The Effects of Inflation on Banks’ Balance Sheets: Evidence from Emerging Markets

We study the impact of inflation on bank asset allocation. Utilizing a Distributed Lag Non-linear Model (DLNM) within a panel data framework, we analyze a comprehensive dataset of commercial banks across 63 emerging and developing economies from 2000 to 2021. Our empirical strategy isolates the marginal effects of country-standardized inflation on the share of investments relative to total assets, while controlling for bank heterogeneity and macroeconomic cycles via a two-way fixed effects specification. Results show a remarkable asymmetry in bank portfolio dynamics following low and high relative inflation. While asset allocation remains relatively insensitive to mild business cycle fluctuations and moderate deflationary environments, extreme positive inflationary environments trigger a severe, compounding structural effect. Specifically, when inflation exceeds two standard deviations above the domestic historical mean, banks persistently reallocate their portfolios toward investments. Crucially, this effect does not quickly dissipate but accelerates over time, reaching its maximum magnitude at a five-year lag horizon. These findings suggest that extreme inflation inadvertently crowds out traditional private sector lending and impairs monetary policy transmission, underscoring the need for macroprudential oversight by central banks and proactive asset-liability management by financial institutions to mitigate long-tail duration risks.