International Research Journal of Finance and Economics
ISSN 1450-2887 Issue 28 (2009)
© EuroJournals Publishing, Inc. 2009
http://www.eurojournals.com/finance.htm

Retail Bank Interest Rate Pass-Through: The Turkish
Experience Bilge Kagan Ozdemir
1

Department of Economics, Anadolu University, Turkey
Yunus Emre Campus, 26470, Turkey
E-mail: [email protected] Abstract

This paper intends to investigate the relationship between a money market rate and
banks’ retail rates by empirically examining the pass-through process in the banking system
of Turkey for the period between April 2001 and June 2007. We also aim to highlight the
main factors that influence the price setting behavior of banks. The main findings from
symmetrical and asymmetrical error-correction models suggest that the pass through from
the market rate to deposit and lending rate is complete in the long run, while in the short
run lending rate shows more flexibility relative to deposit rate. In addition, there is greater
rigidity in deposit and lending rate decreases than increases and retail interest rates does not
adjust asymmetrically to an increase or a decrease in money market rate in Turkey. Keywords: Interest rate pass-through, retail interest rates, Turkish banking system, ECM

2. A Brief Review of Related Theoretical and Empirical Literature
The effectiveness of monetary policy depends on the degree and the speed of interest rate adjustment to
change in policy controlled interest rate. Both theoretically and empirically, the interest rate channel of
monetary transmission has received great attention. A common element found by all researchers is the
stickiness of the retail banks interest rate. One of the most famous attempts to explain interest rate
stickiness is Stiglitz and Weiss (1981). This study examines several information asymmetries that
generate rationing in otherwise competitive market. As such a loan market may be characterized as
credits rationing among observationally identical borrowers some receive loans and others do not. In
this setup expected earnings of banks from loans market are a function of interest rate on loans since
probability of default of borrower is increasing with higher interest rates. Increasing interest rates could
increase the risk of banks’ loan portfolio either by adverse selection or by moral hazard and due to this
increase in riskiness, banks can not increase lending rates even under the case they face higher
marginal costs, i.e. money market rate. Otherwise, safer investors would be discouraged and riskier
ones would be attracted (adverse selection) or borrowers would be induced to invest in riskier projects
(moral hazard) because of higher interest rates. Therefore existence of asymmetric information
between borrowers and lenders in loan market may create an upward stickiness in lending lates.
Hannah and Berger (1991) and Cotterelli and Kourelis (1994) deem the mechanism through
adjustment costs and the elasticity of the demand for loans in order to explain the interest rate
stickiness. They suggest that banking industry, like any industry, faces adjustment costs when prices,
i.e., money market rate, are changed. According to these studies the speed of adjustment of lending
rates to changes in policy interest rate may depend on the elasticity of the demand for bank loans that
depend on the structure of the financial system. Klemperer (1987), in his two period model, shows that
in a mature market switching costs like learning costs, transaction costs or artificial costs imposed by
firms, may cause to stickiness in prices.
The possibility of asymmetric bank interest rate adjustment has been explored, in particular, by
Hannan and Berger (1991) and by Neumark and Sharpe (1992) which was later developed by Scholnic
(1996). These studies both distinguish between symmetrical and asymmetrical rigidities in deposit and
lending rates due to cost of adjustments and they offer two reasons for asymmetrical adjustment:
costumer reactions and collusive pricing arrangements. According to customer reaction hypothesis, one
may expect greater rigidity in deposit rate decreases and in loan rate increases due to customers

precipitate the 2000-2001 crises. They provide a plenty of evidence regarding the risk accumulation in
the banking system in the period preceding the crisis: increase in currency and maturity mismatches
and a rise in non-performing loans. Hence, the banking system was highly vulnerable to capital
reversals. However, risk accumulation was not homogenous throughout the system. There were two
different types of dichotomization: Private versus state banks and within the private banks. While the
state banks were more open to interest rate risk, private ones were more prone to exchange rate risk.
Within the private banking system there were some midsized banks that were heavily concentrated in
government debt instruments business. Moreover, they were carrying these instruments by borrowing
extremely short-term.
Ozkan (2004) point to three sets of vulnerabilities in the Turkish economy that prepared the
ground for the collapse of the Turkish Lira and the resulting 2000-2001 financial crisis. The first
source of vulnerabilities identified was the weak external position caused by excessive levels of debt
repayments. The second has been the weak fiscal position resulting from the record levels of interest
payments on domestic borrowing. When combined with the unfavorable maturity structure of the
existing debt, this resulted in debt servicing placing a considerable burden on the public finances
during this period. Thirdly, her analysis suggests that the weaknesses in the financial and banking
sector have played a major role in preparing the ground for the liquidity squeeze in November 2000
and in aggravating the situation in the wake of the devaluation in February 2001.
Central Bank of the Republic of Turkey (hereinafter CBRT) has gained its independence after the
2001 crisis (in April 2001) as a result of recovery attempts. During the initial process of independence, the
CBRT announced the medium term objective as a gradual move to an inflation targeting framework. As
such at the beginning of 2002 the CBRT began implementing implicit inflation targeting. Eventually, at the
beginning of 2006 the CBRT introduced full-fledged inflation targeting (see Akyürek and Kutan (2006) for
more detailed information).
While high debt level, inflation and macroeconomic instability prevented banks from credit
supply during the pre 2001 crisis era, credit channel has started to work properly in the post crisis era
due to sound macroeconomic policies. During this period, loan portfolio of Turkish Banking System
also showed impressive growth. As of December 2006, the amount of in-cash loans extended by banks
was 219 billion NTL (approximately 156,42 billion USD). Non-performing loans totaled NTL 8,550
billion (approximately 6,110 billion USD) as of December 2006. The amount of provisions set aside

series of variables used in this study are shown in Figure 1.

Figure 1: Trends in Money Market, Lending and Deposit Rates

.1
.2
.3
.4
.5
.6
.7
.8
.9
2001 2002 2003 2004 2005 2006
MMR LR DR4.2. Method of Estimation
In order to analyze dynamic interest rate adjustment between the policy controlled interest rate and the
interest rates on loans or deposits, symmetric error correction model (ECM) is used as a starting point.
11 International Research Journal of Finance and Economics - Issue 28 (2009)
In this model, short run dynamics are linked to long run equilibrium. Our specification of the ECM
takes the following form:
tt
J
j
jtj
I
i
itit

otherwiseect
ectmeanectifectect
t
tt
0=
>=
+
+
(2)
and
(
)
otherwiseect
ectmeanectifectect
t
tt
0=
<=
−
−
(3)
The positive errors (
+
t
ect
) in equation (2) implies that if the deposit or lending rate is above its
equilibrium value following a decline in the money market rate, then it will start falling in the next
period. Similarly, the negative errors (
−
t

measures the speed of adjustment in response to the previous
period disequilibrium relationship between deposit or lending rates and money market rate when rates
are above their equilibrium level whereas the estimated coefficient of α
2
measures the speed of
adjustment in response to the previous period disequilibrium relationship between variables when rates
are below their equilibrium level. The test of whether retail interest rates adjust asymmetrically is
whether α
1
is significantly different from α
2
, and if, α
1
>
α
2
for deposits, banks are quicker in adjusting
deposit rates downwards than they are to adjust them upwards while α
2
>
α
1
in the loan market implying
that banks adjust lending rates upwards faster than they are to adjust them downward.

4.3. Empirical Results
In the first stage, the order of integration is tested using the Augmented Dickey Fuller (ADF) unit root
tests. Unit Root tests are conducted to verify the stationarity properties (absence of trend and long-run
mean reversion) of the time series data so as to avoid spurious regressions. A series is said to be
(weakly or covariance) stationary if the mean and autocovariances of the series do not depend on time.

integration in the data series in order to test whether there is a long run relationship between the
variables. The ADF test on the residuals based on the regression of money market rate and lending
rate, and the money market rate and deposit rate, show that the residuals are indeed I(0), enabling us to
conclude that both the deposit and lending rates are cointegrated with the money market rate. This
study uses the Johansen (1988) approach to test for co-integration. The Johansen co integration
procedure gives the results as reported in Table 3 for lending rate and money market rate relation and
in Table 4 for deposit rate and money market rate relation. The maximum eigenvalue and trace
statistics show that there are one cointegrating vector between lending rate and money market rate, and
deposit rate and money market rate financial development proxies and economic growth at the 5 per
cent level This confirms the existence of an underlying long-run stationary steady-state relationship
between the bank interest rates and the developments in money market rates.

Table 3: Lending Rate – Money Market Rate Equation

Maximun Eigen Value
Null Alternative Statistic %5 Critical Value Probability
r = 0 r =1 34.62 19.39* 0.00
r≤ 1 r = 2 10.08 12.52 0.12
Trace Test Statistics
Null Alternative Statistic %5 Critical Value Probability
r = 0 r ≥ 1 44.69 25.87* 0.00
r ≤ 1 r = 2 10.08 12.52 0.12
Note:* Denote rejection of null hypothesis at the 5% level. Critical values are from Mc Kinnon, Haug, Michelis (1999)

Table 4: Deposit Rate-Money Market Rate Equation

Maximun Eigen Value
Null Alternative Statistic %5 Critical Value Probability
r = 0 r =1 22.82 19.39* 0.02
r≤ 1 r = 2 7.62 12.52 0.28

∆dr
t
-
1
0.45 (2.82) 0.23(1.55)
∆mmr
t
-
1
-0.38(2.18) -0.03(0.13) 0.09(0.52) -0.06(0.32)
ecm
t
-
1
-0.35(3.30) -0.12(1.25)
+
−1t
ecm

-0.19(0.98) -0.10(0.70)
−
−1t
ecm

-050(2.32) -0.69(3.75)
Wald statistics 0.29 0.03
R
2
0.33 0.29 0.21 0.35
DW 1.86 1.41 1.97 1.48

the estimated asymmetric coefficients are equal. From the bottom part of table 5, one can see that the
null hypothesis of equal adjustments cannot be rejected as the Wald statistics are significantly less than
the critical value (χ
2
(1) = 1.94) at 5% level of significance. Therefore, lending and deposit rates adjust
equally to a change in money market rate. 5. Conclusion
In this paper, we investigate the symmetric and asymmetric adjustments of retail interest rates to
money market rate in Turkey for the period between April 2001 and December 2006. This process is
important since the speed and the degree of response is usually associated to the effectiveness of
monetary policy. The empirical results show that Turkish Banking System adjust completely their
interest rates to changes in the market rates in the long run, while in the short run lending rate shows
more flexibility relative to deposit rate. In addition, greater rigidity is find in deposit rate decreases
which is in line with customers’ negative reactions hypothesis and greater rigidity in lending rate
decreases which is in line with in collusive pricing arrangements of Turkish banks due to concentrated
structure of the System. Finally, empirical results presented in this paper suggest that retail interest
rates does not adjust asymmetrically to an increase or a decrease in money market rate in Turkey. References
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