Impact of Inflation Volatility on Banking Sector Stability: Evidence from Frontier Economies

Abstract

This report examines the impact of inflation volatility on banking-sector stability in selected frontier economies. The study is based on the argument that inflation volatility is not only a macroeconomic issue but also a banking-stability issue, because unstable inflation creates uncertainty in credit markets, affects borrowers’ repayment capacity, weakens asset quality, and increases pressure on banks’ balance sheets. Unlike studies that focus mainly on the level of inflation, this report emphasizes the volatility of inflation as a separate macro-financial risk factor. Inflation volatility is measured using a country-specific GARCH(1,1) conditional variance approach based on annual consumer price inflation data. Banking-sector stability is measured primarily by the Bank Z-score, while the non-performing loan ratio is considered as a complementary indicator of banking risk and asset-quality deterioration. The empirical analysis follows a simple panel-data framework using Fixed Effects and Random Effects models. The Hausman test is used to guide estimator selection, and additional specifications include macroeconomic controls such as GDP growth and real interest rate. Robustness checks are also considered through alternative volatility specifications and controlled panel models. The results suggest that inflation volatility is negatively associated with Bank Z-score, meaning that higher inflation volatility is linked with lower distance from insolvency and weaker banking-sector stability. The evidence is stronger and more consistent for the solvency-stability channel than for the non-performing loan channel, which appears weaker and more conditional. The findings indicate that volatile inflation may affect banking systems before credit-quality deterioration becomes clearly visible through reported NPL ratios. The report concludes that central banks and banking regulators in frontier economies should monitor inflation volatility, not only the average inflation rate. Stronger macroprudential tools, better policy coordination, forward-looking provisioning, and improved inflation-expectation management can help reduce the banking-sector risks associated with unstable inflation.