Funding pressures to hammer banks in 2012

The ongoing financial crisis in Europe will raise regulatory pressure on capital and liquidity for banks and insurers this year.

The Ernst & Young Eurozone financial services forecast predicts that solvency will remain an acute concern throughout the region in 2012, despite the recent positive action taken by the European Central Bank. The forecast for lending in the Eurozone has been significantly downgraded, institutions will be forced to fight over retail deposits and the resulting repatriation of capital is likely to hit Eastern Europe hard in particular, potentially pushing some economies in the region into recession.

Moreover, stimulus from the emerging markets, which are expected to drive world growth in the coming years and overtake the developed countries as a share of world GDP as early as 2014, will help lift Eurozone growth back to around 2% in 2014-15, with improving prospects thereafter.

Despite ECB action, funding remains tight and costly
Despite the recent issue of three year loans by the European Central Bank, the forecast and analysis indicate that banks across the Eurozone and beyond will continue to face ongoing funding pressure.

Keith Pogson, Managing Partner, Asia-Pacific Financial Services at Ernst & Young, comments: “New funding only makes up about a third of the total of the take up of the ECB loans. All of the new funding issued by the ECB needs to be backed by collateral, meaning that unsecured wholesale markets are likely to remain closed for the foreseeable future. The irony is that, given the high level of deposits currently being held at the ECB, these extra funds have added little extra liquidity to the market.

“An interesting area to watch in the months ahead will be how much of the new funding finds its way into sovereign bonds - and which countries benefit. It is clear that politicians are hopeful the new funding will help drive down funding costs. However, we expect regulatory pressure on capital and liquidity for banks and insurers to continue unabated. Shareholder pressure to scale back investment in selected wholesale and trading areas, coupled with increased regulation of derivatives trading and clearing houses, will increase funding costs across the sector.”

Forecast for lending sharply downgraded, damaging long-term growth potential
The forecast predicts GDP growth in the Eurozone to slow sharply to just 0.2% in 2012, down from 1.6% in 2011. This slow growth combined with the increased cost of credit means that total loans in the Eurozone are forecast to contract by 0.9% in 2012, a significant downward revision to the last forecast’s previous expectation for positive growth of 1.2%.

“This still represents a less severe contraction than the aftermath of the financial crisis in 2009, when total bank loans fell by around 2.5%,” said Marie Diron economic advisor to Ernst & Young Eurozone financial services forecast, “but lending to businesses is forecast to contract by 0.8%, a downward revision from 2.0%, which will be felt most strongly by the already squeezed SMEs, potentially limiting the future growth potential for Eurozone economies.”

Crisis threatens to spill over to Eastern Europe
As the deleveraging cycle intensifies, the outlook predicts increased market fragmentation and a reduction in cross-border flow of capital.  Pogson comments: “The capital squeeze on the Eurozone banks will see a continuation of the current trend to repatriate some of their capital. This is a worrying development for many
Eastern European economies as nearly three quarters of lending in Eastern Europe depends on Eurozone parent entities. These parent entities should carefully consider their long-term strategies in emerging markets, as competition from Asia Pacific and domestic institutions could well exclude them from these markets permanently.”

Diron adds “Eurozone bank claims total around 34% of Eastern European GDP, the resulting shrinkage of credit could well push several Eastern European economies into recession. The Czech Republic stands out as having the greatest reliance on lending from Eurozone banks, but local subsidiaries are not heavily dependent on funding lines so deleveraging should remain contained. Credit shrinkage is likely to be much more severe in Hungary, where nonperforming loans are already rising rapidly, and deleveraging in Romania and Bulgaria is likely to be significant due to the presence of Greek subsidiaries.”

Retail banks’ deposit war will hit insurers and asset managers
The liquidity gap will force institutions to compete for retail deposits and investments, which risks eroding profit margins across the board.Pogson comments: “In many countries funding pressures will force banks to compete fiercely with each other to attract retail deposits, and we predict that savings products will start to be
seen as an alternative to the investment products already on the market. Insurers are already struggling to meet guaranteed returns in the low interest rate environment, but will find themselves unable to control their costs by lowering the returns offered on investment products. They may have to deploy further capital reserves to remain competitive.”

European insurers are set for another year of constrained growth and profitability, due to subdued investment returns and downward pressure on real incomes restricting premium increases. Those on emerging market investment, which helped to offset the “Western” slowdown in 2011, will be adversely affected by slower economic growth action to rein back asset-price rises, especially in Asia.

Large emerging markets’ average premium growth on life insurance slowed to around 6% in 2011, but this was affected by a one-off fall in Chinese premiums after regulation changes. Eurozone companies’ access to the fastest-growing markets will improve in 2012-15, as several of them liberalize the life sector in ways that allow easier entry by foreign  providers.

“The outlook for asset management is not much better. The mass retail investment market continues to face net outflows and negative investment returns. There is a risk that this period of prolonged low returns may feedback to lower net inflows beyond 2012, with households channeling their limited savings into the higher interest bank deposits or debt repayment rather than fund-based investment.” adds Pogson.

“The Undertakings for Collective Investments in Transferable Securities framework, while primarily designed to boost the internal market, also gives foreign operators an extensively unified EU market, reducing cross-border distribution costs. This will enable fund groups from faster-growth regions especially in Asia, to market their higher-returning products directly into Europe, competing with EU-based managers of emerging market investments.”