Loan Pricing by Euro Area Risk Averse Banks in an Environment of Extended Central Bank Liquidity Provision

Abstract

This paper studies bank loan pricing in the euro area over the period October 2008 to October 2014. This period was characterised by market fragmentation and extended liquidity provision by the ECB. For our analysis we develop a theoretical framework which accounts for the main financing risks faced by euro area banks during this challenging period. In our modelling framework risk aversion plays a critical role, and this is challenging for our empirical analysis. We handle this issue by means of a novel econometric approach whereby bank risk aversion is treated as an unobservable random effect. We find that banks that have access to money markets, and are less reliant on ECB financing, can finance at a lower cost, and can thus offer lower bank lending rates. We also find that banks with a lower cost of debt financing offer lower lending rates. Our results also show that after accounting for financing risks, credit risks, market power and bank business model, our empirical estimates of banks' risk aversion are still positively and significantly correlated with country specific effects, thus highlighting the fragmentation of retail banking along national lines within the euro area.