The western European banking sector, which is arguably better capitalised, has more resilient business models and improved governance practices than previously, is realising that 2022 is shaping up to be a very different year than 2021. Inflation has reached levels not seen in a decade and many pundits are predicting that inflationary pressure might not be temporary. But what impact will inflation have on European banks?
Oliver Wyman’s banking team has explored possible inflationary scenarios in a recent report, ‘The good, the bad and the ugly: the impact of inflation on European banking and what to do about it’. They point out that while many banks have addressed their legacy issues, most current bank executives have yet to lead their organisation through an inflationary period.
“Steering through this time of high inflation, while supporting the real economy in this period of uncertainty and efficiently facilitating the reallocation of resources, will be the measure of success for the banking sector. The central role of banks as an enabler of economic growth will be emphasised yet again,” according to the report.
The report exams how inflation impacts performance areas, such as net interest margin (NIM), cost of risk and fees, among others.
The three scenarios include: soft landing, where central banks succeed in containing inflation in the single low digits; hard landing, where inflation spirals “out of control” in the short-term but monetary tools succeed in taming it; and stagflation, where global economy experiences sustained high inflation.
For example, in a soft landing scenario, NIM is expected to increase as interest rates rise and demand for new financing remains strong, however inflation will put a strain on banks’ cost base, with salaries, overheads and outsourcing costs progressively increasing. In a stagflation scenario, cost of risk will significantly increase as household and corporate finances are damaged by poor growth and rising operating costs, while banks’ fee income will suffer, as wealth management faces significant headwinds.
How can European banks’ best respond to this new environment? Oliver Wyman’s banking team says that a new toolkit is needed navigate this period of high inflation.
According to the report, banks will need to increase managerial and executive committee focus on planning and simulation to ensure that strategic decisions are taken in a timely manner and are informed by clear data, enhance asset and liability management, manage credit through asset quality rating and stress tests of the balance sheet, support their clients throughout this inflationary period and proactively reallocate resources to growth areas.
Banks also need to focus on reining in costs without endangering much-needed digital transformation projects. “This will require a laser-sharp review of spending portfolio to prioritise strategic investments and innovation in the renegotiation of third-party contracts to tackle (vs. prolong) accumulated technology debt,” according to the report.
Joy Macknight is editor of The Banker. Follow her on Twitter @joymacknight
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