How Negative Rates and Court Rulings Reshaped Austrian Banks’ Interest Strategies

An ECB study reveals that negative interest rates, combined with Austrian legal constraints, compressed bank profit margins by disrupting the traditional link between lending and deposit rates. Banks faced dual pricing pressures as loans tracked falling benchmarks while deposits remained floored at zero.

In a major study commissioned by the European Central Bank (ECB) and supported by Austria's Oesterreichische Nationalbank (OeNB), researchers Alessandra Agati and Michael Sigmund have unveiled how Austrian banks adapted to the unprecedented challenges posed by negative interest rates. Spanning data from over 500 domestic banks between 2009 and 2021, the paper examines the structural shifts that took place after the ECB dropped its Deposit Facility Rate (DFR) below zero in June 2014 a historic policy designed to battle deflation and reignite credit growth across the euro area.

The research, part of the ECB Working Paper Series, dives deep into how banks altered their deposit and lending rate strategies amid the ultra-low interest rate environment. Using an advanced econometric framework panel cointegration and vector error correction models—the study finds that negative interest rates fundamentally altered long-standing relationships between key bank rates and market benchmarks like the 3-month Euribor.

Two Hypotheses, One Squeezed Margin

At the core of the analysis are two hypotheses. The first, termed the "spread reduction hypothesis," posits that Austrian banks were caught between falling lending rates and deposit rates that could not fall below zero due to legal and practical constraints. The second, the "two true prices hypothesis," suggests a bifurcation in pricing behavior banks effectively began using two separate reference points: one for loans and another for deposits.

Both hypotheses found support in the data, particularly given Austria's unique legal setting. A 2009 Supreme Court ruling prohibited banks from imposing negative rates on household deposits, while a later decision required that negative market rates be passed on to borrowers with floating-rate loans. This legal asymmetry meant that while banks had to cut lending rates in line with a falling Euribor, they could not lower deposit rates past zero creating a painful squeeze on net interest margins.

"The policy rate going negative changed more than just market expectations," said Sigmund. "It forced banks to rewrite their pricing models, often in ways that cut into profitability."

Legal Boundaries Reshaped Rate Transmission

The study found that Austrian banks' ability to transmit policy rate cuts to depositors was effectively blocked. Households, legally protected from negative deposit rates, became immune to further policy easing on the deposit side. At the same time, the courts mandated that banks could not cushion themselves by refusing to pass on negative Euribor rates to borrowers. This dual constraint created a structural imbalance: deposit rates hit a legal floor while lending rates kept dropping.

This shift also undermined traditional economic models, where a single market reference rate like the 3-month Euribor guides both sides of the bank's balance sheet. Instead, banks were left with two pricing "truths": one constrained by legal floors and another dictated by falling benchmarks. According to the authors, this disrupted the conventional cointegration between lending and deposit rates, leading to thinner margins and lower returns on assets.

The Euribor Held Strong, While the DFR Gained Power

The study also reveals that the 3-month Euribor continued to play a central role in bank pricing, particularly on the lending side. Even in a negative rate environment, Euribor retained a strong cointegrating relationship with loan rates, with its influence growing more pronounced over time.

Meanwhile, the ECB's Deposit Facility Rate, traditionally a secondary influence, gained unexpected prominence due to the introduction of the Targeted Long-Term Refinancing Operations (TLTROs). These special funding programs allowed banks to borrow from the ECB at very low rates, directly linked to the DFR. As a result, banks began anchoring their lending margins to the DFR instead of more traditional benchmarks. This shift was especially visible during the negative rate era, where banks sought to maintain profitability by aligning their lending strategies with TLTRO-linked conditions.

Short-Term Advantage, Long-Term Pressure

The researchers also explored the short-run impact of policy rate changes, using a vector error correction model. The results showed that banks were initially able to benefit from falling policy rates lending rates adjusted more quickly than deposit rates, offering a temporary boost to interest income. However, this effect was short-lived. Over time, equilibrium forces and delayed adjustments in deposit rates brought spreads back down, reducing profitability again.

Perhaps most notably, the study found a high degree of consistency in how banks responded regardless of size or business model. Nearly all Austrian banks exhibited similar pass-through behavior and rate-setting responses, underscoring the systemic nature of negative rate pressures. "It wasn't just the big players feeling the squeeze," Agati said. "This was a sector-wide challenge."

A Lesson in Limits for Future Policy

The findings offer valuable lessons for central banks and financial regulators. While negative interest rates may have succeeded in spurring credit growth and reversing deflationary expectations, they came with trade-offs, particularly for deposit-funded banks operating under legal rate floors. The study adds weight to the growing body of literature suggesting that negative rates, though effective in the short term, can challenge the profitability and resilience of the banking system in the long run.

As interest rates across Europe return to positive territory, the ECB study offers a timely reflection on one of the boldest chapters in modern monetary policy. It also poses a subtle warning: should central banks once again consider negative rates, the legal and institutional frameworks surrounding them will matter just as much as the economic theory behind them.