Interest Rate Spreads in the Baltics and the Rest of the Euro Area: Understanding the Factors behind the Differences

Abstract

This paper analyzes the determinants of interest rate spreads during the period 2014–2020 in the euro area, with a focus on the Baltic countries. Against the background of accommodative monetary policy, interest rates on loans in the euro area have declined markedly, except in a few countries. In Latvia, Lithuania and Estonia, interest rates on new loans to non-financial corporations in 2020 were about the same as in 2014, and at the same time they were among the highest in the euro area. In this study, we apply the Ho and Saunders (1981) theoretical framework to identify explanatory factors of spreads and use the obtained econometric estimates to calculate the so-called pure spread by subtracting the influence of the bank funding structure and other bank-specific factors from the interest rate spread. Our study shows that even after accounting for the conventional determinants of interest rate spread, differences in the pure spread between euro area countries, especially between the Baltic countries and the rest of the euro area, persist. In part, these differences can be explained by varying degrees of financial sector market concentration. However, the bulk of the gap in spreads remains unexplained. The findings of this paper suggest that properly designed policy measures are needed to reduce spreads in the Baltic countries and lessen the fragmentation in the euro area. This would allow for more effective monetary policy transmission and stimulate lending and post-Covid economic recovery in the Baltics.

Keywords: interest rate spread, interest rate on loans, market concentration

JEL Codes: G21, L11, E43, E52