Banking’s UK inflation predictions have come thick, fast and as high as a staggering 22%, but far from a casual observer the sector can expect an at best mixed bag of its own side effects from sky high prices.
Citi Bank has forecast UK inflation, now 10.10%, to peak at 18.6% in the first quarter of 2023. Within a week Goldman Sachs doubled down on the country’s gloom, predicting a 22% peak next year, if gas prices remain at their current extremely high levels.
Bank of England action to help curb runaway inflation as households struggle has seen it raise interest rates six times this year – a balm to banks’ lending departments where the increases filter through into higher borrowing costs for customers.
But if inflationary pressure pushes the economy into recession – which seems ever more likely, according to not least the Bank of England – banks will see slowing loan growth and rising bad debts which will impact profits and capital.
Evarist Stoja, Professor of Finance at the University of Bristol, foresees largely negative effects for the banking sector, due to the association with rising credit costs.
He says: “The banks or financial institutions that specialise in residential mortgages and those providing loans to non-prime borrowers are particularly at risk when inflation is high”.
Diversification into new business areas offers good prospects.
Tightening lending conditions and more expensive credit could be banks’ answer, however. The sector’s risk aversion amid high inflation will also be a factor in how long any recession lasts.
UK inflation predictions, a fairly sedate matter of bobbing around 2% for the past twenty years, have lately jumped in a manner usually reserved for cryptocurrency price spikes. The pace of change is astonishing, with global banks seemingly vying to herald ever worse news. At the end of August, Citi Bank, one of the world’s biggest, made a headline grabbing forecast for UK inflation. At the time 10.1%, Citi predicted it was on course to peak at 18.6% in the first quarter of 2023. Within a week Goldman Sachs also hit the headlines in the United States and in every newspaper in Britain when it bettered the depth of the gloomy outlook, warning its models have UK inflation peaking at 22% next year, if gas prices remain at their current extremely high levels. While households scramble to stave off the worst effects of higher prices, the impact on the banking system from where some of these dire forecasts are emanating, is mixed.
Positive and negative effects of high inflation on banks
First the positives for the banking sector – higher inflation has forced, and is expected to continue to force, the Bank of England to raise interest rates. As at August the Bank had hiked rates six times since December 2021, when the cost of borrowing stood at 0.1%, to 1.75%. At the start of September the Base Rate was expected to hit 4% by February 2023, according to some City experts and analysis. Subsequent Government interventions to cap the energy price hikes at £2500 a year for the average family, with something similar for businesses, announced on 8 September, could put a brake on rising rates by limiting to some extent energy price inflation. But Iain Pyle, investment director at fund management house abrdn, points out any further increase in the base rate would be “hugely beneficial” for banks. He says: “After years of artificially low rates, the normalising of the interest rate environment allows banks to make a return on overnight deposits and benefit from the structural hedge1, as well as expand their net interest margins, as rate rises will not be fully passed through to depositors.”
Effects after this, however, are more uncertain. If the economy can continue to grow in an inflationary environment, then it is likely good for the banking system, and may also be good for customers, Pyle says: “Competition for deposits will ensure rate rises are passed through to depositors, and loan losses are likely to be controlled”.
However, more negatively, if inflationary pressure pushes the economy into recession, banks will see slowing loan growth and rising bad debts which will impact profits and capital. A UK recession seems ever more likely. The latest data from the closely watched purchasing managers index (PMI) showed UK business activity contracted in August for the first time in a year and a half, while services, which is the UK’s largest sector, grew at its slowest pace for 18 months. Released just hours before it was confirmed Liz Truss would be the next prime minister, the strongly negative economic indicator shows the scale of the problems she inherits.
If high inflation is sustained, Evarist Stoja, Professor of Finance at the University of Bristol, foresees largely negative effects for the banking sector, due to the association with rising credit costs. As a result, he points out, all lenders typically face lower loan demand as well as lower borrower credit quality. But, he adds, “the banks or financial institutions that specialise in residential mortgages and those providing loans to non-prime borrowers are particularly at risk when inflation is high”. Some borrowers will unfortunately default and the banks will not lose just the return on those loans but will typically recover only a fraction of the loans themselves. Stoja adds: “This will clearly be challenging for the banking system with lower profits and possibly losses.”
Example of Lloyds Bank
As an example of the type of at-risk bank Stoja is talking about, Susannah Streeter, senior investment and markets analyst at wealth manager Hargreaves Lansdown, highlights Lloyds Bank, which, as a major UK residential mortgage lender, has fortunes in particular that are closely tied to how the UK economy is faring. She says: “The group has been putting more money aside due to the current uncertainty, which has been denting profits”. Lloyds’ income has been helped by increased mortgage lending, Streeter points out, but there are question marks over where lending volumes will go from here. She says: “A slowdown in the residential property market would hurt Lloyds more than its more diversified peers”. Its place as a major lender means as further incremental interest rate rises come through, Lloyds is in a relatively good spot, though, with Streeter pointing out this should boost net interest margins and feed through directly to growth. But Lloyds is also looking for alternative ways to grow by building out the group’s small business offering, and by focusing on larger corporate and institutional clients. Streeter says the other defensive characteristic Lloyds can fall back on amid all this uncertainty is a low cost to income ratio, in particular, due to increased digitisation, which reduces the cost to serve customers and potentially boosts profitability of future revenue growth. But she adds “with dark clouds hovering over the global outlook, Lloyds’ investors should be prepared for ups and downs given the current inclement weather affecting the economy”.
Main potential risks
Banks are more robustly prepared post-global financial crisis to deal with shocks including from high inflation. As Evarist Stoja, Professor of Finance at the University of Bristol, points out UK banks passed the most recent stress tests, which determine the capital requirements financial institutions set aside in case of losses so they do not threaten the stability of the financial system. The Bank of England recently declared no British bank is “too big to fail”. In this context, Stoja says, “I do not see any fatal risks to the sector”.
Iain Pyle, investment director at abrdn, is similarly sanguine. He points out QE has meant there is excess liquidity in the banking system, meaning competition for deposits is low and banks are exceptionally well provisioned having built up credit provisions through the pandemic which are yet to be used. Pyle says: “These factors work in the banks favour and all have been prudent coming into this year, shrinking riskier lending such as credit cards”. Following government loan schemes, Pyle adds, a very high proportion of recent lending to corporates is guaranteed by the government. “So there are good reasons why loan losses may be benign,” he says.
Banks are not without concerns, however. For example, Stoja says, recent high inflation surprises lead to financial market turbulence, “which in turn increases the chance of a messy repricing of assets”. Why is this important? Because the ‘search-for-yield’ that occurred over the past decade and a half led to relatively high asset prices. Stoja says: “This in turn increases the scale of any potential asset price adjustments to the downside”, which would negatively affect banks. Lower profitability is a risk in this case, and in some cases, especially for residential mortgage and non-prime lenders, potential losses.
Banks may respond by tightening the criteria for giving out new loans, and trying to cover any losses by charging more where they can. Medium term, says Stoja, banks may look to differentiate their products to increase their pricing power in an effort to pass on the cost increases to customers. He says: “Those banks that cannot, will find their costs far outpacing revenues”. In addition, he says, banks under pressure to maintain profits might engage in more serious and plainly wrong practices, to the detriment of competition, confidence in the market and ultimately customers. “Sound corporate governance and appropriate supervision is essential to ensure this risk does not materialise,” Stoja says.
Effects of bank risk aversion
Following repeated calls from the charity sector, which has been doing what it can, the government has stepped in with measures like the Energy Bills Support Scheme, and more recently a new Energy Price Guarantee from 1st October. Businesses and public sector organisations will see ‘equivalent support’ over the winter, the Government has said, without providing much detail. Small businesses in particular are struggling, and are expected to continue to do so. Office for National Statistics data at the start of September found sales by small businesses in July fell 10% from the previous month, the largest monthly fall since April 2020 in the first wave of coronavirus. Many are also now struggling to repay Bounce Back loans taken out during the pandemic.
Small businesses may feel the sharpest end of banks’ reaction to the current economic environment, making any impending recession worse. As Stoja points out, “high inflation leads to hard times which in turn increase risk aversion”. Banks, like consumers, become more reluctant to engage in economic activity and to induce them to do so, one has to pay them more, effectively compensating them to overcome their aversion. Stoja adds: “So prices increase further [for things like loans] which for some otherwise good and sound businesses may become prohibitive so they do not invest and simply wait for hard times to pass, prolonging them in the process”.
The Bank of England warned in August the UK will fall into recession this year. While commodity prices obviously dominate, banks’ risk aversion amid high inflation will also be a factor in how long any recession lasts. Banks may be heralding the bad news now, but they won’t long escape becoming part of it.