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Modest Eurozone growth and sovereign risk concerns continue to weigh heavily on European banks

Business Materials 20 July 2011 19:45
With overall GDP growth forecast to continue at a modest rate across the Eurozone - 2% this year, dipping to 1.6% in 2012 and then averaging another 2% between 2012 and 2015, as well as a growing sovereign debt crisis - these are uncertain times for major parts of the European Financial Services sector.
Modest Eurozone growth and sovereign risk concerns continue to weigh heavily on European banks

Azerbaijan, Baku, 20 july /Trend/

With overall GDP growth forecast to continue at a modest rate across the Eurozone - 2% this year, dipping to 1.6% in 2012 and then averaging another 2% between 2012 and 2015, as well as a growing sovereign debt crisis - these are uncertain times for major parts of the European Financial Services sector.

This is according to the first Ernst & Young Financial Services Eurozone Forecast, which examines the implications for the European financial services sector in relation to the current macro-economic outlook.

Marie Diron, senior economic adviser to the Ernst & Young Financial Services Eurozone Forecast comments: "Increasingly we are witnessing a two or even three speed economic outlook in the medium term. The core countries such as Germany and France will see growth rates averaging 2.2% over the next four years, while periphery economies such as Greece, Ireland, Spain and Portugal are only going to see growth of 1.2% at best."

This emerging north/south divide also has significant implications for financial institutions, particularly if they operate on a pan-European basis. In Germany for example, banks loans are forecast to expand by 4% in 2011, whereas Spain will see loans contract by 5%.

Persistently high non-performing loan (NPL) ratios in the periphery economies will also mean that provisions for bad loans will remain at elevated levels, dampening earnings and profitability. Whereas in Germany NPLs are forecast to fall below 3% of total loans this year, for example, NPL ratios in Italy are forecast to remain above 5% of total loans through to 2014.

Sovereign risk is casting a shadow over the banking sector

The sovereign debt crisis remains a defining theme for both the Eurozone economy and the banking sector. CDS spreads for Greece, Ireland and Portugal have risen to new highs, which is translating to higher funding costs that banks are finding difficult to pass on to borrowers in these countries.

Andy Baldwin, Ernst & Young Financial Services Managing Partner for Europe, Middle East, India and Africa, says: "A number of the German and French banks expanded their lending and business operations south and east across the Eurozone over the last decade. It is no surprise that they are now at the forefront of the private sector contribution to resolving the crisis. They will be working closely with their respective governments to ensure an orderly resolution.

"However, it's clear that while finance markets fear some form of Greek default or debt restructuring the greater concern is a 'domino' like progression through some of the smaller economies before hitting the 'fire break' that is hopefully Spain. Such contagion will hit selected European banks hard, particularly those operating at a national level without the benefit of international or business mix diversification."

"The shrinking lending capacity of European banks may cause tension in the Russian banking sector, considering how heavily it relies on international borrowing, and seeing that the aftermath of the crisis keeps showing up on the balance sheets of certain banks". - says Oleg Danilin, Ernst & Young Partner. - "And as always, the Russian SME borrowers may be hit the hardest, with loans becoming more difficult to get".

Credibility of stress tests will determine market reaction

The new strengthened stress test required by the European Banking Authority will reveal this week how real the claims are that European banks will be able to survive a future credit crunch - credible reports will help fight the unsettlingly high degree of uncertainty pervading the financial sector. Early indicators are far more positive than they were 12 months ago.

Marie says: "Banks will be required to disclose more details about the size of their exposures, which will help market participants to calculate the effect of larger stresses for themselves. So while we believe the stress test results are unlikely to significantly dampen risk aversion in the funding markets, enhanced clarity regarding the positions of banks should contribute toward reducing uncertainty."

Slower growth in lending will represent the new norm

The slowdown in loans across the Eurozone seen over the past couple of years looks set to continue. History suggests that lending growth tends to remain sluggish for more than five years in markets that experience a major housing bust and banking crisis.

Andy says: "Our forecast suggests growth in bank loans and total assets will lag behind growth in the broader Eurozone economy over the next few years. New Basel III liquidity standards will also make it more costly for banks to rely on wholesale funding, forcing growth in assets to mirror more closely growth in customer deposits. This is in stark contrast to the years leading up to the crisis, when banks became increasingly reliant on wholesale funding markets and banking sector assets represented a growing share of GDP.

"Although no doubt this will be viewed by some as a welcome rationalization of the Eurozone banking sector in those countries that had experienced an unsustainable credit boom, an overly cautious approach to lending in the aftermath of the crisis will delay the economic recovery."

Credit availability remains a risk to broader economic outlook

There is a risk that forthcoming regulations will have a negative impact on the Eurozone economy as they force banks to change their business mix. For example, stricter rules on the risk-weighting of assets could deter banks from lending to some market segments which are deemed more risky, for example SMEs and property owners.

Andy says: "Under pressure from regulatory authorities, banks have been repairing their balance sheets, but this has had a knock-on effect of restricting credit to businesses and households, thus slowing the recovery. While they are facing an enormous volume of regulatory changes, banks will need to cut costs, boost margins to maintain returns that continue to attract investors. We expect continued evolution of both business models and business mix. This shift will attract regulatory scrutiny.

Insurance and Asset Management

The outlook for the Eurozone insurance and asset management sectors is more positive.

Premium income for insurers is forecast to grow in line with the outlook for the wider economy alongside improving asset values. But there is a risk of rising claims, which will remain a challenge for the sector. Forthcoming Solvency II requirements may also impose significant costs on insurers, particularly for small and medium-sized companies. The new European Insurance Authority's (EIOPA) examined last week the capital positions of Europe's insurance industry in its annual stress test exercise and concluded that just one in 10 insurers would fall short of the Solvency II minimum capital requirements if faced with an 'adverse' scenario. With 90% of insurers passing the test, the EIOPA concluded that the industry as a whole is robust and the exposures of the major insurers to Greek sovereign debt appear manageable at present.

The asset management sector will see funds under management grow faster than overall GDP, underpinned by rising equity markets, an increase in domestically generated savings, and a search for improved yield by individual and institutional investors.

Risk remains

Marie concludes: "But the risk remains that a default on national debt in the Eurozone will have severe consequences on the financial sector. Governments, central banks and all financial institutions need to find common strategies to ensure that crisis does not turn into tragedy."

About the Ernst & Young Eurozone Forecast

The forecasts and analyses presented in the EY Eurozone Forecast are based on the European Central Bank's model of the Eurozone economy. This model embeds state-of-the-art economic theory and techniques and is used by the ECB to produce its quarterly forecasts of the euro area.

About Ernst & Young

Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 141,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential.

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