Imperfect competition in banking markets, rate dynamics, and incomplete pass through

            There is a significant body of work that estimates the magnitude of the pass through from market interest rates to retail bank deposit and loan rates. At the aggregate level, changes in retail deposit rates influence the nonbank public’s holdings of various components of the monetary aggregates.  Thus, an accurate and stable connection between market and retail interest rates is required for an efficient monetary policy, irrespective of whether the operating procedure targets the monetary aggregates or market interest rates.  Empirical findings vary widely across countries, institutional types within countries, and the time periods over which the estimations are conducted.   One finding, however, is common to virtually every study:  the pass through from market rates to bank loan and deposit rates is sluggish and incomplete.  In nearly every country examined, changes in market rates are not fully reflected in contemporaneous bank loan and deposit rates.   Although the latest research finds evidence of slightly increased interest rate pass through to bank retail rates in some countries, cross-country variations still remain very wide. 

            The relationship between deposit rates and other market interest rates is difficult to reconcile in terms of standard banking models without appealing to imperfect competition.  In addition, the sluggish adjustment of bank balance sheets has been recognized for some time.   Nevertheless, no theoretical model has combined these two factors.  Our paper fills this gap by providing a dynamic model of imperfectly competitive retail loan and deposit markets in which rival banks face intertemporal costs when adjusting both loans and deposits.  As is typical in analyses containing adjustment costs, we find that both lagged and expected future values of the model’s variables will affect the contemporaneous desired quantities of bank deposit supply and loan demand.  Assuming standard loan supply and deposit demand functions for the non-bank public, we also find that in imperfectly competitive markets, contemporaneous bank retail deposit and loan rates generally depend on their own lagged values, and on the lagged, current, and expected future values of the market security rate.  

            Most importantly, we show that each of the determinants of the retail rates is directly connected to the competitive structure of the retail markets.  As the extent of competition increases, the size of the impacts of the lagged retail and market rates and expected future market interest rate on the contemporaneous retail rates decreases, while the magnitude of the pass-through effect from the current market security rate to the current retail rate increases.  Pass through from the security rate to retail rates is not one-to-one, but depends on elements such as the elasticities of the non-bank public’s loan supply and deposit demand functions as well as bank cost parameters.  Nevertheless, relative to imperfectly competitive markets, the extent of pass through from market rates to retail rates is maximized at the competitive limit.