The impact of low inflation on bank lending

I have stated several times that I think zero interest rates are qualitatively different from non-zero interest rates. With the introduction of very low interest rates, central banks have not just lowered interest rates by another couple of basis points but fundamentally changed the way banks and the economy overall work. One key driver for this fundamental change is that as I have noted here, at zero interest rates, banks curtail their lending activities and instead look to grow their non-interest business like trading and asset management. The result is that central bank money never really makes it into the real economy and the traditional link between money printing and inflation is broken. 

Now, I have stumbled across an educative case study that shows that this is pretty much what is happening everywhere. Petro Kurmaiev and Serhii Kulpinsky have compared banking activities in Poland and Ukraine. The cool thing about this case study is that while it is far from generalisable, it shows us how two neighbouring countries can have banks with vastly different business models simply due to the differences in inflation and interest rates.

What the two academics did was to look at the lending activity and the fee-generating businesses of banks in Poland and Ukraine. In Ukraine, banks face an environment of high inflation and high interest rates while in Poland, banks face an environment of low interest rates and lower and lower interest rates. Note, though that Polish banks were not involved in the Eurozone debt crisis since Poland is not a member of the Eurozone and not subject to the ECB’s monetary policy. Of course, the Polish economy depends heavily on exports to the Eurozone, but through the devaluation of the Polish Zloty, much of the pain of the Eurozone debt crisis could be prevented. Yet, the Polish Central Bank had to cut interest rates significantly in the 2010s and inflation declined rapidly and then stayed low.

Polish banks adapted to this changing inflation and interest rate environment by reducing their interest income generating business (i.e. traditional lending). A one percentage point reduction in real interest rates leads to a 4.25% decline in the ratio of interest to non-interest income of Polish banks. On the other hand, owning more government bonds on their balance sheet in reaction to central bank monetary stimulus reduced bank lending as well. A 1% increase in government T-Bill holdings on the balance sheet of Polish banks led to a 1.1% decline in the ratio of interest to non-interest income.

In Ukraine, banks face an environment of high and fluctuating interest rates and as a result, it is risky for banks to lend. A sudden bout of inflation could turn any fixed-rate loan into a loss. That is the reason why so many emerging markets struggle to get capital. Even if the borrower is solid, there is a substantial risk you don’t get your money back in real terms. With inflation and interest rates close to zero in Poland, the risk is not a sudden bout of inflation. Instead, banks don’t make loans because they don’t make any money from them. The effect is though the same in both countries: Lending is curtailed, growth and inflation remain low, and central banks have no way of getting out of this trap.