EY ITEM Club

Outlook for financial services
Summer 2016

Banking & Capital Markets forecast

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The banking industry has navigated its way through wave after wave of challenges in the past decade. Just as positive signs were emerging for the sector, the vote to leave the European Union and its impact on the economy, has blown banks operating in the UK into uncertain new waters.

While there are significant downside risks to consider as the economy slows, the sector is well anchored. Banks are in far stronger shape than they were in the financial crisis and much better able to withstand economic shocks.
Robert Cubbage
Partner, UK Banking & Capital Markets Leader
Read Robert’s full banking viewpoint

A slowing economy brings challenges


EY - Robert Cubbage
Robert Cubbage
Partner,
UK Banking
& Capital
Markets Leader

The banking industry has navigated its way through wave after wave of challenges in the past decade. Just as positive signs were emerging for the sector, the vote to leave the European Union and its impact on the economy, has blown banks operating in the UK into uncertain new waters.

While there are significant downside risks to consider as the economy slows, the sector is well anchored. Banks are in far stronger shape than they were during the financial crisis and much better able to withstand economic shocks. ↓ [... more]

The clouds on the horizon

Since our last financial services forecast six months ago, which highlighted the emerging bright spots for UK banks, the horizon has clouded somewhat. These clouds largely come from downward pressures on demand by consumers and businesses rather than any weakness in banks’ ability to lend. Falling consumer confidence brought on by uncertainty following the Brexit vote, the accompanying likelihood of weaker real income growth and rising unemployment, will manifest itself in slower growth in demand for big ticket items, and for buying homes.

For the household sector, we expect mortgage lending growth to slow to 1% per year from 2017 to 2019, down from 3% in 2014 and 2015. Consumer credit will rise by just 3% a year over the next three years, compared to a rate of nearly 10% seen earlier in 2016. Meanwhile for the corporate sector, the change in sentiment will be particularly marked in business investment, which we expect to drop by almost 2% in 2017. All of this will serve to hold back growth in the sector’s revenues.

A well anchored sector

Happily, it is clear UK banks are in a far stronger position than in 2008 and much better equipped to weather any downturn. The sector holds £600b of high quality liquid assets, four times the level held pre-2008, and the aggregate Tier-1 capital ratio stands at over 12%, compared to 4% prior to the financial crisis. That solidity ensured all UK banks passed the 2015 stress tests, which assumed much more onerous scenarios than those we face today. We are in a slowdown rather than a full blown solvency crisis. There have been concerns about the commercial real estate market, but banks are much less exposed to this sector than in the past and have been careful to apply more stringent credit standards and stronger risk management than previously.

A supportive policy framework as rates fall

Policymakers have made it clear they will take swift supportive action, as we saw with the Bank of England’s Financial Policy Committee’s decision to cut the countercyclical capital buffer to zero, and the government’s pledge to drop its target of a budget surplus by 2020.

Even before June, the UK’s government and regulators had been adopting a less hawkish stance towards the banking sector and the current outlook will only encourage this approach.

In the wake of the Brexit vote, the Bank of England said it was prepared to further reduce interest rates, which we expect to be cut to zero by the end of the year, and to step up asset purchases. Of course, low interest rates are a double-edged sword for banks. While they should support demand for loans, they will squeeze banks’ net interest margins, putting a dampener on profits and constraining revenue growth.

Outlook

As Europe’s premier banking centre, it is in the UK’s interests that favourable Brexit terms that provide access to the single market are negotiated. Retaining existing passporting rights that enable banks to trade across the EU would mean disruption will be minimal in the long-term. However, banks’ compliance with MiFID II could help soften the blow of a less desirable outcome from the talks, with regulatory equivalence supporting access to the EU.

With margins squeezed, and Brexit negotiations yet to get underway (let alone complete), banks must use the next two and a half years to consider strategic changes to manage costs. The sector now boasts a much stronger capital position than before the financial crisis, and is getting to grips with the regulatory agenda. This allows banks to move beyond the fire-fighting cost reduction of the last eight years, and take full advantage of technological developments, such as robotics and digital, to dramatically lower costs in the long-term. Banks are also likely to use the Brexit negotiation phase to review their business portfolios, reducing risk on their balance sheets or re-examining their geographic footprints.

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Banking highlights:

Falling demand will challenge banks but their strong capitalisation and support from policymakers provides comfort for the sector.

  • Bank assets will decline to £5.9t in 2017, shrinking until 2019 as a weaker economy curtails demand for loans.
  • Mortgage lending is forecast to grow less than 1% on average per year over the next three years compared to 3% in 2014 and 2015.
  • The stock of business loans is expected to fall to £376b by 2019, the level seen in 2005.
  • The sector is well capitalised, holding more than £600b of high quality liquid assets, four times the pre-2008 footing.