INTEREST RATE PASS-THROUGH IN COLOMBIA: A MICRO-BANKING PERSPECTIVE* Rocío Betancourt Hernando Vargas Norberto Rodríguez**

Transcription

1 INTEREST RATE PASS-THROUGH IN COOMBIA: A MICRO-BANKING PERSPECTIVE* Rocío Beancour Hernando Vargas Norbero Rodríguez** Bogoá, Sepember 2006 *The opinions expressed in his paper are hose of he auhors and do no represen he views of he Banco de la República or of is Board of irecors. **Assisan o he epuy Governor, epuy Governor and Economerician of he Macro Modelling eparmen of Banco de la República, respecively. Corresponding auhor: Rocío Beancour, ybeanga@banrep.gov.co.

2 INTEREST RATE PASS-THROUGH IN COOMBIA: A MICRO-BANKING PERSPECTIVE Absrac Banks and oher credi insiuions are key players in he ransmission of moneary policy, especially in emerging marke economies, where he responses of deposi and loan ineres raes o shifs in policy raes are among he mos imporan channels. This pass-hrough depends on he condiions prevailing in he loan and deposi markes, which are, in urn, affeced by macroeconomic facors. Hence, when seing heir policy, moneary auhoriies mus ake ino accoun hose condiions and he behavior of banks. This paper illusraes his poin by means of a heoreical micro-banking model and shows empirical evidence for Colombia suggesing ha some aspecs of he model migh be relevan feaures of he ransmission mechanism. Keywords: Moneary Transmission Mechanisms, Ineres Rae Pass-Through, Banking JE Classificaion: G21, E43, E44, E52 1

3 1. Inroducion In some economies banks and oher financial insiuions play a key role in he expendiure decisions of firms and households. They are among he mos imporan alernaives of funding and means of saving. As such, banks and bank behavior are criical componens of he ransmission mechanism of moneary policy. In paricular, he ineres rae channel of moneary policy, which operaes when banks ransmi he changes in he moneary policy rae o heir cusomers ineres raes, depends on he banks reacion o differen shocks and o he sae of he economy. Hence, when seing heir policy, moneary auhoriies should ake ino accoun banks behavior under differen economic condiions. This paper illusraes he idea ha he response of marke ineres raes o changes in he policy ineres rae depends on he reacion of banks and financial markes o differen shocks hiing he economy. For ha purpose, a heoreical microeconomic model of he banking firm and he credi and deposis markes is used. We also presen some evidence for he Colombian economy. The paper is organized as follows. A brief review of he lieraure is given in secion 2. A discussion abou he imporance of he banking sysem and ineres rae pass-hrough in Colombia is presened in secion 3. A heoreical model of he banking firm and he financial markes equilibrium is developed in secion 4. This model includes he effecs of moneary policy and oher macroeconomic condiions. The model is hen used o inerpre some episodes of ineres rae ransmission in Colombia. In secion 5, some economeric evidence is shown. Finally, in secion 6 we discuss he imporance for he Cenral Bank o undersand he role of banks and financial markes behavior in he ineres rae passhrough. We do so by means of numerical simulaions of a small-open economy macro model which includes a simple version of our micro-banking model. 2. ieraure Review The lieraure has idenified differen ransmission mechanisms of moneary policy such as he ineres rae channel, he credi channel and he exchange rae channel among ohers 1. The imporance of he banking secor in he ransmission of ineres raes has been recenly recognized in he lieraure on he ineres rae channel 2. A he same ime, he credi channel has focused on he agency problems ha arise beween financial insiuions, paricularly banks, and he agens o which hey lend (Bernanke and Gerler, 1995) 3. Therefore, he credi channel is now considered as a se of facors ha amplify and propagae he effecs of he ineres rae channel hrough heir impac on lending raes and oher ineres rae spreads. 1 See oayza and Schmid-Hebbel (2002) for an overview abou he ransmission mechanisms. 2 The imporance of he banking secor in he ineres rae pass-hrough is heoreically sudied by Hannan and Berger (1991) and empirically assessed by Coarelli and Kourelis (1994). For an overview of he banking indusry and moneary policy lieraure see Ahumada and Fuenes (2004). 3 In conras o he classical monearis view ha emphasizes he role of narrow and broad moneary aggregaes in deermining prices. 2

4 The banking secor has been incorporaed in his lieraure, focusing mainly on he financial srucure and informaion asymmeries 4. These wo elemens clearly influence he behavior of banks and help explain why lending and deposi raes may show a limied response o changes in he moneary policy rae. From Hannan and Berger (1991) and Coarelli and Kourelis (1994), he sickiness of bank lending ineres raes afer a change in he money marke raes has been explained by differen feaures of he financial srucure. Empirical sudies, like Bersein and Fuenes (2003) and Ko (2004) have found some degree of rigidiy of ineres raes in he shor run and higher long-run ineres rae pass-hrough coefficiens. The degree of compeiion in he banking secor, he size of he bank, he ypes of cusomers and he loan risk level, among oher financial feaures, have been found as he main deerminans of ineres rae flexibiliy 5. Furhermore, depending on he counry and also on he mauriy of he ineres raes, hey may respond less han one-for-one o policy raes, so ha he pass-hrough is incomplee a leas in he shor run (e.g. e Bond, 2005). The macroeconomic implicaions of an incomplee long-run pass-hrough from policy o bank ineres raes are analyzed by Kwapil and Scharler (2005), who found ha, under hese condiions, he Taylor Principle can be insufficien for equilibrium deerminacy 6. On a wider perspecive, financial srucure may influence ineres rae pass-hrough by affecing he response of he financial markes o macroeconomic condiions. In paricular, a macroeconomic shock may impac marke ineres raes direcly and in addiion o he response of he policy rae o he shock. In his sense, no only marke raes may reac wih a delay o movemens in policy raes, bu also hey may reac more, less, or simply no reac a all in he shor run. As a resul, he esimaion of ineres rae pass-hrough mus conrol for he direc impac of oher macro variables on marke raes. This paper presens he laer ideas in some deail and explores he evidence of heir relevance in he Colombian daa. 3. The Transmission of he Ineres Raes in Colombia Sudies for Colombia have found ha, alhough here is a long-erm relaionship beween policy and bank ineres raes, ineres rae pass-hrough is incomplee. Some of hese sudies have also documened he imporance of he banking secor in Colombia and have suggesed is significance in he ransmission of ineres raes. 4 Coarelli and Kourelis (1994) consider he financial srucure as a erm ha broadly includes differen feaures such as he degree of developmen of financial markes, he degree of compeiion wihin he banking sysem, he exisence of consrains on capial movemens and he ownership srucure of he financial inermediaries. 5 According o Coarelli and Kourelis (1994) ineres rae sickiness means ha in he presence of a change of money marke raes, bank raes change by a smaller amoun in he shor run (shor-run sickiness) and possibly also in he long run (long-run sickiness). 6 This principle saes ha nominal ineres raes have o respond a leas one-for-one o changes in he expeced inflaion rae o guaranee a sable and unique equilibrium. 3

5 Julio (2001) found a sable long-erm relaionship beween he ineres raes in Colombia using coinegraion for wo periods, before and afer he removal of he exchange rae band. Hueras e al. (2005) used descripive saisics 7 o esimae ha a 1% change in he moneary policy rae implies a change of 0.26% in he 90-day Cs rae in he shor-run and a change of 0.6% in he long run 8. In addiion, using VAR models hey found ha commercial shor erm, lending raes reac one-for-one o he deposi rae, while he shorrun pass-hrough is jus 42% for he preferenial shor erm, lending rae. Hueras e al. (2005) show ha bank credi was he mos imporan source of funds for firms beween 2000 and However hey sugges ha he raher low ransmission of he moneary policy ineres rae o marke ineres raes can be explained by a loss in he effeciveness of he credi channel. They aribued his o he increase of banks holdings of Governmen bonds as an alernaive o loans 10, and o he declining share of bank loans as a source of funds for firms during he period ( ). This is in agreemen wih he resuls of Zamudio and Marinez (2006), who found ha firms decreased heir deb wih he financial secor in 2005 and inernal savings were heir main source of funds (52% in conras o 48% of exernal resources) 11. These resuls show ha he imporance of subsiues for loans in banks and firms balance shees has increased. However, his change may reflec he adjusmen made by agens afer he financial crisis and he recession of , and no necessarily a srucural change. A reducion of he loan supply migh have been due o he higher risk percepion of he economy by he financial sysem afer he crisis, and a decrease in loan demand could have occurred because of an explici policy of leverage reducion by firms and households. Bank loans and deposis remain an imporan componen of privae secor liabiliies and asses, according o he flow of funds accouns. Financial deb funded on average 42% of he households and small firms oal asses during he period This figure is 18% for financial-saemen-reporing firms in he same period. This proporion fell afer he recession, bu has recovered in recen years (Graph 1). Furher, he proporion of small firms and households asses held as deposis in he financial sysem was on average 42% of heir oal asses for he same period 12. This evidence suggess ha he banking secor plays a relevan role as a provider of funds and as a deposi sysem for he privae secor in he Colombian economy 13. Hence, a 7 The auhors also use VAR models in differences in order o see he impac of he inerbank ineres rae on he 90-day Cs ineres rae (TF). 8 The shor run corresponds o one week and he long-run elasiciy was calculaed as an average of he change in he ineres raes beween movemens in policy raes during he period from March 2001 o ecember The auhors analyzed a sample of financial-saemen-reporing firms. 10 According o he auhors he proporion of he privae credi on he banks oal asses was 85% in 1994 and 65% in 2004, while he banks public invesmens as a proporion of he oal asses increased from 7% o 27% during he same period. 11 The sample analyzed includes firms ha repored heir financial saemens during This proporion is 50% if pensions are no aken ino accoun. 13 According o Villar,. e al. (2005), in 2001 he domesic privae credi/gp raio (a measure of financial deepening) was 25% for Colombia, similar o he raios for Argenina, Perú and Ecuador. This indicaor was 65% for Chile, 97% for Thailand, 125% for China and 150% for Malaysia. 4

6 complee analysis of he moneary ransmission channels and ineres rae pass-hrough mus ake ino accoun bank behavior and he equilibrium in he loan and deposi markes. Graph 1. Privae Secor Financial eb/ Toal Asses 60% 50% Firms Households 40% 30% 20% 10% 0% Source: Banco de la República 4. A Micro-Banking Model Recenly, microeconomic models of banks behavior have been used o explain he role of financial srucure in he ransmission of ineres raes. Bersein and Fuenes (2003) presen a Moni-Klein model o explain he long run behavior of he banks under imperfec compeiion, aking ino accoun he exisence of credi risk. By using disaggregaed daa for differen banks, hey find ha banks characerisics oher han he indusrial organizaion can influence he degree of delay in he marke ineres rae response o changes in he policy rae. Ko (2004) uses a similar microeconomic approach o assess he impac of he degree of compeiion in he credi marke on he ineres raes pass-hrough. Amaya (2005) found empirical evidence for Colombia of he imporance of banks characerisics and inflaion as long-run drivers of he marke ineres raes in a compeiive seing. Following his srand of he lieraure, a parial equilibrium model is used in order o explain he ransmission of ineres raes under a perfecly compeiive srucure of he banking secor. From his model wo main resuls are obained. Firs, some macroeconomic variables apar from he policy rae are imporan deerminans of equilibrium marke ineres raes. Second, he relaionship beween policy and marke ineres raes may no be one-for-one and possibly no even linear. 5

7 4.1. Assumpions Following Freixas and Roche (1997) we consider a micro-banking model which allows for he exisence of liquidiy risk. This risk appears when here is an insufficien amoun of reserves o serve he oal amoun of wihdrawals made by he deposiors. We assume ha he level of reserves chosen by banks and he amoun of wihdrawals made ~ by agens depend on he level of deposis, so R = r and X = ~ x where 0 r 1 and x% [ 0,1]. This implies ha he maximum amoun of wihdrawals is equal o he oal amoun of deposis 14 and ha when x % ( r,1], banks have o borrow he shorfall from he ( ) Cenral Bank, incurring a cos (, ) max 0, % I r = r p Ε x r, where r p is he policy ineres rae. Furher, we assume ha he proporion of wihdrawals follows a uniform disribuion beween 0 and 1, so ha ~ x ~ U ( 0,1) and I (,r )= r p ( 2 1 r ) 2. Addiionally, o undersand how credi risk affecs he compeiive pricing of loans, we inroduce a simple approach in which banks can recover only a fracion δ of he loans graned ( ). The recovered proporion depends posiively on he economic condiions of agens, measured by he income (Y ) 15, and negaively on he loan ineres rae ( r ) 16. Therefore, only a proporion δ ( Yr, ) of he loans are paid back and only on his porion agens pay ineres. Thus, each bank has a ne revenue given by rδ Y, r 1 δ Y, r. ( ) ( ( )) Since banking aciviy is modeled as he producion of deposi and loan services, he echnology is represened by a cos funcion C(, ) ha can be inerpreed as he cos of managing a volume of deposis and a volume of loans. The cos funcion is he same for all banks 17. Moreover, i can be assumed wihou loss of generaliy ha coss are separable (cross-effecs are zero), which means ha we don ake ino accoun he exisence of economies of scope in he join producion of loans and deposis. Finally, we incorporae banks holdings of governmen domesic bonds as an imporan decision variable, given ha hey have increased rapidly in Colombia since Thus, banks can inves in his riskless bu illiquid asse (T ), wih reurn r T. 14 In conras o Freixas and Roche (1997), here are no addiional deposis. 15 If firms and households have good economic condiions hey can repay heir loans wih higher probabiliy. 16 This can be inerpreed in wo ways. Firs an increase in he loan ineres rae implies a higher cos of resources for agens, causing a higher probabiliy of defaul. The second inerpreaion follows Sigliz and Weiss (1981) credi raioning argumen, according o which an increase in he loan ineres rae changes he risk of he populaion, eiher because agens ake more risky projecs or because less risky firms drop ou of he marke. 17 This funcion is supposed o saisfy he usual condiions of convexiy and regulariy. 6

8 4.2. The Bank s Problem Assuming a given banking echnology, we examine he behavior of his secor under a perfecly compeiive srucure, where here are N risk-neural banks ha are price akers 18. Each bank chooses he volumes of deposis ( ), loans ( ), reserves ( R ) and governmen securiies ( T ) ha maximize profis subjec o he balance shee consrain: () ( ) ( ) ( ) ( ) Max π = rδ. + rtt r 1 δ. I, r C, TR,,, R= T R = r r p s.. I(, r) = ( 1 r) δ 1 0 r 1 This problem can be rewrien as follows: r Max π = rδ r T + rtt r δ r T 2 r C r T T,, r 0 δ 1 s.. 0 r 1 p 2 (). ( 1 ) ( 1 (). ) ( 1 ) ( 1 ) (,( 1 ) ) where bank s profis are he revenues on asses (loans and governmen securiies 19 ) minus he ineres paid on he liabiliies (deposis), he coss from credi and liquidiy risks, and he operaional coss. Profi maximizing behavior for each bank is characerized by he following firs order condiions: rp ' ' r = ( 1 r) δ (.)( 1+ r) 1 ( 1 r) C C (1) 2 ' ()(. 1 ) 1 r = δ + r C (2) T 18 They ake as given he rae of loans, r, he rae of deposis, r, he reurn on governmen securiies, r T, and he policy rae, r p. 19 We assume ha reserves do no have any reurn because we do no ake ino accoun he inerbank marke. I means ha banks keep in cash heir reserves and ha hey borrow only from he Cenral Bank a a cos r p. 7

9 ' ()(. 1 r ) 1 C δ + r = 1 (3) r From equaions (1) and (3) we obain: p r ()( r ) 2 ' δ. 1+ C 1 ' = C (4) 2r p ' ' where C and C are he managemen marginal coss of loans and deposis, respecively. As in Freixas and Roche (1997) and o simplify our analysis, hese coss are assumed o be ' ' consan, so C = γ and C = γ. Equaion (1) implies ha a compeiive bank chooses he opimal amoun of deposis in such a way ha he marginal ne revenue (aking ino accoun he credi risk) 20, ( 1 r) δ (.)( 1+ r) 1 r, mus equal he marginal cos, which corresponds o he illiquidiy and he managemen coss 21 rp, ( 1 r) ( 1 r) + γ + γ. 2 Equaion (2) saes ha he marginal revenue on governmen bonds, r T, mus equal heir marginal opporuniy cos (of no lending o privae agens, aking ino accoun he credi risk), δ ()(. 1+ r ) 1 γ. Finally, from equaion (3), he opimal level of reserves depends on heir opporuniy cos (of no lending hese resources o privae agens), relaive o he δ (.)( 1+ r) 1 γ savings from no having o borrow hem from he Cenral Bank,. r 4.3. Equilibrium in he eposi and Credi Markes In order o close he model and find he equilibrium marke raes, we pu ogeher he balance shees of he banks and he equilibrium condiions for he eposi and Credi markes. The compeiive equilibrium is characerized hen by equaions (1)-(3) and he following condiions: s * = r, r, r, Y (5) ( T ) * (,, ) d * b(,, T, ) d r r Y = (6) s T T T r r r Y = (7) ( 1 ) r = + T (8) p 20 This ne income becomes from he possibiliy of lend a proporion ( ) 1 r of he deposis and pay ineres on he oal amoun of deposis. I is necessary o ake ino accoun ha here is a credi risk ha no allows recovering all he loans graned and only a proporion of hem pay ineress. 21 The illiquidiy and he loan managemen coss depend on he proporion of deposis graned in loans. 8

10 where: * (,, T, ) s r r r Y is he oal supply of deposis by he non-financial agens, which depends posiively on he domesic deposi ineres rae and income, and negaively on he foreign deposi ineres rae and he reurn on governmen securiies. I is assumed ha hese wo ypes of asses are imperfec subsiues of domesic deposis. d * (,, ) r r Y is he loan demand by he agens in he economy, ha depends negaively on he loan domesic ineres rae and posiively on he agens level of income. I also depends posiively on foreign loans ineres raes, which are assumed o be imperfec subsiues of domesic loans. T s d * is he exogenous supply of securiies by he governmen and T b( r, r, rt, Y) is he demand of hese securiies by oher agens in he economy. I depends posiively on he income and he own reurn, and negaively on he ineres rae paid by domesic and foreign deposis, considered as imperfec subsiues of hese securiies. Hence, in equilibrium: * * * (,, ) ( 1 ) (,, T, ) b(,, T, ) = + (9) d s S d r r Y r r r r Y T T r r r Y The equilibrium deposi and loan ineres raes are derived from equaions (1), (2), (3) and * * r = r r, r, r, T S, Y, γ, γ and (9), as implici funcions of he exogenous variables ( p c ) * * r (,,, S r rp rc r T, Y, γ, γ ) =. These funcions are poenially non-linear because hey depend on he funcional forms of he deposi supply and loan demand The Resuls The comparaive saics analysis of equaions (1)-(3) and (9) allows us o appreciae he effecs of shocks o he exogenous variables on deposi and loan ineres raes (see Appendix A for he deails). Resul 1: The effec of a shif in he moneary policy ineres rae, r p, on he equilibrium loan ineres rae is posiive. The effec of he same shif on he deposi ineres rae is ambiguous. An increase in he policy ineres rae makes he liquidiy shorage more cosly for banks. This has wo implicaions. On he one hand, banks have more incenives o keep a higher level of reserves, implying a decrease in banks loan supply or an increase in deposi demand. Hence, here is an upward pressure on loan and deposi ineres raes. On he oher hand, since he cos of illiquidiy depends on he amoun of deposis, he rise in policy raes 22 Also, hese funcions can be non-linear if he wihdrawals have a non-uniform probabiliy disribuion. 9

11 makes deposis more expensive and reduces banks demand for hem. This pushes deposi raes down. Resul 2: A change in he foreign ineres raes or he expecaions of depreciaion has a posiive effec on equilibrium loan and deposi ineres raes. If he foreign ineres raes or he expecaions of depreciaion rise, agens in he domesic economy perceive a higher cos of borrowing abroad, increasing heir demand for domesic loans. Thus, domesic loan ineres raes increase. The higher demand for loans makes banks raise heir deposi demand a he same ime ha agens reduce heir supply of deposis because foreign deposis are more aracive. Hence, deposi ineres raes also increase. Resul 3: The effec of a change in he income level on he equilibrium loan and deposi ineres raes is ambiguous. An increase in income raises deposi supply and loan demand, implying a decline in he deposi rae and an increase in he loan rae. In order o saisfy he higher demand for loans, banks increase heir demand for deposis, pushing deposi ineres raes up. Addiionally, given ha credi risk is reduced by he agens beer condiions (a higher proporion of loans will be recovered), banks have incenives o increase heir loan supply inducing a downward pressure on loan raes. As a resul, he effec of he shif in income on marke raes is ambiguous. Resul 4: An increase in he governmen securiies supply, T s, implies a rise in he equilibrium level of loan and deposi ineres raes. An addiional supply of governmen securiies compees wih loans in banks porfolios and wih deposis in he agens porfolios. This implies a reducion in he supply of deposis by firms and households, and a drop in he loan supply by commercial banks, increasing ineres raes. This effec is reinforced if banks increase heir demand for deposis o fund heir purchases of governmen securiies. Noice ha, in general, he response of marke ineres raes o he exogenous shocks may no be linear and could depend on macro variables affecing he elasiciies of he loan demand and he supply for deposis. In oher words, ha response is complex and may depend on he sae of he economy. Furhermore, i is possible ha a shock o an exogenous variable has an impac on ohers. For example, an increase in he foreign ineres rae may cause movemens in he policy rae, he expecaions of depreciaion and oupu. Hence, he observed response of marke raes o a shock may involve a reacion o movemens in several variables. As a corollary, we conclude ha here is a possibly complex relaionship beween policy and marke ineres raes. We also conclude ha ineres rae pass-hrough depends on he sae of he economy and ha is esimaion mus conrol for he presence of oher shocks hiing he financial markes. 10

12 4.5. Inerpreing Some Episodes of Ineres Rae Transmission in Colombia The foregoing model may be used o inerpre some episodes of ineres rae pass-hrough in Colombia. In paricular, we will focus on wo evens in which he behavior of marke raes markedly differed from he policy rae 23. Graph 2 shows ha, alhough here is a long run relaionship beween he marke and policy raes, here are differences in heir shor-run behavior. Two periods where hese differences are easily observed are January February 2001 and July May In hese periods marke and policy raes moved in differen direcions. Graph 2 % Nominal Ineres Raes in Colombia Policy ineres rae oan ineres rae M3 ineres rae 90-day deposi ineres rae TF Oc-99 Abr-00 Oc-00 Abr-01 Oc-01 Abr-02 Oc-02 Abr-03 Oc-03 Abr-04 Oc-04 Abr-05 Oc-05 Abr-06 Source: Banco de la República ifferenial beween marke and policy ineres raes Oc-99 Feb-00 Jun-00 Oc-00 Feb-01 Jun-01 Oc-01 Feb-02 Jun-02 Oc-02 Feb-03 Jun-03 Oc-03 Feb-04 Jun-04 Oc-04 Feb-05 Jun-05 Oc-05 Feb-06 Jun-06 oan minus policy rae TF minus policy rae M3 minus policy rae Source: Banco de la República 23 The policy rae corresponds o he ineres rae a which he Cenral Bank gives liquidiy o he marke by means of an aucion, which is called Subasa de Expansión. The marke ineres raes are he lending and deposi raes. The firs one is he average ineres rae for all ypes of loans weighed by heir volume. The second one can be measured by he TF, which corresponds o he weighed average of he ineres raes for he 90-day Cs, and by he M3 ineres rae, which corresponds o he weighed average of he ineres raes for differen ypes of deposis. 11

13 January 2000-February 2001: uring his period he moneary policy ineres rae was sable, while marke ineres raes were increasing 24. A he same ime, he real quaniies of loans and deposis in he financial sysem were going down. These facs sugges shifs of loan and deposi supplies larger han he shifs in heir respecive demands. This is he period immediaely afer a deep recession and a financial crisis characerized by a sharp deerioraion of loan qualiy. A he same ime, here was a large increase in he supply of Governmen domesic bonds. As a consequence, he banks risk percepions of he economy soared, heir holdings of Governmen securiies rose and loan supply dried. This implied a cu in he banks demand for deposis ha, however, was more han compensaed by he reducion in he supply ha followed he increase in counry risk, he rise in foreign ineres raes, he presence of a high depreciaion of he currency and he growing supply of Governmen domesic deb (Graph 3). Graph 3. oan Qualiy 11 Nominal Foreign Ineres Rae (US$) % Mar-98 Sep-98 Mar-99 Sep-99 Mar-00 Sep-00 Mar-01 Source: Banco de la República Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 % Oc-99 Feb-00 Jun-00 Oc-00 Feb-01 Source: aasream Jun-01 Oc-01 Feb-02 Jun-02 Oc-02 Feb-03 Jun-03 PRIME IBOR Oc-03 Feb-04 Jun-04 Oc-04 Feb-05 Governmen Securiies/Toal Financial Secor Asses % Ene-99 Jul-99 Ene-00 Jul-00 Ene-01 Jul-01 Ene-02 Jul-02 Jun-05 Ene-03 Oc-05 Jul-03 Ene-04 Jul-04 Ene-05 Feb-06 Jul-05 Jun-06 Ene-06 EMBI Colombia and Nominal epreciaion Anual epreciaion Embi Colombia Oc-99 Feb-00 Jun-00 Oc-00 Feb-01 Jun-01 Oc-01 Feb-02 Jun-02 Oc-02 Feb-03 Jun-03 Oc-03 Feb-04 Jun-04 Oc-04 Feb-05 Jun-05 Oc-05 Feb-06 Jun-06 Source: Banco de la República Source: Bloomberg and Banco de la República 24 In he beginning of he period marke ineres raes coninued heir decreasing rend for one monh and hen changed heir behavior. The lending ineres rae was sable during four monhs and hen increased by 280 basis poins. The deposi ineres raes increased since February Specifically, he C raes (TF) wen up by 313 basis poins. 12

14 July May 2003: uring his period, a sharp increase in counry risk occurred ha pushed up he depreciaion of he currency. A he same ime, growh recovered (Graph 4) and he qualiy of he loan porfolio coninued o improve. Marke raes slighly declined, while policy raes were kep consan unil ecember 2002, and hen were raised by 200 bps o curb inflaionary pressures semming from he depreciaion of he currency. The real quaniies of deposis and loans showed small increases. The increase in oupu growh and a beer percepion of he risk of he financial sysem pushed up he supply of deposis. This movemen and he improvemen in loan qualiy may have produced a posiive shif in he loan supply. These facors would have implied a reducion in marke ineres raes, given a consan policy rae 25. However, he skyrockeing counry risk and he ensuing depreciaion exered an upward pressure on ineres raes ha counered he previous effec. The jump in counry risk also produced a loss of marke value of Governmen securiies ha may have increased he supply of deposis, as agens rebalanced heir porfolio away from Governmen deb and in favor of financial sysem liabiliies. In he second par of he period, his shif was reinforced when counry risk plummeed. Marke ineres raes mus have declined, bu hen policy raes were raised, offseing his rend. Graph 4. 8,0 GP Anual Growh 6,0 4,0 2,0 % 0,0-2,0-4,0-6,0-8,0 Mar-98 Jul-98 Nov-98 Mar-99 Jul-99 Nov-99 Mar-00 Jul-00 Nov-00 Mar-01 Jul-01 Nov-01 Mar-02 Jul-02 Nov-02 Mar-03 Jul-03 Source: ANE 25 A higher economic growh may have also pushed loan demand. However, afer he financial crisis here was a process of reducion in he leverage of he privae secor. 13

15 5. Economeric Evidence The heoreical model developed in he previous secion implies ha marke ineres raes are affeced by facors oher han he policy rae. Therefore, he esimaion of ineres rae pass-hrough mus conrol for movemens in oher macroeconomic variables, which may impac he loan and deposi markes equilibrium. To es his hypohesis, we follow wo approaches. Firs, we assume he exisence of a long run relaionship beween marke and policy ineres raes. Then we esimae uni-equaional error correcion models for he marke raes, in which oher macro variables suggesed by he heoreical model are included as explanaory variables of he shor run dynamics (See Appendix for he descripion of he variables). In he second approach we acknowledge ha some of he macro explanaory variables may be endogenous in a general equilibrium conex. Hence, we esimae a VARX, perform Granger causaliy ess for he marke ineres rae equaion o verify he significance of he macro variables in deermining is dynamics, and examine he impulse response funcions o check he direcion of he marke ineres rae reacion o differen shocks Uni-equaional Error Correcion Models For boh measures of he deposi ineres rae, TF and M3, we esimae uni-equaional error correcion models for he period June 1999-Augus 2006, wih he policy ineres rae, he indusrial producion index (as a measure of oupu), he EMBI, he foreign ineres rae (IBOR) and he nominal depreciaion as explanaory variables. We also use a measure of he price change of Governmen securiies as anoher exogenous variable. However, because his variable is only available from 2001 on, we decided o esimae anoher model wih his shorer sample. Tables 1 and 2, show he esimaions of differen models for each measure of he deposi ineres rae. The firs model akes as explanaory variables he EMBI, he IBOR and he Policy ineres rae, which can be assumed o be exogenous in a more general model. The second model also includes he nominal depreciaion and he indusrial producion index as exogenous variables, evenhough hey can be endogenous in a more general seing. Finally, he hird model was esimaed for TF inroducing he price change of Governmen securiies. In mos cases, variables differen from he policy ineres rae and he residual of he long run equaion 26 are significan in he error correcion equaions. Hence, he shor run dynamics of deposi ineres raes are influenced by oher macro variables, as suggesed by he heoreical model developed above. Also, in mos cases he signs of he exogenous variables are hose prediced by he heory, wih he noable excepion of he foreign ineres rae. 26 This residual is obained from he esimaion of he long run relaionship beween he policy and he deposi ineres rae. 14

16 Table 1. UNI-EQUATIONA ERROR CORRECTION MOES FOR THE M3 INTEREST RATE ependen Variable: M3 Model 1 (1) Model 2 (2) CONSTANT ( ) ( ) RESIUA(-1) ( ) ( ) EPRECIATION(-1) ( ) EPRECIATION(-4) ( ) POICY(-1) ( ) ( ) POICY(-2) ( ) ( ) EMBI(-1)* ( ) EMBI(-4) ( ) ( ) IBOR(-4) ( ) R-squared Adjused R-squared S.E. of regression Sum squared resid og likelihood urbin-wason sa Akaike info crierion Schwarz crierion F-saisic Sandard error in parenhesis (1) This model does no consider variables which can be endogenous. Sample 1999: :08. Included observaions: 82 afer adjusmens (2) This model includes oher variables bu hey can be endogenous in a more general model. Sample 1999: : 08. Included observaions: 82 afer adjusmens * This corresponds o he difference of he logarihm 15

17 Table 2. UNI-EQUATIONA ERROR CORRECTION MOES FOR THE 90-AY EPOSIT INTEREST RATE ependen Variable: TF Model 1 (1) Model 2 (2) Model 3 (3) CONSTANT ( ) ( ) ( ) RESIUA(-1) ( ) ( ) ( ) TF(-1) ( ) ( ) TF(-3) ( ) TF(-5) ( ) TF(-6) ( ) EPRECIATION(-2) ( ) IPI(-5) ( ) ITES(-4) ( ) POICY(-1) ( ) ( ) ( ) POICY(-5) ( ) EMBI(-1)* ( ) ( ) ( ) EMBI(-2) ( ) EMBI(-4) ( ) IBOR(-2) ( ) IBOR(-3) ( ) ( ) IBOR(-6) ( ) R-squared Adjused R-squared S.E. of regression Sum squared resid og likelihood urbin-wason sa Akaike info crierion Schwarz crierion F-saisic Sandard error in parenhesis (1) This model does no consider variables which can be endogenous. Sample 2000: :08. Included observaions: 80 afer adjusmens (2) This model includes oher variables bu hey can be endogenous in a more general model. Sample 1999: : 08. Included observaions: 82 afer adjusmens (3) In addiion o he variables considered in model 2 we also consider a measure of he reurn of governmen securiies. Sample 2002: :08. Included observaions: 52 afer adjusmens * This corresponds o he difference of he logarihm 16

18 However, o assess he impac of exogenous shocks on marke raes, one mus ake ino accoun no only heir direc effec on deposi raes, bu also he indirec effecs ha occur hrough oher macro variables ha are endogenous in a general equilibrium conex, such as he exchange rae, oupu and expecaions. There may be also feed-back from marke raes hemselves o hose macro endogenous variables. To capure he richer dynamics implied by he argumen above, we esimae a VARX for a se of variables in firs differences. We assume ha he EMBI, he foreign ineres raes and he policy raes are exogenous variables, while deposi raes, inflaion, nominal depreciaion and our measure of oupu are reaed as endogenous (and he reurn on governmen securiies when included). In order o verify our hypohesis, we check he significance of variables oher han he policy rae in he deposi rae equaion by means of Granger causaliy ess. Then, from he impulse-response funcions we examine he impac of some shocks on deposi raes. In his conex, he response o a shif in he policy rae may be regarded as an appropriae measure of ineres rae pass-hrough, since mos direc and indirec effecs are aken ino accoun VARX models Tables 3 and 4 show he Granger Causaliy ess for wo specificaions of VARX ha include TF or he M3 ineres raes, respecively. In each case a sysem was esimaed wih and wihou he price change of Governmen bonds. 27 For he TF equaion, he policy rae, he nominal depreciaion and he EMBI Granger cause his deposi rae when he larger sample is used 28. Wih he shorer sample, he policy rae, he nominal depreciaion, he indusrial producion index, he EMBI, and he price change of Governmen securiies Granger cause he TF rae (Table 3). The equaion for he M3 ineres rae shows ha he policy rae, inflaion, nominal depreciaion and he EMBI Granger-cause his deposi rae in he larger sample 29. For he shorer sample, he policy rae, he indusrial producion index, he EMBI, he price change of Governmen securiies and he foreign ineres rae Granger cause he M3 rae (Table 4). The impulse-response funcions of he VARX for he TF and M3 ineres raes are presened in Appendix B and show a posiive shor-run reacion of marke raes o policy rae shocks. For oher shocks, he marke ineres raes shor-run response is someimes in agreemen wih he heoreical model. In paricular, here is a posiive response of he TF rae o shocks o he EMBI. 27 There may exis a bias in he esimaion because we are no aking ino accoun he long run relaionship beween marke and policy ineres raes and oher long run relaions beween he variables included in he VARX. A mehod ha allows o esimae he correc long and shor run relaionships is a VEC, bu he sample is oo shor o use his echnique. 28 A 10% of significance inflaion also Granger causes he TF. 29 A 10% of significance he foreign ineres rae (ibor) also Granger causes he M3 ineres rae. 17

19 Table 3. Granger Causaliy Tess on TF Model 1 Null Hypohesis Tes-value Probabiliy EPRECIATION no Granger cause TF IPI no Granger cause TF INFATION no Granger cause TF EMBI no Granger cause TF POICY no Granger cause TF IBOR no Granger cause TF * VARX(6,6) 6 lags for endogenous and exogenous variables Granger Causaliy Tess on TF Model 2 Null Hypohesis Tes-value Probabiliy EPRECIATION no Granger cause TF IPI no Granger cause TF INFATION no Granger cause TF ITES no Granger cause TFN EMBI no Granger cause TF POICY no Granger cause TF IBOR no Granger cause TF * VARX(3,3) 3 lags for endogenous and exogenous variables Table 4. Granger Causaliy Tess on M3 Model 1 Null Hypohesis Tes-value Probabiliy EPRECIATION no Granger cause M IPI no Granger cause M INFATION no Granger cause M EMBI no Granger cause M POICY no Granger cause M IBOR no Granger cause M * VARX(6,6) 6 lags for endogenous and exogenous variables Granger Causaliy Tess on M3 Model 2 Null Hypohesis Tes-value Probabiliy EPRECIATION no Granger cause M IPI no Granger cause M INFATION no Granger cause M ITES no Granger cause TFN EMBI no Granger cause M POICY no Granger cause M IBOR no Granger cause M * VARX(4,3) 4 lags for endogenous and 3 lags for exogenous variables 18

20 6. A Small-Open Economy Macro Model In secion 4 we showed ha he equilibrium marke ineres raes depend no only on policy raes, bu also on oher macro variables affecing credi demand and deposi supply, such as income, exernal ineres raes, risk premia and he expecaions of inflaion and real depreciaion among ohers. These are exogenous variables in a parial equilibrium seing, bu some become endogenous once one considers he funcioning of he economy as a whole. Hence, ineres rae pass-hrough may be a complex process, wih changes in policy having boh direc and indirec effecs on marke raes, he laer aking place hrough shifs in income, depreciaion, inflaion and expecaions. By he same oken, shocks hiing he economy may have direc effecs on marke ineres raes, given a consan policy rae. For example, an increase in exernal ineres raes or he counry risk premium will affec no only he exchange rae, as expeced, bu also marke ineres raes, since deposis and cenral bank credi are imperfec subsiues for banks due o he liquidiy risk. Were hey perfec or very close subsiues, he domesic ineres raes would be se by he Cenral Bank and all he adjusmen will be born by he exchange rae. In addiion, he model developed in secion 4 suggesed ha he relaionship beween policy and marke ineres raes migh no be one for one, or even linear. Tha relaionship depends on he funcional forms of he demand for credi, he supply of deposis and he probabiliy disribuions involved in he various risks facing he banking firm. This furher complicaes he ineres rae pass-hrough. A policy implicaion follows immediaely from he previous argumens: The Cenral Bank s policy rule should ake ino accoun he direc effecs of oher (exogenous and endogenous) macro variables on marke raes. I should also consider he possibly complex relaionship beween policy and marke raes. If hese facors are empirically relevan, a failure by he Cenral Bank o include hem in is reacion funcion may increase he risk of missing is arges and/or may inroduce excessive volailiy o ineres raes and oupu. These ideas can be illusraed wih a simpler version of he model presened above. In paricular, assume ha here is neiher credi risk nor public deb. There is only a liquidiy risk for banks. eposi ineres raes are deermined by he equilibrium condiions in he deposi and credi markes and he balance shee ideniy of he banking secor: ( ) ^ ^ e * e e e e e * e e π π π p π π π ( i, i + e, Y) 1 r( i, i ) = C( i + m, i + e, Y) (10) Where (.) and C(.) are he deposi supply and credi demand funcions, respecively. r(.) is he fracion of deposis ha banks opimally choose o hold as reserves. Y is he level of oupu. i and i p are he nominal deposi and policy rae, respecively. m is a consan inermediaion spread ha accouns for operaional coss. i* is he exernal nominal ineres ^ e rae and e and π e are he expecaions of depreciaion and inflaion, respecively. As in secion 4, he following assumpions are made abou he funcional forms: 19

21 > 0, < 0, > 0 i * i C < 0, C > 0, C > 0 i * i Y Y And he following feaures of he funcion r(.) are obained: r < 0, r > 0 Saring from a long run equilibrium siuaion in which π = π e = π TARGET, suppose ha here is a ransiory shock o he exernal ineres rae, i *, and ha he Cenral Bank is a sric inflaion argeer ha will move is policy rae, i p, so ha he inflaion arge is me a every period. Furhermore, assume ha he public fully rus he inflaion arge. In hese e dπ dπ circumsances, = = 0. Assuming ha he Cenral Bank knows all he parameers * di * di and he srucure of he economy, from equaion (10) he required adjusmen of he policy rae is given by: ^ 1 e di p de di dy = * ( r i ) ( *(1 r) C *) * ( (1 ) ) * ( (1 ) ) p i i i r r i C i + Y r C Y * di di di di (11) i ip di Where is he adjusmen in he deposi rae ha is required o keep inflaion on arge. * di dy * is he change in oupu ha resuls from he shock o he foreign ineres rae, i *, he di d e e responses of i and i p and all he subsequen macroeconomic effecs. Similarly, is he * di movemen of he expecaions of depreciaion ha follows he shock o i *, he responses of i and i p and all he ensuing macroeconomic effecs. Three resuls are obained from equaion (11): ^ (i) (ii) The direc response of he policy rae o he required adjusmen in he marke rae is no necessarily equal o one. The expression ( i (1 r) r ) ( ) i C i r ip is generally posiive, bu may no even be consan. I may change wih he levels of Y, i, i * and oher variables ha migh affec he elasiciies or slopes of credi demand, deposi supply and reserves demand. Beyond he direc response o he required adjusmen in he marke raes, policy raes may have o respond independenly o he shock iself. The erm (1 r) C r is generally negaive, suggesing a negaive reacion of ( * * i i ) ( i p ) policy raes o he shif in exernal ineres raes. Inuiively, if marke raes reac direcly o he shock in foreign ineres raes, Cenral Bank raes do no 20

22 change in he expecaions of depreciaion ha resuls from he shock and he ensuing adjusmen. (iii) Also, policy ineres raes may respond o he change in oupu ha follows he shock. In his case, however, he effec on policy raes is ambiguous since, as shown in secion 4, changes in oupu hi boh loan demand and deposi supply, inducing movemens of marke raes in opposie direcions. As an example of hese resuls, Graph 5 show he simulaed responses of several macro variables o a ransiory shock in he foreign ineres rae, based on a small, open economy model wih backward-looking expecaions, imperfec capial mobiliy and a banking secor facing a liquidiy risk. The model is presened in Appendix C and he simulaions assume ha he Cenral Bank ses he policy rae so ha π = π TARGET = 0. Saring from a seady sae siuaion, a one-period increase in he foreign ineres rae induces capial ouflows and a nominal and real depreciaion of he currency. The ensuing inflaionary pressures force he Cenral Bank o raise domesic ineres raes, producing a negaive oupu gap. As expeced, he rade balance becomes posiive on impac. The subsequen dynamics involve a downward correcion in domesic ineres raes o eliminae he oupu gap and couner he currency appreciaion ha follows he reurn of he foreign ineres rae o is long run value and he ineres income received from he previous capial ouflows. The aspec we wan o highligh in he simulaions is he behavior of policy and marke ineres raes. In Graph 5 hey share he same dynamics, wih he levels of he policy rae being higher, as explained in he Appendix C. However, he raio of he wo raes shows ha he reacion of policy ineres raes o he exernal shock is proporionally lower han he response of marke raes 30. This occurs because he shock o he foreign ineres rae has an independen impac on marke raes, so he response of policy raes ha is required o keep inflaion on arge needs no be as large as he required reacion in deposi raes. 30 Since he policy rae is roughly a muliple of he marke rae (see equaion A14 in Appendix C), by consrucion he difference beween hem closely resembles he evoluion of he policy rae. This is why he raio of he raes is a more appropriae measure of heir disance in his model. 21

23 Graph 5. ix Foreign ineres rae id omesic ineres rae ip Policy ineres rae y Oupu gap idip omesicpolicy in.raes raio e Nominal epreciaion q Real Exchange Rae nx Trade Balance

24 7. Conclusions In conras o he sandard approach o moneary policy, which considers he banking secor as a passive aggregae, his paper focused on he implicaions of modeling commercial banks as independen eniies ha opimally reac o heir environmen. Based on a heoreical microeconomic model of he banking firm and he credi and deposis markes, we illusraed he idea ha he response of marke ineres raes o changes in he policy ineres rae may be a complex process ha depends on he sae of he economy. We argued ha he esimaion of ineres rae pass-hrough mus conrol for oher shocks hiing he financial sysem. The model is used o inerpre some episodes of ineres rae pass-hrough in Colombia and he resuls from uni-equaional error correcion and VARX models seem o suppor our hypoheses. Finally, a small macro model illusraed he imporance for he Cenral Bank o undersand he role of bank behavior in he ineres rae pass-hrough. In paricular, consideraion of he direc impac of exogenous shocks on he financial sysem may affec he appropriae policy response. epending on is empirical relevance, his hypohesis implies ha he Cenral Bank may miss is arges or inroduce excessive volailiy o ineres raes and oupu, if financial marke behavior is ignored. 23

25 8. Bibliography Ahumada,., and J.R. Fuenes, Banking Indusry and Moneary Policy: An Overwiew, In: Banking Marke Srucure and Moneary Policy, Cenral Bank of Chile, Amaya, C.A., Ineres Rae Seing and he Colombian Moneary Transmission Mechanism, Banco de la República Colombia, Borradores de Economía, No 352, Bernanke, B., and A. Blinder, Credi, Money and Aggregae emand, American Economic Review, Vol. 78, No. 2, Bernanke, B., and M. Gerler, Inside he Black Box: The Credi Channel of Moneary Policy Transmission, Journal of Economic Perspecives, Vol 9, No 4, Bersein, S., and R. Fuenes, Is here ending Rae Sickiness in he Chilean Banking Indusry?, Cenral Bank of Chile Working Papers, No 218, Coarelli, C., and A. Kourelis, Financial Srucure, Bank ending Raes, and he Transmission Mechanism of Moneary Policy, IMF Saff Papers, Vol 41, No 4, Crespo-Cuaresma, J., e al., Ineres Rae Pass-Through in New EU Member Saus: The Case of he Czech Republic, Hungary and Poland, William avidson Insiue, Universiy of Michigan Business School, Working Paper, No 671, e Bond, G., Reail Bank Ineres Rae Pass-Through: New Evidence a he Euro Area evel, European Cenral Bank Working Paper Series, No 136, e Bond, G., Ineres Rae Pass-Through: Empirical resuls for he Euro Area, German Economic Review, Vol 6, No 1, Ehrmann, M., and A. Worms, Inerbank lending and Moneary Policy Transmission evidence for Germany, Economic Research Cenre of he eusche Bundesbank, iscussion Paper No. 11, Engle, R., and B.S. Yoo, Forecasing and Tesing in Coi-inegraed Sysems, Journal of Economerics, 35, Freixas X., and J.C. Roche, Microeconomics of Banking, MIT Press, Cambridge, Hannan, T., and A. Berger, The Rigidiy of Prices: Evidence from he Banking Indusry, American Economic Review, Vol 81, No 4, Hueras e al., Algunas Consideraciones sobre el Canal de Crédio y la Transmisión de Tasas de Inerés en Colombia, Banco de la República Colombia, Borradores de Economía, No 351,

26 Julio, J.M., Relación enre la Tasa de Inervención del Banco de la República y las Tasas del Mercado: Una Exploración Empírica, Banco de la República Colombia, Borradores de Economía, No 188, Ko, A., Is Ineres Rae Pass-Through relaed o Banking Secor Compeiiveness?, Naional Bank of Poland, Kwapil, C., and J. Scharler, Ineres Rae Pass-Through, Moneary Policy Rules and Macroeconomic Sabiliy, Ausrian Cenral Bank Working Papers, No 118, oayza, N., and K. Schmid-Hebbel, Moneary Policy Funcions and Transmission Mechanisms: An Overview, In: Moneary Policy: Rules and Transmission Mechanisms, Cenral Bank of Chile, Mojon, B., Financial Srucure and he Ineres Rae Channel of ECB Moneary Policy, European Cenral Bank Working Paper Series, No 40, Sorensen, C.K., and T. Werner, Bank Ineres Rae Pass-Through in he Euro Area: A Cross Counry Comparison, European Cenral Bank Working Paper Series, No 580, Sigliz, J. and A. Weiss, Credi Raioning in markes wih imperfec informaion, American Economic Review, Vol 71, No 3, Villar,., e al., Crédio, Represión Financiera y Flujos de Capiales en Colombia: , Banco de la República Colombia, Borradores de Economía, No 322, Weh, M., The Pass-Through from marke ineres raes o bank lending raes in Germany, Economic Research Cenre of he eusche Bundesbank, iscussion Paper No. 11, Winker, P., Sluggish Adjusmen of Ineres Raes and Credi Raioning: An Applicaion of Uni Roo Tesing and Error Correcion Modelling, Applied Economics, 31, Zamudio, N., and J. Marinez, Esrucura Financiera de las Empresas y los Hogares , Mimeo, Banco de la República Colombia,