Does inflation influence banking performance? : empirical evidence from Malaysia and Indonesia

High and volatile inflation over a long haul is detrimental to an economy, particularly to a country's financial sector. While most studies suggest a positive relationship between inflation and bank profitability, others argue for a negative impact. As such, it is evident that the impact of prolonged inflation on banking performance remains unsolved. This study aims at examining the impact of inflation on the financial performance of the banking sectors in Malaysia and Indonesia. These two countries are chosen because their banking markets were severely affected during Asian financial crisis in 1997. This study uses bank's risk management framework as the underpinning model and yearly secondary data are extracted from World Bank database from year 2005 through 2022. To perform empirical modeling, we employ Johansen-Juselius Cointegration technique, as well as Engle-Granger Cointegration (EG) test as estimation tools. The empirical results show that there is a significant long-run relationship between non-performing loans (NPL) and inflation in both Malaysia and Indonesia. In the case of Indonesia, the effect of prolonged inflation is seen to be more perceptible than in Malaysia. With respect to short run dynamic, both countries strongly provide a statistically significant evidence to support the presence of short run relationship between NPL and the three explanatory variables. The policy implication from this study may suggest that inflation rate does have a significant economic influence on banking soundness in Malaysia and Indonesia. It is clear enough to see that an increase in inflation rate does not affect bank's financial sustainability due to proactive risk management approach. Inflation targeting is one of the ideal measures that policymakers could adopt in addressing the issue of inflationary pressure on banking performance. There is always a need for worldwide banks to be consistently monitored by their monetary authorities so as to ensure the global banking sector remains resilient to varying market conditions in the long-run.