 If I asked you how the ECB's monetary policy decisions reach the economy, you might well say through banks. And you'd mostly be right. Banks are indeed one of the main channels through which our monetary policy is passed on to the economy. Plus, it's where many people like you and me feel the changes to monetary policy through the rates for loans and savings. Welcome to the ECB Podcast Summer School, helping you understand what's going on in the economy and central banking. My name is Katie Ranger. Banks aren't doing all the work when it comes to what we call monetary policy transmission. Financial markets are key players and some funds and insurers are also becoming more important as providers of loans and financial services. But here in the Euro area, banks play a particularly important role. That's because our capital markets are less developed than in, say, the US, meaning that those looking for funding are much more likely to turn to banks to find it. Explaining today's topic for us is ECB Chief Economist and Professor Philip R. Lane. Good to see you again, Philip, for the last episode of our Summer School mini-series. It's my pleasure to be here. Now we want to zoom in on exactly how banks pass on our monetary policy decisions to you, to me, and to the rest of the economy, and the important role that they play in helping us to get inflation back down to our target of 2%. So Philip, how exactly does it work? How do banks pass on the changes to our key interest rates? So that's a many layered question. So let me tackle it in a couple of ways. Number one, I think everyone listening understands that they do not have a direct relationship with the ECB. If you as an individual knock on our door, we're not going to open up a deposit account and we're not going to offer you a loan. So as you say, most firms and households in Europe primarily rely on their bank if they want to save or to borrow. You raise deep questions about the role of the wider financial system, whether it's insurance companies, pension funds, mutual funds, other type of market activity, which has grown in Europe, but remains relatively limited compared to the US. So let's take the case where a firm or an individual really has mostly the option if they want to save or to borrow to go to their bank. So then the big question is, how do banks determine what is the interest rate they're going to charge and a loan? And then equally, what is the interest rate they're going to offer on a deposit? And then let me trace that back to us at the ECB. So at ECB, when we raise interest rates, we are basically raising the rates at which banks can deposit money with us or lend money from us. So the ECB is a central bank, and it's called a central bank because our customers are banks, our kind of parties are banks. So if we take the deposit rate, the rate at which they can receive income on a deposit with us, when we raise the deposit rate, it means that it puts a floor on the rates more generally in the economy because a bank, if you like, always has a choice. Well, if I cannot earn more on a loan to a firm, I can always put money on deposit at ECB. So it puts a floor on the rate at which it will lend to a firm or a household, and that floor is very important. Now, you might say, why can't they just charge me the exact same rate that they receive from the ECB? I've always wondered that. And the basic answer is twofold. One is a cost to run a bank. They need to add a kind of margin for running costs. So whether that's the technology to fund the apps we all use these days, whether it's the cost of running a branch network, the cost of regulation because we do that to fight terrorism and money laundering, banks also have to spend a lot of money on what's called know your customer. So all of the regulatory elements from that. So there's a lot of administration there. So one element is there's going to be basically an administration cost extra amount added on top. And then there's also going to be a risk factor because it's not the case everyone pays back their bank loan. Firms sometimes fail. Sometimes individuals get into a problematic situation and don't pay back their mortgage. So banks have to add a risk margin as well. So the rate facing you when you walk into a bank or you phone up or you do an online chat, it's going to be a mix of the costs coming from us in terms of like the wholesale cost of finance and then all of these margins. Let me emphasize also it is in terms of the the overall cost to a bank of making a loan to you. Partly they can borrow from us and they also heavily rely on deposits from customers and then also they have kind of various market type funding that they may issue a bond in the bond marketer. And so the overall cost of finance depends on the rates they have to offer depositors. It depends on the bond market rate and these other sources of funding. So this is why it's not straightforward to see the connection between the ECB rate and the rate offered on bank loans. But this has been a long running topic. Okay so many of us have indeed seen banks pass on higher interest rates quickly when it came to making loans more expensive but not so quickly for the interest we receive on our savings. So what have we seen? Have banks passed on our key interest rate changes this last year? So we know quite a bit about history and what we see now is basically in line with historical evidence. What's happened? They've raised their lending rates quite a bit you know quite sharply and in terms of the rates they offer in deposits let me make a very sharp distinction between two types of deposits. One is if you like the what we call the overnight rate. So everyone who has a bank account will have a current account this is the rate at which the account at which you debit money on your debit card or you add money from your paycheck whatever. On those overnight accounts very little interest is offered but that's always true because essentially people have these accounts not necessarily to save money but just to run their life all the transactions. Now when interest rates were super low maybe people did use these overnight accounts just also to save because what else were they going to do? So what's happened now is essentially banks have raised the deposit rate quite a bit on what's called a time deposits. If you agree to commit your money for a year for six months for two years for five years then the interest rate on those deposits it didn't happen immediately but over time these have gone up and they're not too far away on average to the ECB rate. So this is where you park your money essentially for a certain amount of time and you get a higher rate than if you're just leaving it in your savings account and have access to it all the time essentially. Exactly so this is if you like a return to some normal pattern if you go back to the 1990s when I was a student you know I do recall at that point people would make the effort because they say why would I leave money in my current account when I can get some interest in my saving account and people have essentially over the last year have relearned this at least those who have enough money where it makes a difference. So this is where I think it is happening it's not happening to the same degree across all of the European countries because clearly banks will raise the deposit rates more quickly if they face competitive pressure and also if they're in an economy where there's a big demand for loans so that they want to raise funding in order to provide credit. So in those European economies where there's less demand for loans or where there's less competition it's happened less but the basic economics is it takes time but eventually banks will raise their lending rate which happened quite quickly and will raise their deposit rates but let me emphasize mostly only on those time deposits where the customer does not have if you like instant access you do have to accept that you can't have it both ways if you want instant access you're not going to earn much if any interest if you are no you have the kind of flexibility to put some of your money away for a year two years whatever then you are starting to see visible interest rates again. Let's zoom out to look at how banks affect the economy in particular what we call the real economy so this is the part that produces goods and services so big manufacturers but also the bakery around the corner or my hairdresser the real economy is crucial to the euro areas economic activity and growth so how has the behavior of banks during our interest rate hikes affected the real economy what have we seen there? So again we're one year into this hiking cycle what we've seen is essentially the level of lending has really come down quite quickly and that's a mix of two factors one with high interest rates firms and houses are less interested in taking a loan so one way operates is that loan demand is lower and the other way it operates is that loan supply and it goes back to what we talked about earlier on it is banks become more cautious if they see that essentially risk has gone up because we're high interest rates and with a slowing economy the probability of a firm or household running into trouble it doesn't you know dramatically shoot up but not just up so they are going to be more careful saying well I don't want to make too many loans because some of these loans may turn bad so we see all of that okay where does this matter I think one issue where we would be tracking quite carefully is investment so firms may be tempted to say well you know this year I'm not going to invest for the future because it's too expensive and then over time if there's a lack of investment it reduces the growth capability of the economy so in the near term it means less demand for investment goods so many firms in Europe are there to support investment they're making capital goods that they're advising architects you know project managers there's many people whose job it is to support investment so less investment uh you're going to see it I think we're seeing it also in basic consumption is is is flat consumption is not growing even though incomes are growing so these are things like people buying fridges or yeah so I mean I think in there's a hierarchy it's less activity in the housing market and then it has the knock on effects if this fewer houses being sold then fewer people who are visiting furniture shops you know washing machines all of that so we do think that that's quite visible right now let me emphasize whoever and this is so important to appreciate it is we do think that there's a very fundamental reason why this process is working but in a relatively stable manner because another byproduct of the pandemic was that people did have a period when they were consuming very little so they did save more than normal and these pandemic savings allowed them to reduce their debt allowed them to maybe build up a nest for example a mutual fund or something like that so it does mean if a house gets into trouble they maybe have more buffers and they don't necessarily get get into a bad loan situation so quickly also for firms I mean for firms it differs quite a bit across sectors but many firms were were supported by their governments during the pandemic and then more recently many firms as we talked about in another episode have been making money have been making good profits so there's also if you like the kind of what we think is this will help reduce the amount help cool inflation but will not produce the kind of deep recession we had in Europe 15 years ago and so this is this is a I think very important distinction because people are very nervous when they hear kind of phrases about tightening kind of depressing demand dampening demand and what we're trying to do is do enough that we do make sure inflation comes back to target but we don't see the conditions right now because you usually need this kind of toxic mix where firms are already weak customers are already weak but but you know I think many people are in okay shape so they will respond to high interest rates by reducing demand but we don't think it'll lead into this kind of vortex that leads to a deep recession if we look specifically at economic activity you just mentioned that we're not looking to to have a recession here in Europe the economy is however weak right now and it is expected to recover but only kind of over time do you see that as an issue what does it mean if activity stagnates I mean not a recession but it stagnates well that's not overly focused on on the issue the technical issue of recession because I think we've always said for months now that that you know whether the economy is a little bit above zero a little bit below zero it's not the fundamental issue what I thought about is what's very damaging is a deep and sustained recession so we don't see that and what we do see is compared to where we were last year there's a lot of reasons to believe the European economy will grow over the next couple of years one basically is it remains the case there's still a recovery from the pandemic there's a bounce back we're well below the level of the economy we might have expected if the pandemic had not happened and if you like that that kind of trend line we would expect to reemerge over time we would expect energy price has been a lot lower now that's not fully been arrived in people's utility bills yet but over time lower energy bills will help and now we are seeing wages go up so as wages go up the kind of very difficult situation at the end of last year where inflation was sky high and yet wages were had not gone up over time households should be in a better financial position so there are a number of reasons to believe that the European economy will grow over the next couple of years and the trick for us is basically to make sure demand does not add on supply so it's not a question of having a driving a demand deeply negative it just has to grow more slowly than supply okay well as you know Philip we we always ask our guests to share a tip maybe a book a film a story with our listeners on the topic that we've been talking about today so banks what would you have to share with our listeners today so let me advertise work by some of our colleagues at the Bank of England so I think there's a very nice book which is I think should be of interest to to to many people and the title of the book is called can't we just print more money economics intense simple questions by Rupal Patel and Jack Meening and this book I think is a fantastic explainer of many of the concepts we've been talking about I can only agree it's a fantastic book and I really recommend that everyone reads it as you do well that brings us to the end of this episode I want to thank ECB chief economist Philip Arlene for taking us through the role banks have in passing on our monetary policy and for being our guest on these three summer school episodes if you found them useful please subscribe and leave us a review and be sure to check out the show notes for more on this topic you've been listening to the ECB podcast summer school with Katie Ranger this is my last episode before I hand over the mic for a little while so today I'm signing off with an especially big thanks for listening