The divergence of bank lending rates from policy rates after the financial crisis: The role of bank funding costs

After the global financial crisis, policy rates were cut to near-zero levels, yet, bank lending rates did not fall as much as the decline in policy rates would have suggested. If the crisis represents a structural break in the relationship between monetary policy and lending rates, how should central banks view the post-crisis transmission? This poses a major puzzle for monetary policymakers. Using a new weighted average cost of liabilities to measure banks’ effective funding costs we show a model of interest rate pass-through with dynamic panel data methods solves this puzzle, and has many other advantages over traditional approaches. It confirms central banks should focus on the cost and composition of bank liabilities, as many are now doing, to better understand and steer the dynamics of lending rates.