How Banks Navigate Rising Inflation

Do banks win or lose in a high inflation scenario? The answer is more complex than you might think.

As inflation reaches a decades-long peak, consumers’ money is quickly losing its buying power, and they have less ability to buy goods or invest as before. This negatively impacts consumer spending and saving habits, directly affecting the U.S. financial institutions they trust with their money.

Let’s explore how banks are coping with the staggering effects of inflation in the U.S. and how it impacts their business operations, their risk management, and their customer relationships.  

9.1% — The Current Conundrum

For June 2022, the U.S. consumer inflation rate is at  9.1 percent compared to June 2021— a four-decade high point — and consumers and banks are clamoring for a solution and Fed intervention. Slow, steady inflation can stimulate an economy. However, rapid inflation can be detrimental to those who live within it, especially if it remains unchecked and causes a full-blown recession

If this recent inflation rise causes a recession, it will be one unlike any other. GDP is falling as corporations continue to hire new workers, which is the opposite of what historically occurs during a recession as unemployment typically increases. Also, corporate profits are currently in the double digits and rising, which is at a 70-year high.

There were 11.3 million job vacancies in May 2022, and GDP jumped to 5.68% in 2021 but is now falling again. The pandemic continues, supply chains are disrupted, climate change is affecting global GDP, and international conflicts, like the war between Russia and Ukraine, remain a major factor. 

The Fed’s Response

In 2020, the Federal Reserve lowered the federal funds rate to almost zero to stimulate the economy during the pandemic. Americans were spending more in the past two years in response to this economic stimulation, but fewer are working now than before. Economists are calling this unusual cascade of events a “jobful downturn.”

The Fed uses the Federal Open Market Committee (FOMC) to enact changes in response to inflation based on the specific market factors present. There’s no perfect formula for controlling inflation, but the Fed can use specific measures to help the economy gradually regain equilibrium.

The FOMC can respond to overinflation by:

 The Federal Reserve, according to Chairman Jerome H. Powell, plans to increase the federal funds rate incrementally this year to stabilize the economy and hopefully bring inflation back down to 2%. However, he did admit recently that despite this, an imminent recession is still “certainly a possibility.” The Federal Reserve plans plan to increase the target range for the federal funds rate (which will, in turn, raise interest rates) roughly six times this year to put the brakes on consumer spending. However, he did admit recently that despite this, an imminent recession is still “certainly a possibility.”

Impact on Bank Profits

How have banks prepared for rising inflation? Inflation is a perennial issue that banks regularly contend with, and it’s not just the inflation rate that they need to worry about. So, how will it affect their customers and their bottom line? 

Higher interest rates and lower demand for loans can cause banks to lose income as fewer people want to borrow money or take out loans. Reuters predicts that major U.S. bank second-quarter profits will “fall sharply from a year earlier on increased loan loss reserves, as the pandemic recovery gives way to a possible recession.” 

Banks can rapidly adapt to these predictions before it becomes a sink-or-swim scenario. They can change their lending policies, adjust their loan rates, and turn their focus too heavily securitized loans. Other options include purchasing government bonds in secondary markets with fixed returns or issuing securities they can sell to raise capital.

Impact on Bank Credit

When money sharply loses its value, bank credit is impacted:

  1. An increase in inflation can lead to a decrease in bank credit and decreased earnings on funds invested
  2. Banks will adjust interest rates consistent with the Fed’s target range in response to inflation. The result is higher rates on credit provided by banks.
  3. An increase in inflation can lead to a rise in the price of bank credit. The increased rate businesses have to pay for financing new business activity can reduce growth and invest such as hiring, which has further implications on consumer behavior and borrowing.
  4. An economic recession often follows inflation spikes due to lower rates of consumption and a decline in demand for goods and services, which leads to a fall in businesses’ earnings.
  5. An increase in inflation perpetuates itself as other consumers and businesses follow suit because they may benefit from it (e.g., higher demand for products will lead to more production and, in turn, higher prices of goods).

The Customer Outlook

How is rising inflation affecting customer loyalty? A large percentage of bank customers remain loyal to their chosen financial institution for years, through thick and thin. However, their loyalty will be tested as inflation continues to rise higher than it has in 40 years. 

Customer Loyalty at Risk

In April, roughly 27% of retail banking customers moved some portion of their money from their primary institution to another bank. Banks should prioritize customer loyalty or risk potentially suffering in the long term as their customers jump ship.

Banks are in a difficult position during inflation hikes because while they want to keep their customers satisfied, they also may need to raise interest rates to protect  profitability. As a result, prioritizing customer loyalty becomes vital because it will keep them coming back despite a higher cost of borrowing. 

Make Customer Retention a Priority 

If customers drift to other banks, financial institutions may have a hard time maintaining or growing their customer base, which could harm efforts to protect profitability and margins. A recent economic study discovered that customer loyalty requires accurately identifying customers’ needs and prioritizing their satisfaction. 

According to the research, “perceived value, service quality, customer satisfaction, and brand trust significantly influence customer loyalty.” Making these pain points an integral part of your customer retention plan will help you maintain profits and weather inflation. 

How Banks Are Preparing for Rising Inflation

By remaining agile and responsive to economic downturns, you can be prepared for the future. Adjust your lending policies or loan rates as needed. Turn your focus on new lending methods such as heavily securitized loans, issue securities to raise capital, or utilize government lending programs.

Banks can expect these higher inflation rates to affect nominal GDP and bank profits well into 2023 positively. Once Federal Reserve monetary policy manages to put the brakes on inflation, however, the nominal GDP and bank profits could slow down or fall below the levels predicted by the consensus. 

As a result, it would be prudent for banks to utilize new technology applications such as data analytics, machine learning, and crowdsourcing to predict risks and manage customer expectations more effectively in the future. 

To remain afloat, financial institutions must dynamically respond to what is happening globally and within the banking, world to retain customers, maintain their financial standing, and continue to expand.

Best Practices for Banks During High Inflation

What are the best practices for managing risk in a world of rising inflation? A robust and responsive risk management framework is crucial when the risks are so high. According to McKinsey & Company, in the next three years, “shifts in customer expectations and technology are expected to cause massive alterations in banking,” leading to an increased need for banks to adapt and reinvigorate their risk management plans. 

Risk management for banks involves a complex process of identifying, analyzing, and controlling exposures to loss — such as inflation hikes, recessions, fraud, and adverse economic outlooks. Risk management strategies should include a comprehensive list of potential challenges and a plan with systems and procedures ready to respond to the outlined risks. 

If you want to learn how to accurately predict financial risks and weather economic downturns that may affect your financial institution’s lending practices, we can help you do that. At Lumos, we align valuable government data resources with standardized and automated metrics to tell the whole story — from risk to industry performance. 

Here at Lumos, we have analyzed inflation impacts specific to SBA loans.  We found that Investment Advisory is the industry most impacted by inflation –  a 1-point increase in inflation leads to an 11% increase in annual default rate.  The current rate of inflation of 9.1% leads to an anticipated probability of default of 9.62%

Discover how you can break out of your data silos and make better strategic decisions with SBA-specific predictive models backed by relevant data. Our advanced analytics and visualizations help you turn abstract metrics into clear insights. Schedule a free demo to learn more today.