Central banks around the world are finding that creating inflation is a lot easier than taming it. The International Monetary Fund (IMF) warns sticky inflation will lead to rates remaining higher for longer than previously thought. As a result, they believe bank regulators should begin work to ensure banks are more resilient ahead of potential stagflation, which would threaten a third of global bank assets.
Inflation & Interest Rates Are Expected To Stay Higher For Longer
The IMF tested 900 lenders across 29 countries for a baseline scenario of current expectations. They found 30 institutions are expected to face low capital levels, impacting 3% of global assets. However, they stress these are baseline expectations, not an environment with persistently higher rates.
A stagflation scenario, a plausible scenario according to the IMF, is much worse. Their definition is a 2 percent global GDP contraction, elevated inflation, and “higher for longer” interest rates. Weak institutions rise to 153 in this scenario, accounting for a third of global bank assets. The weakness was also primarily concentrated in advanced economies, not emerging markets as many assume.
Severe Stagflation Scenario
High Inflation and slow growth amid rising rates would leave many banks with insufficient capital buffers.
Source: FitchSolutions; IMF Staff estimates.
The banks wouldn’t necessarily fail, but it won’t be pretty. They would face higher interest costs, rising defaults, and falling security prices. In case it wasn’t obvious, that isn’t just the bank’s problem—but fallout for the general public.
Prepare Banks For Potential Stagflation Now To Minimize Damage
The IMF urges countries to get ahead of the next crisis by tightening bank regulations. They would like to see more robust stress testing, including market-based analysis and small lenders. In addition, these tests should include more severe adverse scenarios that are still plausible.
That last point may resonate with Canadians. Households went from thinking the stress test was excessive to insufficient in less than a year. Risk can force markets to change very quickly.
Since institutions aren’t currently under stress, the IMF thinks now is the perfect time to tighten rules. Once the problem hits, it’ll be too late to suggest pairing down risk, making a resolution much more difficult to manage.
“ … and they should prepare for a possible resurgence of these risks, as interest rates may stay higher for longer than currently priced in markets,” says the IMF.