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INF: The importance of inflation on the performance of banks was heavily discussed in the literature, primarily due to the influence of inflation on the sources and users of banks’ financial resources. In particular, inflation affects companies’ pricing behavior. For instance, if companies expect general

to be higher in the future, they may believe that they can increase their prices without suffering a drop in demand for their output (Driver and Windram 2007, 2009). In this scenario, upon the condition that expected inflation will be equal to actual inflation, there will be no decrease in business activities and no negative effect on banks’ performance.

The impact of inflation on real rates is most evident at the extreme. The economies in our highest-inflation quartile experienced real money market rates and real treasury bill rates of around zero percent on average during the time

period studied. The real time deposit rate for the high-inflation countries was approximately –3 percent. Negative real interest rates provide little incentive for saving, as savers actually lose purchasing power. Perhaps most importantly, we find that inflation has a dramatic negative impact on the profitability of banks. Various measures of bank profitability—net interest margins, net profits, rate of return on equity, and value added by the banking sector—all decline in real terms as inflation rises, after controlling for other variables. Figure 2 plots banks’ real net interest margins against the inflation quartiles to give one example. (The real net interest margin is a measure of the inflation-adjusted spread between a bank’s lending rate and its cost of obtaining funds.) We see that even at fairly modest inflation rates of between 5.1 percent and 9.1 percent, the real net interest margin turns negative. Such low real rates of return suggest that the incentives to expand bank operations simply are not as strong as inflation rises.

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