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Inflation: More For Less and Less For More (Part 2)

Posted on November 16, 2021 Published by

This is the second of two blog posts looking at inflation, what it is and how it may impact financial and lending institutions.

In our previous blog installment, we considered what inflation is by definition and some of the primary ways that inflation is measured. To say the least, it is not particularly simple or straight-forward. These different measures may all have their rightful place in economic discourse. However, some calculations may be more relevant than others in considering the impacts on consumers and small to medium size businesses.

External and Internal Issues

Regardless of the inflation metric considered, credit professionals need to be alert to both external (clients) and internal (institution) issues. We are seeing some unique consumer behaviors and resulting business performances as a response to various COVID-related actions. Government stimulus checks sent to everyone regardless of economic impact or need. They also send them to childcare subsidies for government employees, unemployment supplements, rental subsidies, and eviction/foreclosure moratoriums. These have resulted in a “cash bulge” in some cases or a change in demand.

A July 2021 notice from the Federal Reserve Board of Cleveland observed that durable goods generally benefited during the pandemic. This happened as social distancing and lockdowns shifted spending away from services. Automobile production has fallen not because of lack of demand but due to insufficient materials, notably semi-conductors. Demand is strong combined with low inventory is driving price increases.

As work-from-home becomes more prevalent, there is a relocation of workers from the urban centers to suburban and rural areas. This is increasing housing prices, need for household durable goods, and construction labor. Extended supplemental unemployment benefits are slowing the return to work in many locations, so businesses are unable to meet demand. While this list is by no means exclusive it is indicative of the inflationary pressures that exist.

Possible Impacts

So, what are some of the possible impacts from these inflationary pressures? Are they “transitory” or indicative of a longer-term trend? A likely impact if the trend looks to be something other than short-term is an increase in interest rates. Will supply chain issues continue, and for how long? Part of the answer may be outside the control of the U.S. economy depending on the source of the “supplies” and who controls access to the materials necessary for their production.

While the unemployment level and the number of jobs that are available would suggest that the need for workers will balance out, when that will happen is certainly at issue. The more government programs intervene in the equation, the longer it will take.

How It Affects The Lending Industry

All of the above suggests that the lending industry and credit professionals will need to “up their game”. We are experiencing the economic results of an unprecedented (at least in my lifetime) epidemic and government responses, actions, and orders. As a lending organization, our actions will likely fall into two categories.

First will be to look internally. In a rising interest rate environment, how is our portfolio positioned from an asset/liability management perspective? What does our balance sheet look like? How are our assets funded? Are you at risk for a major squeeze on interest margins? Looking outside at your clients, what is the overall leverage and the mix of long-term vs short term tenor of the debt? Is a large short-term rate exposure with immediate re-pricing? If so, what is the sensitivity to a one or two (or more) percent increase in rates on the borrower’s cash flow and debt service?

Then, there is the portfolio side. As credit professionals we may need to be asking better questions and/or questions that we had not asked before. If our borrower experienced a good year, is it because of a short-term COVID response to excess liquidity? Is your borrower experiencing issues with hiring and maintaining qualified employees? What actions are necessary to adjust and what are the impacts on the bottom line? Are there supply chain issues? Where are they (both geographically and where in the process) and what will it take to resolve them? How long will it take? Have concerns about COVID and current or future government actions resulted in an overall industry impact such as travel and leisure or large venue entertainment?

Pay Attention

In conclusion, whether the current inflationary environment is transitory or a more permanent structural economic issue, as lending professionals and managers of financial institutions, there is an acute need to pay attention to the current trends. The Bureau of labor Statistics (BLS) reported that the CPI for all urban consumers was up 5.4% in the 12 months ending July 2021 equaling the previous record high of 5.4% for the 12 months ended August 2008.

We each need to be critical of the economic reporting we hear and see. Be knowledgeable about what is included in the statistics and, perhaps more importantly, what is not included. Not all inflation is created equal. Increases in housing, medical, energy (fuels), and/or transportation costs have a disproportional impact on low to moderate income wage earners and those persons living on fixed incomes.

If these socio-economic groups are your direct customers or are the customer of your business clients, you will need to be alert to changes in your credit reporting metrics and covenants in advance of payment defaults. As always, the credit professionals at Enlighten Financial can assist with either a targeted or full portfolio review to help identify potential problems as well as analyze sensitivity to inflationary issues such as rising interest rates and asset/liability mismatches.

 

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.

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— Meghann Kasper, Chief Credit Officer, Bank First
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— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors.”
— Bill Beardsley, President, Michigan Business Connection
“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors."
— Bill Beardsley, President, Michigan Business Connection