Should we worry about Inflation?

Of course we should (says the mainstream economist). Moderate levels of inflation (2 per cent) may be acceptable for they help greasing the wheels of an economy. But as soon as inflation swings to the exciting side of 5 per cent for a prolonged period of time, its true nature surfaces. Given we are slowly ridding ourselves from the shackles of a terrible recession, this is all the more worrying, for central banks have tried to mop up the mess by injecting unprecedented amounts of liquidity into the system. If withdrawal of these funds comes too late in an eventual recovery, we may be facing an inflationary episode with levels well above what we have witnessed during the period of relative calm since the early 1980s. But even without a proper recovery, commodity prices surging ahead of an obvious cycle could trigger stagflation, ie, rising inflation without sizeable growth to go with.

Inflation will affect banks in two ways:

On the one hand, if inflation rises, so should long-term interest rates. As a consequence, capital (or, more precisely, the economic value of equity) will shrink, reflecting the effect of the change in interest rates on the loan portfolio -particularly, if large volumes have been renewed lately. However, by simple logic of renewing existing assets, rising interest rates will help banks to boost their income. Additionally, existing payer swap positions start paying out, and the relative impact of loan rate negotiations is alleviated (a 30bp discount on a 3 per cent loan is 10 per cent off ; 30bps on a 6 per cent loan amounts to a discount of 5%). As long as the maturities of large bond issues do not get in the way, this will help cushion the inherent loss of capital value.

On the other hand, and more worryingly, think of the particular workings of inflation. Inflation is nothing but a redistribution from creditors to debtors, ie, the real burden of debt shrinks. Will this affect a bank's lending business? Well, as long as rising interest rates do not offset the effect of the alleviation of the real debt burden the answer is no (given that banks are reporting their earnings in nominal terms). However, things may look somewhat different when it comes to deposits. Depositors will have to re-assess their options, since leaving the money in the bank seriously threatens their savings. Sure, while depositors will initially put up with modest levels of inflation, inflation above a certain threshold will change depositors' behavior. Clients eventually want to start hedging the real value of their savings. In other words, they might just grab all their liquid assets and move them off their banks' balance sheet. Where do they go? Safe bets include gold and shares (or anything that is not nominal, really).

Frankly, for most banks this is a terrifying prospect. At the moment, clients' risk aversion helps banks to enhance their funding structure in the light of complying with Basel III and the Net Stable Funding Ratio. But this development is fraught with two fundamental dangers. Firstly, a sudden rise in the demand for saving deposits will lead to breakneck competition in the hunt for savings (as we currently witness in markets like Spain). If this is exacerbated by a sudden burst of inflation, we might enter an era of permanently tight margins on saving deposits, severely denting profitability. Secondly, a loss of deposits could mean unplanned-for refinancing operations -in an environment where bond markets are already under a considerable stress due to maturity concentrations of both sovereigns and banks.

Consider two countermeasures to tackle this dilemma. Knowing who might withdraw and who will not, is of utmost importance. Luckily, Basel III already mandates the banks to analyze the stickiness of its funding in order to come up with a proper Liquidity Coverage Ratio and Net Stable Funding Ratio. But one should go beyond this and leverage the effort to derive ALM implications. Using this information to establish adequate hedging strategies will allow banks to stay ahead of the curve. However, developing (and advising on) retail products which allow clients to hedge the adverse effects arising from inflation could significantly improve a bank's ability to win the hunt for savings (and yes, this will bring back reasonable margins). One could even go as far as to use credit and debit card transaction data information to analyse a client's exposure to inflation, hence providing an up-to-date portfolio analysis of this most ancient fundamental risk of holding cash.

So, should we worry about inflation? Of course we should. But comprehensive risk analysis, product innovation and technology will help softening its otherwise devastating effects.