The European Central Bank (ECB)’s January release includes data on composite lending and deposit rates for November 2020, both of which continue to fall by small margins. These rates along, with ECB’s own lending and deposit rates, reveal a challenging balancing act. Central banks reduce their official rates to partially stimulate the economy through transmission mechanisms to commercial lending rates. However, this transmission mechanism works within thresholds; if it goes over the thresholds it could erode commercial bank profitability, endangering economic recovery/stability. Commercial lending rates can be reduced up to the point they sufficiently cover costs — the deposit rates — which, in turn, could be lowered, but up to a non-negative floor (no one is willing to pay banks to keep their money).
In other words, there is a limit to how far central banks can lower official rates to stimulate the economy without hurting commercial bank profitability; that limit is governed by the lending-deposit spread. The chart indicates that ECB has probably reached that limit. Its refinancing rate has effectively been stuck at zero for more than four years, while its deposit rate has been at -0.5 per cent since late 2019. Against this backdrop, the composite lending and deposit rates have been falling since 2014, maintaining, however, a spread marginally above one basis point even during 2020. Additionally, the commercial deposit rate is so low (0.19 per cent in November 2020), that any further cuts in ECB’s deposit rate would probably not be transmitted by banks. In fact, the ECB’s official rates are probably as low as they can be without undermining the required lending-deposit spread that is necessary to avoid hurting bank profitability.
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