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Inflation can affect banks in many different ways

DNBulletin

Published: 10 November 2022

DNB kantoor jaren 70

In many respects, Dutch banks are in a very different position when dealing with the impact of high inflation than they were in the 1970s and 1980s, when consumer prices also rose rapidly. This emerges from a DNB Analysis (Dutch only) released today, which discusses the channels through which high inflation can hit the banking sector.

The analysis reveals that Dutch banks have less scope to cut costs than they had back then. Contrastingly, a steady rise in interest rates may actually have a positive effect on banks' net interest income during this period of high inflation. How banks’ profitability evolves will also greatly depend on developments in the real rate of interest, which rose sharply four decades ago, adversely impacting employment and the housing market. Given the uncertainties surrounding the current economic environment, banks would do well to maintain solid capital buffers.  

Banks benefited from higher nominal growth

As now, the Dutch economy was hit by major inflation shocks in the 1970s and 1980s (see Figure 1) which were caused by the two oil crises of 1973 and 1979.  To offset inflation, businesses tried to negotiate higher output prices, while workers negotiated higher wages. Consequently, high inflation was accompanied by high nominal growth, which hovered around 10% until the mid-1970s. Amid high nominal growth – and correspondingly high credit demand – the Dutch banking sector’s total assets tripled over this period.

Figure 1 - CPI inflation in the Netherlands

CPI inflation in the Netherlands

High inflation did not push up costs for banks

Banks operational costs may rise in times of high inflation, just like those of other businesses. Depending on the extent to which banks can pass on cost increases to customers, higher inflation eats into a bank’s cost-to-income ratio (operating costs divided by total income). Following a slight uptick in the early 1970s, the average cost-to-income ratio of Dutch banks fell substantially after the first oil crisis, from 72% to 62%. In particular, banks managed to keep relative wage costs from rising as much as income, which rose sharply due to high demand for credit. In addition, Dutch banks consolidated further. It will be challenging for banks to achieve similar efficiency gains in the years ahead. After all, Dutch banks have lower cost-to-income ratios on average today, and it remains to be seen whether they can once more benefit from higher credit demand.

Tightening monetary policy squeezed banks' net interest income

Higher inflation is often accompanied by higher nominal interest rates. In the 1970s and 1980s, interest rates rose by several percentage points a year. Moreover, rates were already at substantially higher levels than they are today (see Figure 2).

Figure 2: Dutch short-term and long-term interest rates

Dutch short-term and long-term interest rates

During that period, Dutch banks’ net interest income – which is the difference between the rates they pay on deposits and other funding and the rates they receive on loans – was under strong pressure. Initially it fell from 2.5% to 1.5% of total assets, before stabilising more or less at 2% in the years following the oil crises (see Figure 3).

Figure 3 - Average net interest income (percentage of total assets) of Dutch banks

Average net interest income (percentage of total assets) of Dutch banks

In contrast to the 1970s and 1980s, a steady rise in interest rates may actually have a positive impact on banks' net interest income in the period ahead. This is because a steadily climbing interest rate eases the pressure on net interest income that banks have experienced in recent years, during which negative interest rates and a relatively flat yield curve posed major challenges. The extent to which banks will benefit from rising interest rates depends firstly on the pace at which higher rates will be reflected in their loan books (which, in turn, depends on the volume of new loans, maturing interest periods and interest rate derivatives). Secondly, it depends on the extent to which banks will be forced to raise interest rates on their deposits and the rising risk premiums on market funding they will face. If interest rates continue to rise sharply over short periods, banks may be forced to raise interest rates on their deposits faster than they anticipated in their lending policies and interest rate management. In such scenarios, net interest income will remain under pressure.

Higher inflation and interest rates drove up credit risks

Any impediment to inflation pass-through, such as businesses’ limited ability to pass on cost increases or lagging wage increases for households, and an abrupt rise in interest rates may cause businesses and households to experience liquidity and solvency problems. In the 1970s and 1980s, the two oil crises and the subsequent sharp interest rate hikes – with real interest rates rising from -5% to 5% between 1975 and 1980 – led to negative real growth. On top of this, unemployment went up sharply and house prices fell substantially (-30%) in the early 1980s. In response to deteriorating loan portfolio quality, banks increased their bad loan provisions (see Figure 4). Whereas provisions still stood at 0.1% of total assets in the early 1970s, they increased substantially after the first oil crisis and more notably after the second. In the early 1980s, provisions peaked at 0.7% of total assets, which, by comparison, is higher than the levels reached at the time of the 2008/09 global financial crisis or the COVID-19 crisis. Currently, provisions are still at a relatively low level (0.05% of total assets), but are expected to go up as the economic impact of higher inflation and interest rates makes itself felt with a time lag.

Figure 4 - Provisions (percentage of total assets)

Provisions (percentage of total assets)

Lesson from the 1970s and 1980s: prepare for adverse scenarios

The 1970s and 1980s teach us that the fall-out from inflationary shocks can materialise over a period of several years. For example, the impact of the first oil crisis in 1973 on the banking sector and the economy was relatively minor, and most risks did not materialise until a few years after the second oil crisis (1979).

Profitability, driven in part by high nominal growth and cost savings, was a key factor for banks in pulling through the challenging economic period of the 1970s and 1980s. As net interest income outweighed the substantial provisions banks had to make, they were able to expand their absolute capital position to achieve balance sheet expansion and meet high credit demand.

The current uncertain outlook underlines the importance of sufficiently high capital buffers (see also our autumn 2022 Financial Stability Report). In itself, a gradual rise in interest rates can have a positive impact on the profitability of Dutch banks, which are currently relatively well capitalised. Even so, banks would be well advised, in projecting their capital positions, to be prepared for more adverse scenarios, in which, for instance, interest rates rise rapidly and sharply and credit losses go up substantially.

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