Before the pandemic, investors were concerned that interest rates and persistently low inflation could reduce the benefits of banks. Paradoxically, they also worried the profitability of banks when, with reopening after COVID-19, inflation and interest rates of central banks were shot. The bankruptcy of Silicon Valley Bank and other American lenders in early 2023 seemed to confirm these fears.

Our new study on the relationship between inflation and bank profitability helps us understand these concerns. Most banks are largely safe from inflationary fluctuations, since the exposure of their income and expenses tend to compensate each other. However, some have significant exposure to inflation, which could cause financial instability in the event that concentrated losses cause a more generalized panic in the banking sector. Several important central banks are reexamining their monetary policy frames after the postpandemic inflationary rebound, and a deeper understanding of the links between inflation and bank profitability could help design better monetary policy frames.

The results of our research indicate that central banks might take into account financial stability by setting their monetary policy to combat inflation.

Inflation matters

Is inflation for bank profitability important? The little attention that has been given to this question surprises. To respond, we combine data on balances and income of more than 6,600 banks of advanced and emerging economies with almost three decades of economic data of the IMF.

Most lenders seem to be largely covered in front of inflation, since both revenues and banks increase with inflation in similar degrees. The income and expenses related to indebtedness and the granting of loans are indirectly exposed to inflation, since they mainly react to monetary policy interest rates, which fluctuate in response to inflation. On the other hand, other income and expenses – like those derived from non -traditional banking activities, services, wages and rentals – are directly affected by price variations.

At the national level, the impact of inflation on the income and expenses of the banks varies considerably from one banking system to another. In some countries, variations in inflation are reflected in income and expenses much faster than in others. However, again, since in most countries both increase in similar degrees, a large part of banking systems seem to be, to a large extent, protected against inflation.

Concentrated exhibitions

So, should inflation concern us?

Our study identifies specific vulnerabilities: some banks are especially susceptible to inflation due to their different business and risk management models. Atypical banks, both in advanced economies and in emerging and developing markets, can suffer large losses if inflation and interest rates are triggered.

Surprisingly, 3% of the banks of advanced economies and 6% of the banks of emerging economies are at least exposed to high interest rates such as Silicon Valley Bank at the time of bankruptcy. In addition, the banks of emerging economies seem to be more exposed to inflation directly, possibly due to more generalized price indexation.