Cyprus bank customers face slower rate cuts due to market concentration

High concentration in banking markets delays the speed at which central bank interest rate changes reach consumers and businesses, according to a study released by the Central Bank of Cyprus (CBC) on Tuesday.

The study, authored by Aris Avgousti and Stephani Michael of the centre for strategy and policy production, showed that banking concentration and monetary policy transmission remain intrinsically linked, with more concentrated markets exhibiting a weaker and slower pass-through of policy rates to retail interest rates.

“The empirical analysis demonstrates that more concentrated banking markets present a weaker and slower transfer of policy rates to bank rates across the euro area,” the authors explained.

This effect is particularly intense in deposit rates, and primarily in the deposits of non-financial corporations, the study explained.

Moreover, the study showed that the degree of competition between banks fundamentally affects the operation of the financial system and, by extension, the effectiveness of monetary policy, credit constraints, financial stability, and economic growth.

“A competitive banking system facilitates the faster and more efficient pass-through of policy rate decisions toward lending and deposit rates,” the authors stated.

In markets with limited competition or high concentration, dominant banks may be less sensitive to changes in policy rates, thereby weakening the transmission mechanism.

The existence of market power in the banking system usually leads to higher lending rates, which indirectly affects inflation, the researchers observed.

Healthy competition, when supported by strong institutional and supervisory frameworks, can lead to higher quality loan allocation, improved access to credit, and the allocation of resources toward more productive uses, according to the report.

While high concentration has been recorded in the Cypriot banking sector in recent years, the findings suggest this does not automatically translate into a corresponding strengthening of market power.

“Estimates of market power through two basic indicators, the Lerner index and the Boone indicator, suggest a moderate degree of competition during the period from 2018 to 2025,” Avgousti and Michael said.

Between the second half of 2022 and the first half of 2024, a temporary widening of profit margins was identified, with estimates suggesting that the divergence between loan price and marginal cost fluctuated, on average, at 37 per cent to 45 per cent of the loan price.

The change in the direction of European Central Bank (ECB) monetary policy from the second half of 2022 and the slower adjustment of deposit rates led to this widening, the report explains.

The paper notes that the trend was due in part to the significant excess liquidity in the banking system and structural market characteristics, such as the significant share of loans with floating interest rates.

The slow movement of depositors from current accounts to time deposits and the deposit rate floor in the previous period of negative interest rates also contributed to this shift.

Promoting a more competitive banking environment in the euro area, and specifically in Cyprus, is cited as a key way to improve the transmission of monetary policy.

“Increased competition can limit the spreads between loan and deposit rates and enhance access to finance for businesses and households, particularly in markets with high concentration,” the authors stated.

The potential increase in the presence of European banks, including digital ones, is expected to intensify competition for domestic banks, according to the researchers.

Maintaining competitiveness and the continuous adaptation of domestic banks are described as vital for the resilience of the system and overall financial stability.

“Very intense competition can lead to excessive risk-taking, especially by new market participants such as fintechs, neobanks, and payment platforms,” Avgousti and Michael noted.

This is particularly true when these new players are not subject to equivalent regulatory and supervisory rules as traditional banks, the study adds.

Systematic monitoring of developments in profit margins and the market power of banks in Cyprus is recommended, especially after the recent acquisitions of large banking institutions.

“The goal of such monitoring is the continuous evaluation of how concentration affects the degree of competition and the transmission of monetary policy,” the authors reported.

Moreover, the researchers observed that retail banking markets remain largely at the national level due to barriers related to language and culture.

The report also points to national legislations that differ from country to country, such as insolvency and foreclosure laws, which limit the operation of a unified banking market.

Limited cross-border activity of banks, due to reluctance to undertake large initial investments and risk aversion, remains a significant factor, according to the authors.

Most banks operate mainly within their national borders, meaning interest rates and products offered to consumers are largely determined at the national level.

“Reliable measurement of competition is important for policymakers, mainly for anti-monopoly authorities, supervisory authorities, and central banks,” the authors stated.

High profitability of banks can be the result of either favourable macroeconomic conditions or increased efficiency in their operation, Avgousti and Michael explained.

The researchers noted that a combination of high profitability maintained for a long time, high market concentration, and the existence of entry barriers can indicate the ability of banks to exploit their market power.

“Healthy competition can improve the quality of borrower assessment, limiting risk-taking,” Avgousti and Michael stated.

The study suggests that lower interest rates resulting from increased competition reduce the probability of default for borrowers.

A more competitive environment is also said to encourage innovation and diversification, improving the overall resilience of the financial system.

“Increased competition reduces concentration, which limits the number of systemic banks and reduces the risk to public finances and the economy in the event of a crisis,” the authors noted.

Ensuring a level playing field for banks and promoting healthy competition also enhances the resilience of the banking system, the authors explained.

“The implementation of the single rulebook and consistent supervision reduce the phenomena of regulatory and supervisory arbitrage,” Avgousti and Michael stated.

The analysis shows that more competitive markets punish less efficient firms more proportionately, which is reflected in the relationship between cost efficiency and profitability.

In competitive markets, increases in input prices are passed through more to revenues, whereas in monopolistic markets this effect is limited.

Banking products with lower demand elasticities are priced higher, according to the findings of the study.

“More intense competition in the loan market reduces spreads and accelerates the pass-through of market rates to deposit and loan rates,” the researchers noted.

Banks may offset the reduction in revenue from loans by reducing deposit rates, the authors stated.

“Deposit rates show greater rigidity in concentrated markets, particularly in periods of rising monetary policy interest rates,” Avgousti and Michael explained.

The study adds that limited competition and entry barriers lead to a slower and partial pass-through of monetary policy to lending rates.

“Recent entry of online and digital banks intensifies competitive pressures as they tend to adjust their rates faster and more aggressively than brick and mortar banks,” the authors observed.

Variability in consumer loan rates is mainly explained by country-level characteristics that remain stable over time, rather than market concentration or liquidity.

The researchers stated that interest rates for mortgages and business loans are slightly higher in more concentrated markets, while rates for corporate deposits are slightly lower.

“Healthy competition improves access to credit and directs resources to more productive uses, helping growth and macroeconomic stability,” Avgousti and Michael explained.

The transition from a banking sector with moderate concentration to one with high concentration has been recorded in Cyprus in recent years, the paper notes.

The weighted average of the Lerner index fluctuated between 0.34 and 0.45 in the last two years, indicating that the divergence between the price of a loan and its marginal cost is on average 34 per cent to 45 per cent of the loan price.

“Cypriot consumers perform significantly more transactions at points of sale via cards and mobile applications compared to the euro area average,” the authors observed.

The use of cash for payments in Cyprus decreased by 11 percentage points between 2022 and 2024, Avgousti and Michael explained.

In peer-to-peer transactions, Cypriot consumers prefer the use of cards and mobile applications, with cash following as a second choice.

“Digitalisation of the banking sector accelerates the transition to more flexible business models, strengthening innovation and contributing to more intense market competition,” the authors stated.

The non-completion of the Banking Union and barriers to customer switching, such as tying practices and high exit fees, continue to limit competition in retail banking.

“The participation of new financial service providers can offer alternative solutions and exert competitive pressure on traditional banks,” the researchers explained.

Progress toward completing the Banking Union with a unified deposit insurance system has the potential to reduce fragmentation and enhance the confidence of depositors and investors.

“Facilitating customer mobility through tools for easy account switching and digital infrastructures can contribute to more equal terms of competition,” Avgousti and Michael stated.