How Australian banks can respond to the impact of high inflation

31 August 2022 9 min. read

In the first six months of 2022, economies across the globe recorded the highest levels of inflation seen in decades, and economists are predicting that inflationary pressure might 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 global peers (inflation in Europe for example hit a 25-year high earlier this week), however, it has by no means been spared.

The biggest inflation drivers are the recent global rise in energy prices, increases in commodity prices and disruptions in supply chain (all exacerbated by the war in Ukraine). But also in Australia there have been localized conditions lifting inflation rates, including the flooding in Northern NSW and QLD, coal outages impacting local energy prices, capacity constraints in certain industries like construction, and a deteriorating trade relationship with China.

For banks across the country, it is key to understand what the impact of inflation can be on their finances and operations. On the one hand to mitigate risks, and on the other hand to be able to tap into opportunities that will unfold.

To this end, four experts from strategic consulting firm Oliver Wyman (Julian Granger-Bevan, David Howard-Jones, Ross Eaton, Mark Wakeling) have developed possible scenarios that outline how the macroeconomic situation might evolve over the next couple of years, and translated those scenarios into possible implications for the industry. Based on their analysis, the experts put forward five recommended actions for banks.

The inflation scenarios

Soft landing

Central banks succeed in reducing inflation back to the single low digits, without compromising post-pandemic GDP growth, avoiding substantial spikes in unemployment and excessive supply chain pressures. Government yields remain sustainable, while credit spreads remain contained.

The divergence in the speed and intensity of the monetary policy responses between Australia, Europe and the US is limited, and foreign exchange effectively compensates any differences, with no disruptions to international trade patterns.

Hard landing
Inflation spirals out of control in the short-term (high single digits), forcing central banks to adopt a more vigorous monetary response. Ultimately, the monetary tools succeed in normalizing inflation, at the price of slowing down economic growth in 2023‑24, inducing volatility in foreign exchange and straining international trade patterns.

The global economy experiences sustained high inflation despite the severe tightening of monetary policy, slowing down economic growth for several years and triggering a price spiral that is complex to break. Possible divergences of monetary policy between Australia, Europe and the US could further deteriorate this scenario with negative effects on trade, which is already under significant strain due to the war in Ukraine and supply chain issues.

Implications for banks

According to Oliver Wyman’s analysis, inflation will impact banks’ financial performance via multiple mechanisms. While there can be major differences in the magnitude of impact, there at the same time will be some generic implications:

Net interest margin
Higher rates increase interest income on the lending book but put pressure on cost of funding of banks (deposits and wholesale funding). In terms of volumes, any associated economic slowdown reduces the total financing need for corporate and retail clients negatively impacting interest income.

Individual bank characteristics, such as the makeup of the lending book and its duration, the elasticity of the customer base to rate changes, as well as a bank’s credit spread will drive the magnitude of the impact.

Cost of risk
Balance sheet quality deteriorates, driven by higher default rates of highly leveraged customers that are sensitive to inflation and interest rates, or impacted negatively from a broader economic slowdown. Given Australian banks’ high exposure to residential property, any scenario where house prices fall significantly could cause highly geared borrowers into negative equity situations, placing further pressure on default costs.

Non-interest income
Fee and commission income likely to be mixed, with some resilience in non-discretionary items (e.g., insurance, and facility fees), however volume-based fees expected to slow-down as less favorable markets and trade volume dynamics drive down transaction banking and asset management activities. M&A and equity capital markets fees are likely to be negatively hit driven by uncertain economic outlook — although this can vary by sectors as this might trigger market consolidation.

Securities portfolios
Possible mark-to-market losses on certain credit instruments and government debt held in bank’s securities portfolio, or as part of its liquid asset buffer. Increase in bond coupons on newly issued debt.

Operating costs
Increasing wages and cost of third-party service providers with limited ability to pass on these costs to bank customers in the short term.

The impact: short versus the long term

Due to the relatively high net interest margin share of income that Australian banks enjoy, and with a large proportion of products linked to administered rates, any rising rate scenario is expected to benefit the Australian banks (at least initially).

Banks can reprice to meet their own objectives and rebuild margins that were compressed in the extended low-rate environment. This net interest margin impact is expected to dominate other impacts for Australian bank performance, which can be seen in the soft-landing scenario with a net positive impact to ROA.

However, this is only true up until a critical point. Should inflation and rate rises cause sufficient stress for retail and business customers, lending volumes will fall, property prices will materially decline, and the more highly geared borrowers may begin to face negative equity situations. At this point, banks’ cost of risk will grow significantly, and with declining lending volumes and rising operational costs, net interest margin gains are offset and we could see declining overall profitability.

In the stagflation scenario, this is further emphasized as economic downturn depresses lending volumes even further, costs continue to grow, and retail confidence declines.

Recommended actions for banks

Commercial banks should further develop and stretch their muscles for dealing with a period of high inflation not experienced in the last decade of declining interest rates.

The obvious challenge will be to sufficiently mitigate the potential pressure on their bottom line during the more severe inflationary scenarios regime (increased credit losses, operating expenses, disappearing of capital gains on securities), whilst ensuring that they do not overlook growth opportunities short term and ensure they are protecting their relationships with customers in the medium to long term.

This will require banks to consider five actions:

1) Seize the opportunity to support their clients throughout this inflationary period, proactively reallocating resources to growth areas and managing exposures to hardhit sectors.

Banks will need to determine their credit strategies across geographies and sectors, paying particular attention not to accelerate or deepen customers’ challenges. They also need credit strategies for sectors that will benefit from new investment due to either the implementation of recovery and resilience plans, or because they gain once post pandemic supply chains become re‑established.

Banks who hold a clear and updated view on the income and debt situation of their borrowers and understand how these will react to a changing economic environment will be able to better target their response. First movers will be advantaged by developing strong views and sectorial plays in areas of growth.

2) Use the rising rate environment to go on offense but ensure that investment is carefully channeled. Look for opportunities to build for longer term value growth, whilst continuing the much-needed transformation and modernization of banking infrastructure.

Review the spending portfolio to prioritize strategic investments and be willing to adapt pace should the macro environment require a pivot in the amount or direction of investment. Ensure an appropriate investment balance between longer term value plays, continued platform consolidation, and inflation proofing capabilities.

3) Invest in collections capabilities, focused particularly on systematic early intervention in the case of deteriorating credit quality and careful management of changing collateral values. Organisations can significantly improve credit outcomes and reduce their cost of risk through well timed, and tailored actions. However, building these capabilities takes time, so it is important to invest before material deterioration in credit quality occurs.

Early warning systems help to identify clients that are likely to experience stress, making use of broad macroeconomic data, sector specific information, and alternate data sources, and enabling the bank to take actions early. Where deterioration subsequently occurs, a modern collections capability can scale more rapidly if adequate investment has been made into automated or assisted self-serve capabilities.

Make use of tools to determine the optimum course of action to minimise the bank’s losses whilst ensuring fair customer outcomes.

4) Expand planning and simulation capabilities in two main ways:

First, develop modeling capabilities to allow more granular, asset level analyses, particularly for mortgage books. Australian banks can learn from European and US peers who have taken the opportunity to build upon significant investments made for regulatory stress testing purposes to support internal scenario modelling.

Second, expand scenarios being considered to cover significant downside scenarios, and extremes, including specific inflationary scenarios and longer periods of lower or negative growth. For example, late 1970s in the UK, Japan’s lost decade, etc. to ensure the bank is aware of potential impacts of a lasting downturn and can prepare a playbook of responses.

5) Reviewing internal incentive setting and financial resource allocation mechanisms that have been calibrated in a benign, low-rate environment, and haven’t been tested in rising rates. We are already seeing banks undertake strategic reviews in this area, to ensure that front line staff are being incentivized effectively and given the right amount of freedom to price and compete in an increased rate environment.

This becomes even more important should the “soft landing” scenario not be achieved, and economic growth becomes subdued as banks will need to compete for declining overall volumes.