Banking systems are largely insulated from inflation, but vulnerabilities at some banks could lead to tradeoffs between containing inflation and protecting financial stability, a recent study by the International Monetary Fund (IMF) found. Before the pandemic, investors worried about how persistently low inflation and interest rates would crimp bank profits. Paradoxically, they also worried about bank profitability when post-Covid reopening sent inflation and central bank interest rates soaring. The failure of Silicon Valley Bank and other US lenders in early 2023 appeared to validate these fears.
The IMF study says most banks are largely insulated from shifts in inflation—the exposure of income and expenses tend to offset each other. Yet some have significant inflation exposures, which may lead to financial instability if concentrated losses lead to wider panics in the banking sector.
“As several major central banks are reassessing their monetary policy frameworks in the aftermath of the post-pandemic inflation surge, a deeper understanding of the links between inflation and bank profitability can help design better monetary policy frameworks. Our findings imply that central banks may need to consider financial stability when setting their policy stance to combat inflation,” said the IMF study, a copy of which was made available to The Egyptian Gazette.
Most lenders appear largely hedged against inflation with both bank income and expenses rising with inflation to similar degrees. Income and expenses tied to borrowing and lending are exposed indirectly to inflation because they primarily react to policy rates that fluctuate in response to inflation, according to the study.
In contrast, other income and expenses—revenues from non-traditional banking activities, services, salaries, and rent—are exposed directly to price changes.At the country level, the impact of inflation on bank income and expenses individually varies widely across banking systems.
According to the IMF, three percent of banks in advanced economies and six percent of banks in emerging economies are at least as exposed to elevated interest rates as Silicon Valley Bank at the onset of its failure. Banks in emerging economies also appear more exposed to inflation directly, possibly due to more widespread price indexation.
“Shifts in inflation are reflected in income and expenses much more rapidly in some countries than in others. But, again, since both income and expenses rise with inflation to similar degrees in most countries, most banking systems appear largely hedged to inflation,” it added.
