Do banks gain or lose from inflation?

As net monetary creditors, they lose. But as issuers of demand deposits, they gain. With greater indexing and more correct anticipation of future inflation, the second effect could well swamp the first.

In recent years, bankers have learned to recognize and deal with interest rate risk. In significant part owing to the efforts of the editor of this journal in a series of articles in American Banker, bankers learned of the necessity to hedge their balance sheets against this risk by using duration analysis. Immunization against interest rate risk involved setting the duration of equity (a value-weighted average of the durations of assets and liabilities) equal to zero; thus positioned, the bank was said to be immune to small changes in interest rates. This immunization procedure, however, protected only the nominal rather than the real market value of the bank -- that is, the market value of the bank in today's dollars, rather than the market value of the bank in inflation-corrected dollars. This article seeks to begin a discussion to redress this omission.

Do banks gain or lose from inflation? Is it the level of inflation or changes in the level that is crucial? Is the effect of changing prices symmetric? Does disinflation have equal but opposite effects from inflation? What role do expectations play? Can banks avoid these effects?

We are primarily concerned here with the effect of changing prices on net interest income and changes in capital values. We leave to future articles the effect of inflation on noninterest revenue and expenses and on the real resource production function of banks. For purposes of this paper, this latter assumption amounts to the reasonable (but debatable) view that real (adjusted for inflation) noninterest revenue and expense are not related to price changes.

The discussion centers on inflation's impact on banks, rather than what has affected banks during particular inflations. Thus, we abstract from such events as increasing competition among banks and changes in regulation (which clearly affect banks results) since such events are not necessarily caused by inflation.

We begin with a review of the economic literature and its major "overview" theories. We then indicate how these theories are the special cases of a richer approach whose key elements are rates of change of expectations and speeds of portfolio adjustment. The richer theory serves as a backdrop for future research.

The effect of inflation on real bank profits has been widely discussed in the economics and finance literature. Two competing and conflicting models exist. Alchian and Kessel (A-K) argue that banks are net monetary creditors (i.e., their nominal assets are greater than nominal liabilities). Rising prices would then decrease the value of their nominal assets more than diminishing the value of their nominal liabilities. Consequently, banks will lose during an inflation.

On the other hand, the inflation tax school has argued that since banks' demand deposits are a portion of the money supply, they should capture a portion of the inflation tax and therefore gain during an inflation....