Inflation: Three Outcomes that Could Test Capital Resiliency
Inflation | Capital | Credit Stress Testing
Leverage and net worth ratios have declined, on average, by over 1% since the onset of the pandemic, driven by inflated balance sheets following the flood of deposits into the banking system. While earnings were strong over that period, they were not enough to offset the pressure on leverage ratios.
Fast forward to today, and the earnings tailwinds of 2020 and 2021 have faded (i.e., PPP activity, allowance reversals, mortgage income, reductions in deposit costs, etc.), and asset levels remain elevated.
“. . . triple-barreled tightening — rate hikes + QT + fiscal tightening — will result in a considerable slowdown, people should be aware the odds of recession next year are high. That is not speculative, it is common sense.”
– Chris Low, FHN Financial [1]
We believe there are three potential outcomes that could test capital resiliency across the industry.
[1] April 19, 2022
1) Recession
The probability of a recession over the next year has more than doubled compared to a year ago and is 50% greater than only three months ago, based on a Wall Street Journal economist survey[1].
Futures markets and economists are indicating that the Fed may aggressively raise rates through 2022 but will need to come down from these high levels in 2023. A Fed over-tightening could restrict loan growth while increasing pressure on funding costs, which would have a material impact on already stressed capital buffers (i.e., earnings pressure). A subsequent recession resulting in a reduction in interest rates and elevated unemployment would drive a flight to safety, inflating balance sheet sizes even further at a time when credit losses are potentially building.
[1] The Wall Street Journal, “Recession Risk is Rising, Economists Say,” April 10, 2022
How to Prepare
Include potential credit-related loan losses in both your tactical and long-term capital forecasts and ensure these are empirically supported. The speed and magnitude of losses will be the “X” factor in determining capital adequacy. Exclusively taking losses experienced almost 15 years ago and applying them to today’s loan portfolio will not be sufficient. The opportunity cost of extremely conservative loss assumptions or loan losses that are arbitrarily low is suboptimal. Variations of earnings and asset growth assumptions will also be required to determine your capital buffer.
2) Stagflation
60% of fund managers in a recent Bank of America survey[1] predict that the US will experience an environment with high inflation, high unemployment, and low growth. Over the past three months Goldman Sachs, Moody’s, and others have also warned of stagflation[2]. Increased prices of goods and services that outpace wage gains lead to a reduction in consumer spending and negatively impact corporate profits. If supply chain issues persist, driving up input costs, it may result in a scenario where layoffs are required to reduce expenses to offset lower earnings.
[1] Forbes, “Most Wall Street Experts Now Predict Stagflation – Here’s What That Means for Investors and the Economy,” March 15, 2022 [2] Forbes, “Major Bank Is First to Forecast a Recession – More Could Follow,” April 5, 2022
How to Prepare
In this scenario it is imperative to understand what a reduction in earnings would mean for the future of your capital position. This can be accomplished by isolating the earnings impact to capital then applying potential credit losses based on different economic outcomes (i.e., different severities of economic downturn).
Loan concentrations could also be a concern as consumers and businesses seek liquidity. Modeling the capital impact of higher loan concentration levels (i.e., changes to risk weighted assets and/or asset quality) is best practice for analyzing your risk-based capital ratio buffer.
3) Prolonged Inflation
Globalization, technological advancements, and demographics have all contributed to a decline in inflation over the past 40 years. Recently, factors such as rising protectionism, global supply chain vulnerabilities exposed during the COVID recovery, and an aging population are raising concerns of a prolonged period of high inflation. More specifically, a lower labor force participation rate (i.e., less labor supply) with the same demand for goods and services, at a time when the supply of those goods and services is under pressure, could result in inflation trends that become more entrenched.
How to Prepare
Earnings variations, increased concentrations (due to rising demand for credit), and rising loan losses are all key assumptions in determining your capital buffers in a sustained high inflation environment. A scenario where earnings are low and loan losses are materializing will provide capital buffer clarity. Having support for your assumptions will provide comfort in developing a strategy on how to combat the inflationary pressure on capital that is based more on analytics than gut instinct.
Where do we go from here?
Start by understanding the potential impact of changing economic conditions. Ask the following questions and analyze responses through the lens of your capital position:
To what extent could loan credit losses mount?
What will earnings look like?
Is the size of our balance sheet expected to be larger or smaller?
How could our balance sheet mix change (e.g., risk-weighted assets)?
What options would I have to bolster capital in each of these scenarios?
No one has a crystal ball. Understanding what could happen by “what if-ing” will allow you to manage through adverse stress events when the time comes – because the time will eventually come. Remember, the strategies that you may consider today might not be there tomorrow (e.g., gains on sales or access to capital at low rates) when demand is at its greatest. Now is the time to prepare.
Learn more about how capital forecasting and stress testing can help your financial institution better understand capital risks and develop remediation strategies for potential downside impacts.
ABOUT THE AUTHOR
John Demeritt is a Managing Director at Darling Consulting Group working directly with senior management teams in capital planning and credit risk management initiatives. DCG’s web-based Credit Risk and Capital Simulator provides credit risk assessments through a multitude of macroeconomic scenarios and allows customizable and instantaneous capital ratio forecasting on growth plans.
© 2022 Darling Consulting Group, Inc.
