0.24)

-(0.05) -(0.06)

For households, mortgages make up the majority of outstanding amounts and are the onlyloans which exhibited a significant pass-through before the crisis. Loans and overdrafts fornon-financial corporations showed a full pass-through for floating rates and almost full pass-through for fixed rates until 2009. Since 2009, the pass-through has become insignificant formortgages and fixed rate loans up to 30 mio CZK. The pass-through for larger loans andfloating rate loans up to 30 mio CZK has remained significant, but greatly reduced.


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Loans Pre break Post break

Mortgage - Floating rate and up to1 year rate fixation

0.69** -(0.18)-(0.25) (0.15)

Mortgage - Over 1 year ratefixation

0.65** -(0.04)-(0.16) -(0.08)

Loans up to 30 mio CZK -Floating rate and up to 1 year ratefixation

1.14** 0.25**-(0.31) -(0.11)

Loans up to 30 mio CZK - Over 1year rate fixation-

0.8** (0.06)-(0.16) -(0.23)

Loans over 30 mio CZK 0.82** 0.67**-(0.10) -(0.20)

Based on the tables above, there is a large degree of heterogeneity in how the pass-throughhas evolved over the past years. Loans for households and small business were impacted themost by the crisis, while loans for larger businesses were impacted only later on. Since the

policy rate has approached the zero lower bound, there have been other factors drivinginterest rates for loans and deposits. Regarding deposits, banks have sought to secure longterm funding, therefore they have not decreased rates for long term deposits with the policyrate. Regarding loans, concerns for the solvency of the borrowers and the slow lendinggrowth, have made banks increase their markup over funding costs in order to preserveprofitability. Thus, interest rates for loans have not fallen since June 2012, even though theCzech National Bank has cut the policy rate by 0,7% since then.

As the economy recovers and loan growth picks up, the pass-through is expected to improveas the policy rate moves above the zero lower bound and banks transfer additional funding

costs to their customers. Until then, the Czech National Bank must look beyond traditionalinstruments such as the policy rate, in order to influence the economy.


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Bibliography

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Beckmann, J., et al. (2013). "Interest Rate Pass-Through and Banking Crises."

Bernanke, B. S. and A. S. Blinder (1992). "The federal funds rate and the channels of monetarytransmission." American economic review 82(4): 901-921.

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CNB (2013). Financial stability report 2012/2013, Czech National Bank, Research Department.

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Gertler, M. and S. Gilchrist (1994). "Monetary policy, business cycles, and the behavior of smallmanufacturing firms." The Quarterly Journal of Economics 109(2): 309-340.

Horvth, R. and A. Podpiera (2012). "Heterogeneity in bank pricing policies: The Czechevidence." Economic Systems 36(1): 87-108.

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