Lessons from low interest rate policy: How did euro area banks respond?

Abstract

This paper studies the impact of the Eurosystem’s low interest rate policy on euro area banks. We first assess the impact of low rates on banks’ net interest margins. An important extension to previous studies is that we split the interest margin into a funding and lending component. The decomposition makes clear that the low interest rate environment significantly reduced banks’ net interest income by squeezing funding margins, which corroborates the reversal rate literature. We find no strong evidence that banks have boosted their lending margins to offset the lost funding margin. However, we do observe that banks partly compensated for the impact of low rates by switching to non-interest income sources and by cost savings. We also find that low interest rates have not reduced bank lending, which suggests that banks’ compensatory measures largely outweighed the impact of low rates.