Why is a bank an inflation asset?

[bitchstewie]

With all the talk about the impact of inflation on investment returns I get that asset classes such as commodities can be considered useful (let's ignore whether that actually works out).

What I don't understand is why banks as an asset class seem to be considered as worth holding in times of high inflation?

UPDATE 1-Global bond allocation drops to record low on inflation scare -BofA

Apologies if it's a totally dumb question, bloody retail investors

[btdk5]

Inflation up, interest rates up.

Interest rates up net interest margin increases.

[stongle]

btdk5 said:

Inflation up, interest rates up.

Interest rates up net interest margin increases.

Simply yes. The problem banks are going to face (in respect to NIM), and a reality that may not be fully priced by retail - there is likely an upper limit for rates; before the CB's do other calming measures. If UK rates hit 0.5% (which is still low), the next step in the BoEs armoury, isn't increase rates again; but start unwinding QE. That's likely to have a much larger impact on inflation as the banking system starts to deleverage.

It's not even a secret, the BoE tell you this in its inflation reports.

Mind you, if you are in Europe; the state pays you take the banks away. Italy may have to stump up 7billion plus to get Unicredit to take on MDP. That's a whopping tax payer hit.

[Halitosis]

btdk5 said:

Inflation up, interest rates up.

Interest rates up net interest margin increases.

Exactly. Since the credit crunch banks have had their interest margin squeezed (difference between the rate they pay savers and the rate they charge borrowers). This will have an opportunity to widen with inflation.

Having said that, I don't personally believe traditional bank stocks are a good long term investment as there are so many headwinds and disruptors in the marketplace.

[Flooble]

Did stongle just say that rates won't go above 0.5%?

Time to leverage myself up I think!

[stongle]

Flooble said:

Did stongle just say that rates won't go above 0.5%?

Time to leverage myself up I think!

Not quite, I repeated what's in the BoE forward guidance, and what they suggest might happen.....

I wouldn't make a heavy bet that rates won't go higher, inflationary pressures are exceptionally high. BUT rates aren't the only inflationary control / stimulus mechanism - QE has been a massive crutch since 2008. Monumental infact. The major CB's only had balance sheets around $7trillion in 2008, now it's £25trillion+ (IIRC). All that HAS to go back into circulation at some point, normally when growth and inflation conditions allow. That should / could deleverage the private sector. Its quite likely that the cost of credit increases - even if Central Bank rates remain low. Leveraging that warehouse full of Porker GT3s usig comedy auction values - might just get a teensy bit more expensive as banks look at their cost of creating leverage (capital / loss absorption, levy, maturity transformation costs etc).

[NickCQ]

stongle said:

deleverage the private sector

Bit of a euphemism given the MTM hit for the average bank if central banks started dumping their balance sheets!

[stongle]

NickCQ said:

Bit of a euphemism given the MTM hit for the average bank if central banks started dumping their balance sheets!

"I" think we are in pretty untested waters - IF (and WHEN) the CBs start unwinding QE. You only have to say "taper" and the equity markets get a bit skitish. You'll likely get a conundrum where lower grade collateral such as Equity, ETF etc being financed start to get hit, reducing balance sheet potential. It wasn't much of a concern in 2008, as it wasn't a popular collateral class (interbank); but its grown massively since.

Or nothing will happen.

I did see the Express article the other day screaming "SHOCK!!!! BoE to raise rates 500%". Well, quite; to a pre-Covid 0.5%. Once we get there, I think the potentially interesting stuff needs to be looked at. The state that Italy, MPS and Unicredit are in; should be ringing alarm bells. The deal that Unicredit wants (with $8bn of state support) - appears to leave a lot of the poorer bits of Italy with less banking options.....

[Cheib]

stongle said:

btdk5 said:

Inflation up, interest rates up.

Interest rates up net interest margin increases.

Simply yes. The problem banks are going to face (in respect to NIM), and a reality that may not be fully priced by retail - there is likely an upper limit for rates; before the CB's do other calming measures. If UK rates hit 0.5% (which is still low), the next step in the BoEs armoury, isn't increase rates again; but start unwinding QE. That's likely to have a much larger impact on inflation as the banking system starts to deleverage.

It's not even a secret, the BoE tell you this in its inflation reports.

Mind you, if you are in Europe; the state pays you take the banks away. Italy may have to stump up 7billion plus to get Unicredit to take on MDP. That's a whopping tax payer hit.

Yes and no. Banks make money from the term structure of interest rates i.e. a steep yield curve. What is more important for the banks is where 3, 5 and 10 year Gilt yields are as that is where they do a lot of their lending to corporates and indeed individuals through mortgages. The term steep yield curve refers to the difference in yield/interest rate between say 3 months and 10 years….recently that relationship has been very small which is known as a flat yield curve and is historically very bad for banks profitability…right now longer dated interest rates are rising (yield curve steepening) and that is what the market is excited about re banks profitability.

[NickCQ]

stongle said:

Or nothing will happen.

Something will happen - if you look at the economic DV01 of the average bank a rates up scenario is pretty punitive on an MTM basis even if wider lending spreads generate more capital in future.

[stongle]

Cheib said:

Yes and no. Banks make money from the term structure of interest rates i.e. a steep yield curve. What is more important for the banks is where 3, 5 and 10 year Gilt yields are as that is where they do a lot of their lending to corporates and indeed individuals through mortgages. The term steep yield curve refers to the difference in yield/interest rate between say 3 months and 10 years….recently that relationship has been very small which is known as a flat yield curve and is historically very bad for banks profitability…right now longer dated interest rates are rising (yield curve steepening) and that is what the market is excited about re banks profitability.

I get and understand that. It's also fair to say the deleveraging has a pretty significant reduction in Capital costs - assuming you can delevarge the stty RoC or non-protfitable bit. (MDP being a prime example). They could have a bit of a double win.

That saying.....

I'm suggesting that post 2008 - Central Banks and Banks engaged in behaviours that are outside the traditional normals. I think this is a fair chance these processes might give some fairly significant headaches IF conditions allow. It's a non-obvious risk, but if you have switched vast parts of your financing portfolio into term derivatives (away from traditional repo), you have a LOT - A LOT of liability overhang. Your balance sheets can become structurally rigid despite the need to deleverage (basically the maturity transformation and leverage extension flows get into a bit of a regulatory driven dust-up). I think it will be fairly specific to banks more invested in Equity / PBs etc; but we've seen recent collateral squeezes that the Fed has intervene; it could create some interesting outputs. Or again, the market shrugs and moves on.