EY Eurozone forecast: Spring 2014
Outlook for financial services
Welcome to the Spring 2014 edition of the EY Eurozone Forecast: Outlook for Financial Services.
“Spring may be here, but signs of renewal are more visible in some areas of the Eurozone than others. Overall economic growth remains anemic, and we continue to see a two-speed recovery. But this is not simply about a solid core and a weaker periphery. Instead there are indications that a split may be emerging between the countries that have made structural reforms and others that are yet to do so.”Andy Baldwin
EMEIA FSO Managing Partner
Read Andy's Forecast Overview here
The Eurozone recovery is expected to gather momentum from 2014 and GDP is expected to reach 1.6% growth per year in 2016-18. But financial services still face challenges from ongoing low interest rates, high unemployment, and the regulatory agenda.
- Banking Forecast
This year’s forecast for bank lending growth is a mere 0.5% but - despite uncertainty around the size of capital shortfalls uncovered by the results of the ECB’s asset quality review (AQR) - lending is expected to pick up to 3.8% in 2015. This positive lending outlook is also supported by the forecast for non-performing loans (NPLs) to fall in 2014, and assets to remain unchanged from 2013 at around €30t. Read more...
- Insurance Forecast
Low interest rates, upcoming regulatory hurdles, and high unemployment (12% of the workforce in 2014) across the Eurozone continue to put pressure on insurers adapt their business models and redesign their product mix. A shift to less interest-sensitive products is forecast to help life premiums reach 4.1% growth in 2014, whereas non-life premium growth - at only 2.4% - is more limited. But, despite the challenging environment, profits in the insurance industry are forecast to average growth of 10% in 2014. Read more...
- Asset management forecast
Over the next five years AUMs in the Eurozone are forecast to increase by 24%, helped by improved investor confidence and a retreat from emerging markets. Bond funds continue to lose ground to equity funds as risk appetite improves and in 2013-18 bond funds are expected to grow by only 6%, compared with growth of 50% in the same period for equity funds. Solid gains of 56% in 2013-2018 are also forecast for multi-asset funds, and while hedge fund AUM should start to grow this year, by 2018 they will still be 21% below their 2007 peak. Read more...
What do these, and other economic developments in the Eurozone mean for your financial services organization and the wider industry? Read our Spring 2014 forecast to find out more, or contact us for in-depth insight on the issues affecting your organization.
EY Eurozone Forecast: outlook for financial services - Spring 2014 highlights
Banking sector highlights
“It is increasingly uncertain that Eurozone banks will be able to achieve pre-crisis levels of credit growth in the foreseeable future. In fact, many remain under pressure to exit non-core businesses and reduce their overall leverage.”Robert Cubbage
EMEIA Banking & Capital Markets Leader
The ECB’s AQR has barely begun, but there are plenty of signs that it is already having a significant impact on the Eurozone’s banks. Several major institutions have announced “kitchen sink” results in recent weeks, taking radical steps to tidy up their balance sheets.
It is too early to judge the long-term benefits of this spring cleaning, but the medium-term effects on lending are clear. Forecasts for business lending growth in 2014 have been revised down again, from 1.6% to just 0.5%. True, lending growth is expected to strengthen next year, and demand for credit could expand faster if the Eurozone recovery accelerates. However, economic underperformance or a further deterioration in asset quality could have the opposite effect.
Overall, it is increasingly uncertain that Eurozone banks will be able to achieve pre-crisis levels of credit growth in the foreseeable future. In fact, many remain under pressure to exit non-core businesses and reduce their overall leverage. So it is likely that some banks will adapt their business models by providing less direct lending to corporate customers, in favour of advising them on accessing finance from a range of different sources.
A forecast that Eurozone banks’ total assets will not exceed their 2011 peak until 2018 seems to support this vision. Of course, limited credit growth will create other challenges for the Eurozone’s banks. The most fundamental will be the need to rebuild their returns on equity (RoE). Many large banks are currently generating returns of around 4%, far below their typical target levels of around 15%.
Research by EY suggests that banks will find it extremely challenging to achieve this kind of RoE uplift. Our analysis indicates that cost reductions of around 35% or revenue growth of more than 20% might be required just to achieve their average cost of equity (10%). Should banks wish to reach 15% RoE they would be required to reduce costs by 66% or grow revenues by 44% - a goal beyond the scope of most banks in the current climate. This also does not take account of the fact that many banks could still see 1%-2% knocked off their RoEs by tougher capital requirements and leverage limits. Whatever the effects of the AQR, the Eurozone’s banks face a long road back to recovery.
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Insurance sector highlights
“For most Eurozone insurers, adapting their business models to a post-Solvency II world is likely to be much harder than meeting the required standards for capital, disclosure and reporting.”Andreas Freiling
EMEIA Insurance Leader
With the announcement of the January 2016 date, European insurers finally have a fixed Solvency II target to aim for. The largest insurers are already prepared, having previously been working toward compliance in 2013 or 2014. Mid-market insurers may need to initiate a few final projects, but the European Insurance and Occupational Pensions Authority’s interim measures should not cause significant problems for most firms.
For most Eurozone insurers, adapting their business models to a post-Solvency II world is likely to be much harder than meeting the required standards for capital, disclosure and reporting. The task is made more urgent by the low growth, low interest rate environment facing the industry.Life insurance premiums are only recovering very slowly, reflecting the squeezed household incomes and high unemployment that characterize many markets. Non-life premiums are growing slightly faster than before, but this conceals significant variations. For example, since the start of the year growth forecasts for 2015 have been upgraded for Germany, but downgraded for France.
Life insurers are responding to current market conditions with increasing interest in assets that offer attractive but acceptable risk-return profiles. Many firms are being drawn to debt backed by real estate or infrastructure assets. A handful are also dipping their toes into direct corporate lending, but their natural caution means that this is unlikely to represent anything more than a small proportion of total assets.
Meanwhile, non-life insurers’ results continue to feel the effect of the floods and storms that hit Europe in late 2013 and early 2014. The impact is largely limited to gross results, and reinsurance rates are likely to climb as a result. Some classes of business could also see localized increases in primary rates, but this is unlikely to herald any broad-based upturn in pricing.
Returning to regulation, Solvency II is not the only item on insurers’ agendas. The IASB’s implementation target of 2018 for IFRS 9 may be a long way off, but firms should be aware that IFRS 4 Phase II accounting for insurance contracts may be introduced on this date too. By midsummer, the Financial Stability Board will announce those reinsurers designated as Globally Systemically Important Insurers (GSII). The nine insurers already designated as GSIIs will watch with interest the developments at the International Association of Insurance Supervisors (IAIS) as it develops the basic capital requirements (BCR) which will apply to all group activities, including non-insurance subsidiaries. Field-testing begins in March 2014 to calibrate the BCR to adequately capture the risk profiles, with the aim of finalizing its design by November this year. The IAIS will subsequently work to develop the high loss absorption (HLA) requirements for GSIIs to be completed by the end of 2015.
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Asset management sector highlights
“European asset managers are casting their net wider than ever in the search for attractive yields. As a result, the investment environment is becoming more and more creative.”Roy Stockell
EMEIA & Asia Pac Asset Management Leader
As predicted last quarter, the economic recovery continues to attract capital into European equities. As in the US, this trend is being mirrored by a widespread withdrawal from bond markets. The Eurozone’s ratio of equity funds to bond funds, which stood at 100% at the start of 2013, is predicted to reach 129% this year and 140% in 2015. The shift is so rapid that many bond management houses are rushing to enhance their equity management capabilities. Investors’ increasing willingness to reduce their cash holdings — a key indicator of risk appetite — is further illustrated by growing outflows from money market funds.
Should this level of inflows be ringing alarm bells? Some of the current interest in European equities reflects the recent emerging markets retreat and is unlikely to be sustainable. Several large European asset managers have also recently changed hands. In the past this has sometimes been an early indicator that equity values are reaching their peak.
But for now, we see no reason for concern. With the major Eurozone economies all expected to grow in 2014, the prospects for European company profits are growing brighter. Recent M&A activity involving asset managers seems to owe more to banks’ capital needs than to overvalued equity markets. Equities are not the only show in town. European asset managers are casting their net wider than ever in the search for attractive yields. As a result, the investment environment is becoming more and more creative. Shipping assets and debt are just two examples of real-world assets catching the attention of new investors. It is good to see firms embracing innovation in the search for value, but those of us with long memories will hope that managers remember to keep a careful eye on possible illiquidity risk.
Of course, asset managers are not getting things all their own way. The regulatory temperature remains high, with new European restrictions on variable compensation a particularly hot issue. In theory these should improve the alignment of interests between asset managers and their clients. In practice it is far less certain that they will reduce overall costs, or have any meaningful effect on investor protection.
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Spring may be here, but signs of renewal are more visible in some areas of the Eurozone than others. Overall economic growth remains anemic, and we continue to see a two-speed recovery. But this is not simply about a solid core and a weaker periphery. Instead there are indications that a split may be emerging between the countries that have made structural reforms and others that are yet to do so. This is illustrated by the contrast between a resurgent Ireland and a recovering Spain, and persistently weak forecasts for growth in France, Belgium and the Netherlands.
In the case of Ireland and Spain, it may also be significant that economic reforms have been matched by restructuring in the banking sector. If so, perhaps we can expect that the asset quality review (AQR) getting underway across the Eurozone will allow other countries to feel the benefits of a fresh start. There is growing evidence that the Eurozone’s major banks — encouraged by national regulators — are taking action to pre-empt the AQR’s findings and avoid surprising shareholders with the announcement of a capital shortfall.
The effects of the AQR may also be felt beyond the 129 Eurozone banks covered by the comprehensive assessment of the European Central Bank (ECB). If the AQR leads to a “halo effect” for smaller banks and those outside the Eurozone, we will know if the initiative has succeeded in establishing a new ‘gold standard’ for balance sheet reporting.↓ [... more]
With the AQR in progress, attention is now shifting towards its possible consequences for European financial services. Strategic planning requires firms to look beyond the outcome of the process and consider the broader impact. What will the Eurozone financial landscape look like once the AQR has run its course?
One possible effect of the AQR may be to encourage the ECB to hold interest rates at their current very low levels for even longer than expected. Having taken steps to strengthen the Eurozone’s banks, this would encourage companies and consumers to borrow, as well as potentially making it easier for Eurozone governments to run larger deficits or delay necessary reforms.
However, the experience of the past few years suggests that a new paradigm of ultra-low interest rates and increasing regulation will create significant challenges for the financial industry. These include margin pressure (particularly for insurers) financial repression for savers, and a tendency for pension deficits to deepen. Prolonged low interest rates would also increase the pressure on financial firms to cut costs further and adapt their business models. While this may encourage innovations such as new digital services to emerge, it could also lead to tighter insurance underwriting and tougher lending standards. For now this is all conjecture, but these are the types of scenarios that Eurozone financial firms should be modelling.
Whatever the AQR’s long-term effects, in the short term governments will be hoping that it helps to ease the flow of credit to the SME sector that plays such a vital role in the Eurozone’s economy. With the economic cycle at an inflection point, it is also a good time for governments to look critically at promoting other sources of funding to support growth. This is about much more than banks’ balance sheets. Insurance capital, pension fund capital, investment fund capital and other sources of debt will all be needed to meet Europe’s future investment and infrastructure requirements. Certainty and stability in the regulatory and legislative environment will be essential to attracting investors.
So it is encouraging that European policy-makers show growing awareness of this issue. Positive developments include the recent movement on matching-adjustment under Solvency II, which should significantly increase the available pool of investment capital, and the EC’s green paper on long-term investment funds.
These are welcome first steps, but much more needs to be done. Possible pitfalls, such as tighter shadow banking regulation, also need to be navigated. The ability of Eurozone governments to deliver a sustainable economic recovery may depend on achieving better balance and diversification in long-term funding markets.
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