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Inflation can cause banks to cut back on lending, further harming economy: study

Inflation can cause banks to cut back on lending, further harming economy: study
Posted 2022-11-15

A new study from the UBC Sauder School of Business finds banks most exposed to inflation are more likely to cut back on lending, which can negatively impact housing prices and construction jobs.

With inflation rates reaching highs not seen since the 1980s, consumers are having to tighten their purse strings and rein in their spending. But according to a new UBC Sauder study, shoppers aren’t the only ones feeling the pinch: the banking sector likely is too, and the ripples from those shocks can be felt economy-wide.

According to UBC Sauder Assistant Professor and study co-author Dr. Isha Agarwal (she/her/hers), prior to the 2009 global financial crisis, experts in macroeconomics often overlooked the direct role banks played in the broader economy. But the crash proved they were critically important — and when the banking sector got hit hard, the shock deeply affected housing, jobs, investments and more. 

So what happens to banks during periods of significant inflation, like the one we’re experiencing now? For their study, Inflation and Disintermediation, Dr. Agarwal and colleague Matthew Baron of Cornell University looked at global inflation episodes dating back to the 1800s, and examined their impact on the banking sector around the globe.

They found the banks that were most exposed to inflation were also the most likely to reduce their lending — but that drop could have also been the result of other factors such as lower demand, higher interest rates or currency fluctuations.

So to determine whether inflation was behind the pullback, the researchers zoomed in on the balance sheets of U.S. banks in early 1977, a rare period when inflation rose from five to seven per cent but there wasn’t a real interest rate jump or large currency change.

Looking specifically at the state-level cash reserve requirements, and using balance sheet data from individual banks, they then constructed a measure to calculate each bank’s inflation exposure and their asset-liability mix.

What they found was that the banks with the highest inflation exposure — that is, the ones that were required to keep the most cash in reserve — reduced lending the most. In fact, their loan growth was reduced by 2.7 per cent that year, as compared with the average loan growth of 19 per cent the same year.

“If the supply of credit in the economy goes down, this can be bad, because a lot of small firms depend on banks for investment,” explains Dr. Agarwal. “But if banks are negatively affected by inflation, they won’t be able to provide credit, which will have a further negative impact on the economy, because it limits that investment.”

The researchers also found that the banks most exposed to inflation cut back on household lending, and that the states with the most inflation-exposed banks saw decreases in housing prices and construction employment. In other words, when banks were getting hit by inflation, and the value of their cash reserves fell, they couldn’t afford to lend as much, and that in turn rippled through the broader economy.

Business lending tended to be less affected, likely because the loan terms in that area are far shorter than lengthy mortgage loans.

“Banks aren’t afraid of making a new loan to a company because they know they can change the terms of the loan relatively quickly. So even if inflation is higher in the future, they know they won't suffer losses,” says Dr. Agarwal, adding that this distinction can vary from country to country, depending on their lending rules.

Dr. Agarwal says their results held more generally in all U.S. commercial banks from 1976 to 2019.

“In certain countries, the problem was so bad that banks stopped giving out mortgage credit completely because they were worried that if they locked in an interest rate for 20 or 30 years, they could lose out, because they could see inflation persisting for at least the next three to five years,” says Dr. Agarwal. “It became a big problem.”

Since the 1970s, many in the financial world assumed inflation was a thing of the past, so didn’t seriously consider banks’ exposure to inflation — but the researchers’ findings can help today’s banks understand their own risks as they navigate another inflationary stretch. The results could also help regulators and policy makers when it comes to mitigating inflation’s negative effects.

“Whenever we think about how Inflation affects the economy, we talk about how Inflation directly affects people’s income and purchasing power, but we never really think about how the banking sector can also be affected, which can then affect credit in the economy,” says Dr. Agarwal. “But the banking sector can be a primary transmitter of those shocks.”

Interview language: English