Why are the key rates of the European Central Bank and my bank’s interest rates different?

You have probably asked yourself this question when applying for a loan from your bank. The rate offered by your bank was quite different from the rate at which your bank can borrow from the European Central Bank (ECB). How can we explain the difference? What is the link between the key ECB rates and your bank’s interest rates?

The three key ECB rates

Let’s start at the beginning. The main key ECB rate is the refinancing rate. At the time of writing, the ECB refinancing rate is 0.050%, its lowest level ever. What does this 0.050% rate mean?

To keep the prices stable (inflation below, but close to, 2%) the European Central Bank uses several monetary policy instruments to steer interest rates and manage banking liquidity. The most traditional operations are what we call the Main Refinancing Operations (MRO). When liquidity is needed, a bank can borrow directly from the ECB. Every week, banks of the Eurozone go (virtually) to the ECB desk to borrow money at the refinancing rate fixed by the ECB (0.050%).  The loan is made under the form of a Repurchase Operation (Repo). The bank sells security assets to the ECB and borrows money. One week later, the bank gives the money back with interest to the ECB and recovers its security assets.

The two other key ECB rates are the overnight deposit rate (-0.20%) and the overnight marginal lending rate (0.30%). The first is the interest rate paid by the ECB to banks having a deposit (for the moment, it is the opposite because the rate is negative). The second is the rate paid by banks to the ECB when they want to use overnight credit outside the refinancing operations. 

The interbank rates (Eonia and Euribor)

As their names suggest, the three key ECB rates are monetary policy instruments used by the ECB to have an impact on the granting of loans and to regulate inflation in the Eurozone. The main role of the ECB is not to lend and banks only turn to the ECB when they don’t find any liquidity in the interbank market. Most of the time, banks finance their needs with other banks in the interbank market by using two reference rates, Eonia (Euro Overnight Index Average) and Euribor (Euro Interbank Offer Rate). The first is the overnight interbank rate and the second is calculated for longer loan terms (from 1 week to 12 months). The evolution of these two types of rate depends on the evolution of the key ECB rates. Why?

Let’s take the example of the Eonia rate. It is the simplest. The Eonia rate evolves according to the levels of the ECB overnight deposit rate and the ECB overnight marginal lending rate. It is logical! The Eonia rate can’t be lower than the ECB deposit rate because, in that case, a bank with liquidity surplus would make an overnight deposit to the ECB instead of lending money to another bank.  The Eonia rate can’t be higher than the ECB overnight marginal lending rate: a bank with liquidity demand would borrow from the ECB instead of from another bank. 

The interest rate of your bank

In turn, the interbank rates will play a decisive role in the calculation of the interest rates at which your bank can give you a loan. The difference between the loan rate and the interbank rate of the same maturity will depend on a variety of factors such as your risk level, the term of your loan or the guarantees that you can give.

In a nutshell, the key ECB rates have an impact on the rate of your loan but a lot of other factors also come into play depending mostly on your personal situation. Some good advice: before borrowing, talk to your banker first. He knows your professional and private situation and will be able to guide you in your choices. 

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