How Digital Banks Are Reshaping Monetary Policy Transmission Across Europe

Digital banks are making monetary policy more powerful on the deposit side by reacting faster to interest rate changes, but struggle to pass costs to borrowers, squeezing profits. This creates a faster, more competitive but potentially more fragile banking system with higher risks of rapid deposit movements.

The rise of digital banks across Europe is beginning to reshape how monetary policy works in the real economy. A new European Central Bank (ECB) working paper shows that these app-based, branchless institutions are not just changing how people bank, but also how interest rate decisions travel through the financial system.

Digital banks, often called neobanks, have grown steadily over the past decade. They still make up a small share of the euro-area banking system, just over 3 percent of total assets, but their influence is growing quickly. Built around mobile apps and online platforms, they operate with fewer physical costs and compete aggressively on pricing, especially for deposits.

Why digital banks behave differently

What makes digital banks different is how easy it is for customers to switch. With a few clicks, people can compare interest rates and move their savings. This reduces loyalty and makes customers far more sensitive to changes in interest rates.

As a result, digital banks depend heavily on household deposits, particularly short-term or overnight funds. To keep these deposits, they must respond quickly when interest rates change. This creates a more competitive and fast-moving environment compared to traditional banks, where relationships and branch networks still play a role.

Faster response to rising interest rates

When the ECB began raising interest rates in 2022 to tackle inflation, digital banks reacted more quickly than traditional banks. They increased deposit rates faster and by larger amounts, especially for household savings.

This means that customers of digital banks benefited sooner from higher interest rates. At the same time, it forced banks to pay more to keep their funding. Economists call this the “funding channel” of monetary policy, and digital banks are making it stronger.

However, there is a catch. While digital banks pay more to depositors, they do not raise lending rates by the same extent. Loan rates increase at a similar pace to traditional banks, which means digital banks cannot fully pass on their higher costs. This squeezes their profit margins.

Growth continues but with pressure

Despite rising costs, digital banks continued to attract strong inflows of deposits during the period of higher interest rates. By offering competitive returns, they were able to keep growing even as conditions tightened.

But the pressure showed up elsewhere. Lending growth slowed more for digital banks compared to traditional ones, especially later in the tightening cycle. This reflects the impact of lower margins and higher funding costs.

In simple terms, digital banks can grow quickly when times are good, but they feel the strain more when interest rates rise sharply.

What happens when rates fall

As the ECB started lowering interest rates in 2024, the pattern began to shift. Digital banks reduced deposit rates faster than traditional banks, showing that they are also quick to adjust when rates fall.

At the same time, their advantage in attracting new deposits weakened. Customers became less motivated to move their money, and traditional banks began to catch up. Lending rates, however, did not fall as quickly, allowing digital banks to slowly rebuild their margins.

This shows that digital banks react strongly in both directions, raising and cutting rates faster than others, but not always in a balanced way.

Risks and what it means for policy

The growth of digital banking brings both opportunities and risks. On the positive side, it makes monetary policy more effective by speeding up how changes in interest rates reach savers.

But there are concerns as well. Because deposits can be moved instantly, digital banks may face faster outflows in times of stress. A bank run in the digital age could happen much more quickly than before, without queues or visible warning signs.

For policymakers, this means adapting to a new reality. Central banks may need to rethink how policy decisions affect banks and customers in a digital world. Regulators will also need to keep a closer eye on how stable these deposits are.

For banks, the challenge is clear. They must balance attractive rates for customers with sustainable profits. Digital banking offers speed and convenience, but it also creates a more competitive and fragile system.

In the end, the ECB study highlights a simple but important shift: digital banks are making the financial system faster, more responsive, and potentially more volatile.