Historically low borrowing growth for this stage of the recovery to hit bank profitability
6 May 2014
- A shift to alternative sources of finance sees business lending growth fall to 1.5%
- Banks expected to protect borrowers from some of the costs of a BoE base rate rise
- Annuity changes will further slow insurance profit recovery – 2013 saw a 44% slump
The profitability of banks is likely to be hit by subdued growth in household borrowing and business lending, warns a new report from the EY ITEM Club forecast for financial services.
Total household lending will increase only marginally to 2.4% by the end of 2014, from its current annual rate of just 1.6%. This is historically low given the point in the economic cycle. In 1994, in the early stages of the recovery following the recession of the early 1990s, annual growth in household lending was 5.8%. Over 2015-2018, loans are expected to grow at an annual average rate of 4.2%, whereas in 1997 – five years into the 1990s recovery – lending growth remained close to 6%.
Growth in business lending in 2014 is predicted to be just 1.5%. This has been revised down from the EY ITEM Club’s 2.5% winter forecast prediction, as corporates increasingly turn to other sources of finance to drive investment. By 2018 – a decade after the crisis - the stock of business lending is expected to be still 10% below 2008 levels.
Martin Beck, Senior Economic Advisor to the EY ITEM Club forecast for financial services, says: “Low borrowing is good news for the sustainability of the recovery, but bad news for banks’ profitability. While the economic recovery will support an expansion in consumer credit, there is little prospect of a return to the rapid credit growth of the noughties. Banks will need to continue exerting tight controls on costs and innovate further to close the gap with pre-crisis rates of profitability.”
Businesses are relying less on banks for finance
The forecast for growth in business lending for 2014 has fallen from 2.5% to 1.5% in 2014, and by 2018, the stock of business lending is expected to be 10% below 2008 levels. This represents a more bearish view compared to the winter forecast, which predicted year on year growth reaching 6.8% in 2017.
With the economy picking up, businesses are expanding investment. However, according to the report, they are turning ever more to non-bank routes to raise capital, relying increasingly on bond issuance, which is up almost 20% since 2009, and to a lesser extent, other sources like peer-to-peer lending. In addition, growing profits and existing large cash balances (the latter amounting to over £330b at the end of 2013) mean that businesses can make more use of retained earnings to finance investment, further reducing their reliance on banks.
Omar Ali, UK head of banking and capital markets for EY, says: “The forecast of slower growth in business lending, alongside modest mortgage growth despite interventions such as help to buy, and dampened consumer credit growth, is a blow for banks as they strive to rebuild their return on equity to an attractive level. There’s no denying that some of the banks’ traditional core market is looking to alternative sources of finance.
“The good news is that SMEs are still looking to banks as their primary source of funding. Given the recent economic upturn and pressure on banks’ traditional lending client base, they may look to rebalance more towards SMEs. This overall will be better for the UK economy.”
Rate rises on the horizon, but banks will protect borrowers
The Bank of England (BoE) base rate is forecast to rise 2.5% by the end of 2017, but banks are expected to raise market rates only marginally and absorb some of the subsequent costs for borrowers. This will protect people from potentially crippling like-for-like interest rate rises on their mortgages and loans. It will also signify a move towards more historically ‘normal’ levels of lending spreads of around 1.5% (currently 2.6%), which compares to the very narrow 0.08% pre-crisis spread seen at the beginning of 2007.
A BoE base rate rise will be felt most acutely by mortgage and business loan holders. People aged 30-49 (the bulk of whom have mortgage debt) are likely to be hit the hardest, as their repayments are the highest nationally, averaging £85 per week (in 2012) compared to an average of £46 per week for the population as a whole .
Beck says: “Homeowners and small businesses alike have grown accustomed to five years of low interest rates and relatively affordable monthly repayments. A sudden increase could send them spiralling into unaffordable debts, which could increase banks’ write-off rates. But it is likely the Bank’s base rate will rise fairly slowly and that competition among banks will mean that the sector absorbs some of the impact of higher rates on borrowers, giving them more time to adjust, and not putting the financial burden of a rate rise on savers’ doorsteps.”
Budget kick-starts battle for share in the annuity market
The changes to the annuities market, announced in the Spring Budget, are adding further uncertainty to the financial services sector. Fundamental changes are expected to re-shape the reported £12b annuities market, and the battle for market share is on. Insurers are looking to retain the lion’s share of retirees’ money, and asset managers and banks are keen to enter the market. However, alternative investment products are unlikely to offer the high profit margins that annuities typically do, so potential achievable profits from this segment of the market will be lower whoever wins the battle.
Mark Robertson, UK head of insurance for EY, says: “The pensions market has always been dominated by insurers, so over-zealous predictions that asset managers and the banking sector will deplete insurers’ pool of customers must be tempered. Insurers are already innovating their product offerings and will still be best placed to provide annuity products, which for many people will remain the most appropriate retirement option. It is still early days, and we will gain clarity over the next 12 months.”
The changes to the rules around annuities will significantly impact the insurance industry, which is already struggling to recover profits. Between 2010 and 2013, profits experienced a 44% slump. This is set against a backdrop of growth trajectory for asset managers, who represent the biggest annuity market entrant threat, and who had a record year for profits in 2013. Assets Under Management (AUMs) reached £808b, 16% higher than in 2012, and UK-focused funds are expected to exceed £1tr by 2016, which is close to two-thirds of the annual UK GDP figure for that year. If asset managers can take just a quarter of the £12bn currently flowing into annuities annually, they look to significantly improve their already booming balance sheets.
Gill Lofts, UK head of wealth and asset management at EY, says: “Asset managers are positive about the budgetary changes and the role they might now be able to play in the decumulation market, but there are mixed views about the speed the impact will have on the sector. The gains look to manifest themselves over the longer term. Asset managers will definitely focus on creating the investment building blocks for others to wrap into the product.”
Mark Robertson comments: “What is clear is that there will be an even greater convergence of asset management and insurance business in the UK now, as better quality and affordable post retirement propositions are created for a growing consumer demand.”
The insurance industry is expected to see gradual recovery in 2014, with a bounce-back in profit growth of 27%, but this is set to fall dramatically to just 5% in 2015 (revised down post-Budget from 18.5%). Profit growth will pick up gradually from this low, with a forecast peak in 2016 of 11.9% (revised down from 17.2%), dropping in 2017 to 7.6%, before picking up again in 2018 to 8.5%.
Beck says: “The negative effect of annuity reform is partly offset by the positive boost from a stronger GDP growth forecast, but the changes are a weighty hit to the sector, and life insurance premiums are not expected to exceed their 2007 peak of £212b until 2018.”