Lacklustre growth forecast for UK to hit financial services

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London 31 October 2011: Even assuming that the recent Eurozone agreement on an orderly restructure of Greek debt can be implemented, the ITEM Club’s forecast for growth in the UK economy is lacklustre, with GDP set to grow just 0.9% this year and 1.5% next year. The effects on financial services will be far-reaching, impacting employment, increasing loan write-downs by £3bn, and reducing lending, which will in turn hamper the UK's recovery, according to the EY ITEM Club Financial Services Outlook.

Weak outlook for financial services job market will hamper the wider economy
The difficult environment facing financial services will impact employment in the sector. Overall there has only been a modest rebound in employment since the significant shake-out seen during the global financial crisis, with only a third of jobs lost regained. In Q2 2011, employment in the sector dropped by 14,000 and we expect employment to be broadly flat in 2012.

Dr Neil Blake, Senior Economic Advisor to the EY ITEM Club, comments: “Given the extent to which highly paid employment in the sector underpins consumer spending, tax revenues and house prices in the UK, the projections for financial services employment is concerning. The government has set out to de-risk the sector and make the UK less reliant on it in order to make the economy more secure. Unfortunately, if no other sectors step into the resulting gap, prosperity will go down across the country.”

The UK financial services sector is heavily interlinked with the fortunes of the Eurozone through trade and any worsening in the European economy will have a direct knock-on effect on the outlook for the sector in the UK.

Bank loan write-offs to increase by £3bn
The latest market data suggests upward pressure on bank loan write-offs is already present and ITEM forecasts that the weaker growth outlook for the economy will lead to write-offs over the next few years being approximately £3bn higher than we previously assumed.

“Most of this increase in write-offs will come from non-financial corporate and unsecured household debt. Low interest rates and a gentle recovery in house prices means that write-offs on mortgage debt should remain low,” said Dr Blake.

Pressure on bank lending limits credit supply and opens corporate banking up to shadow banks
Total loan growth over the next two years is now forecast at just 0.5%pa – a reduction of 30 basis points. Dr Blake comments: “As the financial services sector comes under increasing pressure, the supply of credit to the broader economy slows, which in turn impacts the growth prospects of the wider UK economy.
"Banks may now also face increasing competition for corporate lending from non-bank lenders who are unencumbered by some of the balance sheet restraints that banks currently face. This expansion of the UK’s shadow banking system may be beneficial for UK businesses as they seek out alternative funding, but for banks it is another factor which puts pressure on their current business models, risking long-term loss of market share.”

Banks have deleveraged and are on track for CT1 targets
UK banks have had some success in deleveraging; the leverage ratio halved between 2007 and 2010 and now sits at two thirds the leverage ratio of large European banks. The UK’s reliance on wholesale funding has also more than halved since its peak. Altogether this means UK banks are now better placed in the event of a severe financial crisis or a drying up of wholesale funding markets.

“Although this progress on building capital ratios and deleveraging may have had a negative impact on the growth of the economy in the short-term, it has improved the health of UK banks. Despite significant economic headwinds UK banks remain on course to hit both Basel II and ICB CT1 targets,” said Dr Blake.

Insurance profitability hit by real-term shrinking of premiums
Profitability continues to be a concern for insurers. Inflation-adjusted figures show that in 2009 UK premiums fell by 8.6% in real US $ terms and by 2.7% in 2010, compared to growth in Western Europe and Worldwide for the same period.

Dr Blake comments: “The prolonged period of depressed and volatile investment income has raised the importance of premium income to overall profitability for insurers. The UK’s real-term shrinking of premiums across both life and non-life will hit profitability, and the forecast for slow real income growth will limit the recovery of sales and remain a restraint on real premium growth for the foreseeable future.”

Regulation fundamentally challenges UK life business model
The combination of Solvency II capital requirements for guaranteed income products and the introduction of RDR will put significant pressure on the business model of life companies and their returns. The forthcoming UK pensions law, which will allow the pension to be drawn down at different levels, will reduce demand for annuities, hitting new business revenues for life companies.

“Profitability from savings and investments is under pressure from both EU and domestic regulations and as a result companies will be looking elsewhere, for example to Asia Pacific, in the search for better returns for capital. In the long-term, however, we are hopeful that these pressures will also herald a wave of product innovation,” said Dr Blake.

Q3 results for insurers hit by stock market volatility
Volatility in their investment portfolios will hit insurers’ results. Insurers reported strong cash positions in Q2 but the combination of the recent falls in equity markets and the reduction in sales of traditional investment products will impact their cash positions as reported in Q3 this year.

Quantitative easing prompts fear of prolonged phase of negative real rates
ITEM predicts that the Bank of England’s commitment to keeping base rates at historic lows, despite above-target inflation, will deter investors from retail deposits.

Dr Blake commented: “The commitment to low interest rates and a new round of QE will make retail deposits unattractive and savers will be increasingly drawn to UK-domiciled investment funds, such as unit trusts, open-ended investment companies and pension funds, although weak real income growth and economic uncertainty may push big increases back to the second-half 2012.”

Absolute return funds affected by lack of uncorrelated investment opportunities
Absolute return funds usually prosper in periods of market volatility but the unusually high correlation among asset classes has impacted their ability to spread risk and therefore adversely affected their returns.

“It is unusual for asset classes to be so closely correlated, even in periods of volatility but until the US and EU have moved more clearly towards debt sustainability we expect these conditions to continue” said Dr Blake.

Asset managers hope EU deal will “stop the rot”
Asset managers are hopeful that an orderly resolution of the EU debt crisis will trigger inflows. Dr Blake said: “If the latest agreement is seen to ‘stop the rot’ and draw a line under the EU debt problem, the expectation of market revival could trigger inflows, however any suspicion of other countries defaulting in Greece’s wake could spark a deflection of inflows away from equities for a much longer period.”

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