Inflation could be good news for banks

10.20.2021 3 min
Read my article in the Revue Banque of November 2021

As we all know, and contrary to what we sometimes read, low interest rates are not in themselves a bad thing for banks. For them, what matters is not so much interest rates as the slope of the interest rate curve. Note that in France, for example, loans, such as home loans and investment loans, are on average fairly long term and mostly fixed rate, whereas deposits are fairly short term, and are either non-interest-bearing or term deposits, which bear interest indexed to short-term rates.

If the difference between long- and short-term rates is large enough, it does not matter whether interest rates are high or low. The same slope generates the same net interest margin (NIM). On the other hand, very low long-term rates of close to zero do not enable a steep enough interest rate curve to generate an adequate NIM. This is with good reason, as deposits with negative interest rates are far from attractive and are difficult for households and small and medium-sized businesses to accept.

Rising interest rates is favorable to the NIM

In practice, banks quickly see an increase in their NIMs if the interest rate curve moves steadily upwards. The reverse also applies. This counter-intuitive effect is due to loans being rolled over faster than savings. When short- and long-term interest rates rise, the average outstanding loan rate rises faster than the average outstanding deposit rate, which is usually indexed to regulated rates.

Conversely, when the curve falls, interest rate adjustments and early home loan repayments gather pace. Households therefore benefit from the drop in interest rates, while liability-side investments by households, in housing savings plans, for example, are rolled over less quickly, as households want to keep the previous, more advantageous rates, for longer.

The European Central Bank’s crucial role in the equation

What impact might inflation therefore have on banks’ NIMs through the change in interest rates? Given what they are announcing, the most likely scenario is that central banks will reduce their quantitative easing by gradually stopping their net purchases of long-term securities on the markets, or tapering, before raising their key rate, i.e. short-term rates. This could have a positive effect on banks’ NIMs, since long-term rates could rise faster than short-term rates, thereby steepening a slope that is currently very flat.

This would also be good policy, as the central banks would gradually stop underpinning financing conditions, as growth and inflation picked up, while allowing banks to effectively finance loan applications thanks to the lessened impact of quantitative easing on profitability. This positive effect should not, however, obscure the impact of the simultaneous disappearance of the support provided to banks by central banks, particularly through tiering and Targeted Longer-Term Refinancing Operations (TLTROs) in the euro zone.

Another factor that should now be considered is volumes. Movements due to the interest rate effect, i.e. the change in NIMs, may be more or less offset by the volume effect, in other words changes in loan and deposit outstandings. In fact, by setting off the interest rate effect against the volume effect you ultimately arrive at the change, by value, in the NIM itself.

A cautious normalisation of monetary policy would theoretically have a positive impact overall. If rates were to rise gradually and fairly smoothly, the resulting volume effect should be relatively neutral. If the central banks went ahead with this normalisation only very gradually, and after announcing it, which is the most likely scenario, this might also limit the ups and downs on the financial markets.

However, if, for one reason or another, the central banks did not respond to a sustained increase in inflation, their credibility would be undermined, and long-term rates would rise more sharply, while short-term rates would be flat. Demand for both housing and investment loans could be affected, possibly generating a negative volume effect, or a less positive effect than under a gradual approach. The bond and equity markets could experience substantial capital losses.

A bleak scenario to be avoided

In such a scenario, the bubbles would deflate more quickly and the shocks to both bank balance sheets, and the balance sheets and profit and loss accounts of banks’ clients, could be more severe, and have repercussions for bank provisions and trading income. Highly indebted companies and states that failed to prepare for the likely rise in interest rates could suffer even greater consequences.

The central banks therefore play a major role. In order to prevent the forming of excessively large bubbles, even if inflation is contained, sooner or later they should normalise their monetary policies so that nominal interest rates are not left too far below the nominal growth rate for too long.

Olivier Klein
CEO of BRED and Professor of Financial Macroeconomics and of Monetary Policy at HEC Paris