The return of inflation: what consequences for banks?

Tue 12 Jul 2022

For several months now, we have been in an economic and financial environment that we have not seen for some years. In May, inflation in the Eurozone reached 8.1%, with six countries exceeding 10%, while the United States recorded an 8.6% year-on-year price increase.

The short-term reasons for the return of inflation are well known, including the appearance of strong bottlenecks resulting from the disruption of production chains following the Covid pandemic and, more recently, the surge in energy prices as a direct and immediate consequence of the war in Ukraine.  These reasons, which we hoped would be transitory, are now being replaced by several long-term trends. These long-term trends are firstly linked to the relocation of certain production chains, with the pandemic highlighting excessive dependence on certain countries. Another factor is the urgent and imperative nature of the energy transition, which is painfully illustrated by the situation in Ukraine. As a result, the financial markets have entered a period of volatility with a general downward trend, and long-term rates are slowly but surely increasing. Equally, central banks, aware that this is no longer a transitory phenomenon, are now resigned to raising rates in an attempt to curb this inflationary surge. In the short term this will probably have more of a negative impact on growth than on prices, which are linked to imported inflation and over which central banks have little control.

No quick fix for credit institutions

It is traditionally considered that rising interest rates are favourable to banks so long as transformation activity leads them to lend in the long term and refinance in the short term. At the same time, banks must generate a transformation margin linked to the gap between higher long rates and short rates.  This being the case, there is little hindsight in an environment marked by a rise in rates following a very long period of low or even negative rates; hence the impact on banks is expected to be mixed.

In reality, the low rates we have been experiencing for a long time now have weighed on banks’ profitability due to very low or even negative yields for deposit collection activity. Indeed, retail banks have been very strongly penalised during this period, insofar as the negative interest rates applied by central banks on deposits and the very low interest received on loans granted have come at a financial cost. That said, the European Central Bank’s (ECB) announcement of an increase of 0.25 basis points at the end of July followed by a similar increase, or higher, in September heralds the return of interest rates to positive territory for European banks in the Autumn. This will be favourable for financial institutions since their deposits with central banks would no longer lead to financial outlays. At the same time, interest received on loans granted would be higher.

However, the impact of a rate hike is not expected to result in an immediate improvement in banks’ profitability. Indeed, in addition to problems related to the necessary adjustment of their asset liability management (ALM) policy, the stock of assets granted at fixed and very low rates will impact banks’ balance sheets. This impact will be felt mainly in Europe, particularly France, where the share of fixed-rate loans is higher than in other countries such as the United States.

A period of turbulence ahead

A rise in short-term rates will indeed put pressure on financing costs, and the beneficial effect of an increase in long-term rates will only be gradually felt depending on the speed with which the balance sheet is renewed, which in turn will depend on the average duration of the assets held by banks. Hence, we can anticipate a jaws ratio phenomenon within retail and universal banks that will impact their profitability for a while, particularly concerning their lending activities.

As far as market activities are concerned, the return of inflation and especially the change in the monetary policies of central banks have already had a depressive effect on the markets. This would continue as monetary tightening impacts growth. Plus, as the main factors of inflation are imported, a gradual decrease in growth would have a knock-on effect on inflation. At the same time, the deflation of certain asset bubbles fuelled by the expansionary policies of central banks, particularly in the bond sector, will also negatively impact market activities.

All in all, the coming wave of interest rate hikes will lead financial institutions into a period of turbulence due to both downward market volatility and the scissor effect on retail banking profitability, which will last until the average profitability of assets adjusts to these new conditions. Particular attention must be paid to ALM policies and, in particular, to interest rate hedging, which will also have to be adjusted.

Learn more about the impact of rising interest rates on ALM models in the attachment below.