1. How ECB Transmission Works to Spain

The next stage of monetary policy transmission sees the interbank market interest rates passed on to the cost of loans and mortgages that banks grant to households and businesses. In Spain, for example, one-year EURIBOR is usually the reference rate for variable-rate mortgages, while three-month EURIBOR is usually reference rate for variable-rate loans to businesses.

ECB signals through Deposit Facility Rate [currently the rate to focus on] -> ESTR -> EURIBOR -> Bank retail rates.

5 Channels relevant to Spain:

1. Interest Rate Channel: DFR up => EURIBOR up => Mortgage payment up. With 12-month EURIBOR oscillating between 3.4% and 3.9% in recent months, Spanish households felt 400 bps hike in 12 months.
2. Credit / Bank Lending Channel: Spanish banks are bank-dependent economy [85% of corporate finance via banks]. Research by Banco de España shows evidence of nonlinear effects of transmission to credit standards for loans to non-financial corporations due to unprecedented intensity of rate hikes
3. Balance Sheet Channel: ECB analysis shows nonlinear model taking into account not only overall size of rate hikes but also size per unit of time gives much better fit when trying to replicate observed loan creation. Rapid hikes = faster credit crunch.
4. Risk-Taking Channel: Low rates 2014-2021 pushed Spanish banks to search for yield abroad [UK]. High rates 2022-23 reversed.[LatAm]
5. Sovereign-Bank Nexus: Transmission of ECB policy for Italy and Spain is found to have reverted to that of normal times after OMT announcement. Impairment in transmission was limited to period before sharp falls in sovereign yields following OMT. Spanish banks hold ~ €120bn Spanish gov bonds; if spreads rise, transmission breaks.

Special Instruments for Spain:

• TLTRO III: To support transmission and lower floor on TLTRO rates, keep funding taps open for credit-constrained parts of Eurozone as banks - with Italian and Spanish banking sectors still under stress, new TLTROs would partially offset impact from tighter policy
• Transmission Protection Instrument [TPI] 2022: ECB argues measures to limit rising sovereign spreads are justified to protect effective transmission - without TPI, rising sovereign yields could prompt higher interest rates for companies and households

2. Impact on Spanish Banks - Dual Phase

Phase 1: Negative Rates 2014-2021 - Profitability Squeeze

Funcas analysis:

Prior to ECB rate hikes, Spanish banks net interest margins remained stuck at 0.8% of average total assets, with interest income at 1.1% and expense 0.3%

Spanish banks frontloaded provisioning at height of crisis, allowing them to reap benefits later. But low rates delayed generation of new credit.

Result: Cost-cutting - closure of 50% branches, staff cuts, fee income push.

Phase 2: Tightening 2022-2024 - NII Boom then Normalisation

• NII grows by 47% y-o-y in 1Q 2024, 55% y-o-y in 2023 - Significant strengthening of recurring profitability
• Reason: Variable-rate repricing is fast on asset side, slow on deposit side [Spanish deposit beta ~ 15% vs 40% Eurozone average].
• But by 2024: Banco de España reported zero profit in 2023 and 2024, after releasing provisions to offset operating losses due to shift in monetary policy stance - paying interest on excess reserves and TLTRO repayment.

Other impacts:

• Mortgage demand -60% in 2023, credit standards tightened sharply - nonlinear effect
• Unrealized losses on bond portfolio - AFS/HTM impact smaller than US because Spanish banks hold less fixed-rate long duration
• Liquidity: TLTRO repayment € 200bn+ for Spanish banks in 2023, replaced with more expensive market funding

3. Case Laws - The Legal Limits of ECB Transmission

A. EU Constitutional Cases Defining ECB Mandate

1. Gauweiler & Others v. Deutscher Bundestag, C-62/14 [OMT Case] 16 June 2015
German Constitutional Court asked whether OMT program - ECB promise to buy unlimited sovereign bonds of stressed states like Spain - violates prohibition of monetary financing [Art 123 TFEU].

ECJ held: OMT is monetary policy, compatible, provided it is proportionate, does not involve direct purchase on primary market, and has conditionality [ESM program]. This saved Spain - after Draghi's "Whatever it takes" and OMT, Spanish 10y yield fell from 7.6% to 4% without ECB spending 1 euro. Transmission restored.

2. Weiss & Others v. Germany, C-493/17 [PSPP Case] 11 Dec 2018
Applicants argued PSPP exceeded ECB mandate and was economic policy, and violated proportionality.

ECJ ruled that ECB's PSPP is compatible with EU law. The ECJ dismissed claims that PSPP did not constitute monetary policy or violated principle of proportionality. Judgement echoed Gauweiler in emphasizing broad discretion should be given to ECB in deciding which instruments to deploy

German BVerfG later in 2020 declared Weiss ultra vires, but ECB continued - creating tension.

These two cases are the legal basis for TPI - ECB can buy Spanish bonds to protect transmission if justified.

B. Spanish Mortgage Cases - Where Transmission Fails at Retail

3. Spanish Supreme Court Judgment No 241/2013, 9 May 2013 - Floor Clauses
BBVA, Caixa Galicia, Cajamar included cláusulas suelo that prevented mortgage rate falling below threshold even when EURIBOR dropped.

Spanish Supreme Court ruled floor clauses were illegal when included without sufficient transparency

But limited retroactivity to May 2013 only - to protect banks.

4. ECJ Joined Cases C-154/15, C-307/15, C-308/15 - Gutierrez Naranjo v. Cajasur, 21 Dec 2016
ECJ overruled Spanish Supreme Court:

ECJ ruled that Spanish banks that had loaned money on variable rates were breaking European law when they refused to pass on savings from fall in rates after 2009 by enforcing floor clauses. ECJ declared clauses null and void and called for compensation of total money overcharged - ruling was retroactive

Impact: Cost to Spanish banks €3-7 billion, estimated borrowers owed €3,000 per year from 2009, average payout €15,000. This is direct judicial intervention to force transmission of ECB rate cuts to households - banks had blocked transmission via contract.

5. Spanish Supreme Court & ECJ on IRPH Index
After floor clauses, many banks switched to IRPH [more expensive than EURIBOR]. ECJ Case C-125/18 Marc Gómez del Moral Guasch v. Bankia held IRPH clauses subject to transparency control under Unfair Terms Directive 93/13.[2020]

4. Current Tension

ECB now faces reverse problem: How to ensure rate hikes transmit fully without breaking Spanish households? Banco de España notes that Spanish mortgage stock is 80% variable pre-2022, but new production since 2023 is 60% fixed/mixed - banks adapting to reduce transmission sensitivity.