Rising Rates May Trigger Financial Instability, Complicating Fight Against Inflation

IMF Blog, February 13, 2025

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Research combines balance sheet and income data for more than 6,600 banks in advanced and emerging economies with nearly three decades of IMF economic data.
Most lenders are largely hedged against inflation: income and expenses tend to rise with inflation to similar degrees.
Distinction in exposures:
- Income and expenses tied to borrowing and lending are exposed indirectly to inflation because they primarily react to policy rates that fluctuate in response to inflation.
- Other income and expenses—revenues from non-traditional banking activities, services, salaries, and rent—are exposed directly to price changes.
Cross-country variation:
- At the country level, the impact of inflation on bank income and expenses individually varies widely across banking systems.
- Shifts in inflation are reflected in income and expenses much more rapidly in some countries than in others.
- Nevertheless, since both income and expenses rise with inflation to similar degrees in most countries, most banking systems appear largely hedged to inflation.

Some banks are particularly susceptible to inflation due to different risk management and business models.
Outliers in both advanced and emerging market and developing economies stand to see large losses when inflation and interest rates spike.
Key statistics:
- 3 percent of banks in advanced economies are at least as exposed to elevated interest rates as Silicon Valley Bank at the onset of its failure.
- 6 percent of banks in emerging economies are at least as exposed to elevated interest rates as Silicon Valley Bank at the onset of its failure.
Banks in emerging economies appear more exposed to inflation directly, possibly due to more widespread price indexation.

Tradeoffs:
- Amid high inflation, tightening monetary policy, while necessary, could lead to meaningful losses for banks with large exposures.
- Customers and investors may then reassess risks across all banks, which could lead to panics and financial instability.
Recommended measures to contain inflation exposures and reduce systemic risk:
- Strengthen prudential regulation and supervision.
- Heighten required risk management at banks.
- Improve transparency.
- Use granular risk assessments accounting for the key factors highlighted in the research for a broad set of banks.
If losses at individual banks leave room for wider contagion, central banks may need to balance raising rates to contain inflation against the potential for financial instability.

Katharina Bergant, Mai Hakamada, Divya Kirti, Rui C. Mano, February 13, 2025.