In our briefing note on inflation, we consider potential inflationary scenarios and the implications of them on Australian banks. We also outline five recommended actions for Australian banks – including deliberate shifts in the sectoral mix, continuing investment into areas of long term potential, building collections and scenario analysis capabilities to manage potential shocks, and realigning internal mechanisms to promote the right incentives.

In the first quarter of 2022, economies across the globe recorded the highest levels of inflation in a decade, and economists started acknowledging that inflationary pressure might not be temporary. This required central banks to materially increase interest rates in an effort to return inflation to target. In absolute terms, Australia has not seen inflation quite reach the heights of global peers, however it has by no means been spared.

The recent global rise in energy prices, exacerbated by the war in Ukraine, is the latest and likely the biggest inflation driver in the short term, however we’ve also seen upward pressure domestically due to more localized conditions e.g., flooding in Northern NSW and QLD, coal outages impacting local energy prices, capacity constraints in certain industries like construction, plus a deteriorating trade relationship with China.

Whilst there are many possible scenarios, we believe that banks will initially benefit from resulting higher interest rates through higher Net Interest Margin (NIM), however with a material risk that more severe inflationary scenarios may cause volumes to reduce and cost of risk to increase.  The banking system will face this evolving environment after having addressed legacy issues (better capitalization, more resilient business models, solid governance practices, simplification of business lines). However, this does not necessarily imply that the system is fully prepared for this kind of disruption.

Furthermore and in comparison to international peers, the Australian financial system and its participants have arguably fewer scars from navigating previous crises, having avoided the depths of the Global Financial Crisis and the subsequent European sovereign debt crisis. For example:

• Organizational capabilities: Australian banks haven’t faced the same level of urgency to develop the required processes, tools, and data management strategies to effectively take emergency actions when required as their international peers. For example, developing stress testing models – especially for mortgage books – beyond a base level of maturity; improving early warning capabilities to be able to detect and intervene early in cases of deteriorating serviceability (including leveraging the vast amounts of real time transaction data), and getting prepared to manage any assets that subsequently come on balance sheet
• Leadership experience: Australian banks will have frameworks in place to respond to a crisis, and while they may have played out simulations of a crisis scenario, it is unlikely that they will have the same degree of insight that has been developed by leadership of say US and European bank peers, who have faced these situations in real life.

The future is presenting sharp uncertainties. While the Australian banking sector is well capitalized for the road ahead, banks that prepare now, and remain flexible in these volatile times, are more likely to benefit as the broader economic landing point becomes clearer.