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In the first six months of 2022, economies around the world saw the highest levels of inflation in a decade, and economists predict that inflationary pressures may not be temporary. For banks, the high inflation environment brings both threats and opportunities.
While Australia has not seen inflation quite reach the heights of its global counterparts (inflation in Europe, for example, hit a 25-year high earlier this week), it has by no means been spared.
The biggest drivers of inflation are the recent global rise in energy prices, rising commodity prices and supply chain disruptions (all exacerbated by the war in Ukraine). But there have also been localized conditions in Australia that have lifted inflation, including flooding in northern NSW and QLD, coal outages affecting local energy prices, capacity constraints in certain industries such as construction and deteriorating trade relations with China.
It is crucial for banks across the country to understand the impact inflation can have on their finances and operations. On the one hand, to mitigate the risks and on the other hand, to be able to take advantage of the opportunities that arise.
To this end, four experts from strategic consultancy Oliver Wyman (Julian Granger-Bevan, David Howard-Jones, Ross Eaton, Mark Wakeling) developed possible scenarios outlining how the macroeconomic situation could develop over the next few years and translated these scenarios into possible implications for industry. Based on their analysis, the experts proposed five recommended measures for banks.
Inflation scenarios
Soft landing
Central banks are managing to reduce inflation back to the low single digits without jeopardizing post-pandemic GDP growth, avoiding significant increases in unemployment and excessive supply chain pressures. Government yields remain sustainable while credit spreads remain tight.
Differences in the speed and intensity of monetary policy responses between Australia, Europe and the US are limited and foreign exchange effectively compensates for any differences without disrupting international trade patterns.
Hard landing
Inflation will spiral out of control (high single digits) in the short term, forcing central banks to adopt a more aggressive monetary response. Ultimately, monetary instruments succeed in normalizing inflation at the cost of slowing economic growth in 2023-24, causing exchange rate volatility and strained international trade patterns.
Stagflation
The global economy is experiencing persistently high inflation despite a sharp tightening of monetary policy, slowing economic growth for several years and triggering a price spiral that is difficult to break. Potential differences in monetary policy between Australia, Europe and the US could further exacerbate this scenario with negative impacts on trade, which is already under significant pressure due to the war in Ukraine and supply chain issues.
Implications for banks
According to Oliver Wyman’s analysis, inflation will affect the financial performance of banks through several mechanisms. While there may be large differences in the extent of the impact, at the same time there will be some general implications:
Net interest margin
Higher rates increase interest income from the loan portfolio, but put pressure on banks’ funding costs (deposits and wholesale funding). In terms of volumes, any associated economic slowdown reduces the overall funding need for corporate and retail clients, which has a negative impact on interest income.
The size of the impact will be determined by individual characteristics of the bank, such as the composition of the loan portfolio and its duration, the elasticity of the customer base to changes in rates, as well as the bank’s credit spread.
Cost of risk
Balance sheet quality is deteriorating, driven by higher default rates among highly indebted customers who are sensitive to inflation and interest rates, or negatively impacted by the broader economic slowdown. Given Australian banks’ high exposure to residential property, any scenario where property prices fall significantly could put highly focused borrowers in negative equity, putting further pressure on default costs.
Non-interest income
Fee and commission income is likely to be mixed, with some resilience in non-discretionary items (eg insurance and facility fees), however, volume-based fees are expected to slow as less favorable markets and business volume dynamics push down transaction banking and asset management activities. M&A fees and capital markets fees are likely to be negatively impacted by an uncertain economic outlook – although this may vary across sectors as this may trigger market consolidation.
Securities portfolios
Possible losses based on the market value of certain credit instruments and government debt held in the bank’s securities portfolio or as part of the liquid asset reserve. An increase in bond coupons on newly issued debt.
Operating costs
Increasing wages and costs of external service providers with limited ability to pass these costs on to bank customers in the short term.
Impact: short term versus long term
Given the relatively high proportion of net interest margin to income held by Australian banks and the large proportion of regulated rate products, a rising rate scenario is expected to benefit Australian banks (at least initially).
Banks can reprice to meet their own targets and restore margins that have been squeezed in the extended low-rate environment. This net interest margin impact is expected to dominate other impacts on Australian bank performance, which can be seen in the soft landing scenario with a net positive impact on ROA.
However, this only applies up to a critical point. If inflation and rising rates put enough stress on retail and corporate customers, loan volumes would decline, property prices would fall significantly, and higher-oriented borrowers may begin to face negative equity situations. At this point, the banks’ cost of risk will rise significantly, and with falling loan volumes and rising operating costs, the net gains from interest margins are offset and we could see a decline in overall profitability.
In a stagflation scenario, this is further accentuated as the economic downturn further reduces credit volumes, costs continue to rise and retail confidence declines.
Recommended actions for banks
Commercial banks should continue to grow and flex their muscles to deal with a period of high inflation not seen in the last decade of falling interest rates.
The obvious challenge will be to sufficiently mitigate the potential pressure on their bottom line during a regime of more severe inflationary scenarios (increased credit losses, operating costs, disappearing capital gains from securities) while ensuring that they do not overlook near-term growth opportunities and ensuring that they protect their customer relationships in medium to long term.
This will require banks to consider five steps:
1) Seize the opportunity to support your clients during this inflationary period, proactively reallocate resources to growth areas and manage exposures to hard-hit sectors.
Banks will need to determine their lending strategies across geographies and sectors, paying particular attention to not accelerating or deepening customer challenges. They also need credit strategies for industries that will benefit from new investment either through the implementation of recovery and resilience plans or as they accrue once post-pandemic supply chains are restored.
Banks that have a clear and up-to-date view of their borrowers’ income and debt situation and understand how they will react to a changing economic environment will be better able to target their response. First steps will be favored by developing strong views and sector plays in growth areas.
2) Use the rising rate environment to attack, but make sure investments are carefully targeted. Look for opportunities to build for longer term value growth while continuing to transform and modernize the banking infrastructure much needed.
Review the spending portfolio to prioritize strategic investments and be willing to adjust pace if the macro environment requires a change in the amount or direction of investment. Ensure an appropriate balance of investments between longer-term values, continued platform consolidation and inflation-proofing capabilities.
3) Invest in collection capacities focused mainly on systematic early intervention in case of deteriorating credit quality and careful management of changing collateral values. Organizations can significantly improve credit outcomes and reduce their risk costs through well-timed and tailored actions. However, these capabilities take time to build, so it is important to invest before credit quality deteriorates significantly.
Early warning systems help identify clients likely to experience stress, using broad macroeconomic data, sector-specific information and alternative data sources, enabling the bank to take early action. Where degradation subsequently occurs, modern collections capability can scale more quickly if adequate investment has been made in automated or assisted self-service capabilities.
Use tools to determine the optimal course of action to minimize bank losses while ensuring fair client outcomes.
4) Expand your planning and simulation capabilities in two main ways:
First, develop modeling capabilities to enable more detailed asset-level analyses, particularly for mortgage books. Australian banks can learn from European and US counterparts who have taken the opportunity to build on the significant investment made for regulatory stress testing purposes to support in-house scenario modelling.
Second, expand the scenarios considered to cover severe downturn scenarios and extremes, including specific inflationary scenarios and longer periods of lower or negative growth. For example, the late 1970s in the UK, the lost decade of Japan, etc., so that the bank is aware of the potential effects of a sustained downturn and can prepare a list of responses.
5) A review of internal incentive settings and financial resource allocation mechanisms that were calibrated in a favorable low-rate environment and not tested at rising rates. We are already seeing banks conduct strategic reviews in this area to ensure that frontline staff are effectively incentivized and given the right amount of freedom to set prices and compete in an environment of increased rates.
This becomes even more important if the “soft landing” scenario fails and economic growth is dampened as banks have to compete for declining overall volumes.
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