Credit: CSL
The Luxembourg Chamber of Employees (Chambre des salariés) recently published a new EcoNews report highlighting a significant lag in how Luxembourg banks pass on European Central Bank rate hikes to consumers, leading to increased profit margins.
One of the main instruments of the European Central Bank (ECB) to influence activity and the price level in the eurozone is the three key interest rates. In order to address the record inflation rates since the post-COVID recovery and the start of the war in Ukraine, the ECB has abruptly increased its interest rates. However, the effectiveness of this instrument depends on the speed with which credit institutions pass on changes in interest rates to their customers. The longer banks wait before passing on a rate increase to their customers’ savings accounts, the more they can increase their interest margin. The same effect occurs when there is a decrease in key interest rates that is not immediately passed on to variable interest rates on mortgage loans.
It is therefore interesting to compare the historical development of the three key rates with the interest rates applied to sight deposits, term deposits and variable-rate mortgage loans. Historically, the interest rates on term deposits and sight deposits have evolved at the same pace as the ECB's key rates.
Analysis of interest rates on term deposits
Since 2003, the interest rate received by households on their term deposits has almost always been equal to the main refinancing rate. For almost twenty years, the interest rate on term deposits has therefore been within the corridor formed by the three ECB key rates. However, since November 2022, the latter have increased more sharply. Thus, after the recent cut in key interest rates by 0.25 percentage points (pp) in June 2024, the main refinancing rate is currently at 4.25%, while term deposits were only paying 3.3% in June. In September 2023, the spread between these two rates was the highest in at least two decades. The calculation of the average spread shows to what extent the recent development is exceptional, the Luxembourg Chamber of Employees noted. Between January 2003 and October 2022, the difference between the two interest rates averaged 0.29 pp. However, between November 2022 and June 2024, the average difference was 1.03 pp.
Before the financial crisis of 2007-2008, the interest rate on sight deposits more or less corresponded to the interest rate on the deposit facility. This meant that banks passed on almost entirely to their customers the interest they received from the European Central Bank on their deposits. In the 2010s, marked by extremely low interest rates, the rate on sight deposits was at the same level as that on term deposits, and thus within the policy interest rate corridor. Banks were unable to pass on the negative interest rates to their customers. This makes sense because otherwise, customers would have preferred to keep their money at home rather than be financially penalised for their bank deposits, the Luxembourg Chamber of Employees explained. As with term deposits, the remuneration of demand deposits has not followed the recent rise in key interest rates to the same extent. In June 2024, the deposit facility rate was 3.75%, while that on-demand deposits was 1.64%. Here too, the gap in recent months was the highest in at least two decades. Between January 2003 and October 2022, the gap between the two rates averaged 0.41 pp. Between November 2022 and June 2024, the average difference was 2.15 pp, the Luxembourg Chamber of Employees added.
Analysis of Variable Interest Rates on Mortgage Loans
According to the Luxembourg Chamber of Employees, the observation is different for variable interest rates on mortgage loans. Between 2003 and 2012, mortgage interest rates followed the marginal lending facility rates. However, since 2012, banks have not fully passed on the interest rate cuts to the cost of mortgage loans for households. While between January 2003 and December 2011, the average spread between the two rates was 0.31 pp, between January 2012 and June 2022 it was 1.17 pp. During the period of negative interest rates, the difference between the variable rates applied by banks to household mortgage loans and the rates paid by banks to the ECB for lending money for one day was therefore on average almost four times higher than during the previous period. In contrast to what happened with household deposits, banks passed on the recent increases in policy rates to mortgage loans without delay. This combination of an immediate increase in mortgage interest rates and a more hesitant increase in household deposit interest rates logically inflates the interest margin of banks, the Luxembourg Chamber of Employees noted.
Figures from the Central Bank of Luxembourg confirm that the interest margin account of all credit institutions in Luxembourg has “exploded” over the last two years. The difference between interest income and interest expenses in 2023 (€10.7 billion) was 116% higher than the average for the years 2003 - 2021 (€5 billion).
Luxembourg banks are not the only ones to have benefited from the development of interest rates. Higher margins are almost synonymous with higher dividends. For example, in its report, asset manager Janus Henderson calculated that the number of global dividends paid by companies in 2023 increased by 5.6% on an annual basis to reach a record level of $1.66 trillion. The banking sector also paid a record amount of dividends in 2023, contributing significantly to the growth of dividends worldwide. More specifically, global dividends from the banking sector increased by more than 13% on an annual basis to reach $220 billion in 2023. Compared to 2021, the increase was even 28.6%.
While the ECB's restrictive monetary policy has undoubtedly helped to restore control of inflation, it has also had negative effects for indebted households. Analysing the evolution of interest rates and the amount of dividends distributed by banks, the Luxembourg Chamber of Employees observed a redistribution from debtors to shareholders.
