By Daniel Hunter

The Ernst & Young ITEM Club Outlook for financial services predicts that the real effect of the ongoing funding crisis in the banking industry will begin to be seen, as overall bank lending contracts for the first time since 2009.

Small to medium sized enterprises (SMEs), commercial real estate and personal customers who fall outside of standard credit terms will be hit particularly hard.

The growth of payday loan companies and alternative corporate funding vehicles is also set to continue at pace, as the paralysis of bank lending opens up the market further to alternative or ‘shadow’ banking at both ends of the market.

The ITEM Club has also modelled what proportion of the revenues of the FTT would come from the UK. Even if the UK opts out, if a reverse charge mechanism was applied, the UK financial sector would contribute around 60% of total revenues.

Bank lending to contract by 2.2%

After expanding by an estimated 4.3% in 2011, the ITEM Club expects total bank loans to contract by 2.2% in 2012, with just 0.9% growth forecast in 2013.

"We have been warning about the impact bank deleveraging could have on the economy for some time, but this is the first time there will be an annual contraction in total loans since 2009, when the UK economy was still suffering from the immediate effects of the global financial crisis,” Neil Blake, senior economic adviser to the Ernst & Young ITEM Club commented.

The contraction in corporate loans is expected to be particularly sharp, with a 5.7% fall forecast for 2012. Financing conditions are likely to be particularly tight in the construction and real estate sectors and smaller companies will be particularly badly affected.

“Funding for small and medium-sized enterprises is likely to be particularly difficult to obtain as banks seek to reduce credit risk," Blake added.

"The average interest rate on smaller loans, of £1m or less, is already double that charged on loans of £20m or more, and we expect this trend to continue. As these young companies tend to be high-growth businesses, this will have adverse knock-on effects for economic growth.”

Consumer credit won’t recover until 2014, but payday loans’ market share rockets

With banks expected to further tighten lending conditions, consumer credit will continue to shrink rapidly, contracting by a further 5.4% in 2012, and won’t hit 2011 levels again until 2014. However, whilst banks and building societies’ unsecured lending to individuals has contracted by 23% (£34bn) since 2007, net lending by alternative high-cost consumer credit providers has risen by 42% (£29bn) over the same period.

“The contraction in consumer credit is driven by lack of demand to an extent, but we just need to look at the phenomenal rise in payday loans to see that the focus on decreasing demand masks a shift towards alternative providers," said Blake.

"Households that fall outside of the credit terms of traditional lenders are increasingly looking toward other credit providers, regardless of the cost. With banks expected to further tighten lending conditions, we expect the shift towards alternative lenders to continue unabated."

Write-offs will increase across the board

Write-offs are forecast to increase across consumer credit and corporate loans. Consumer facing industries will be hit by the low growth forecasts for household income and consumer spending and bankruptcies in retail, hospitality and leisure, and defaults on unsecured lending are all set to increase.

However, with rates forecast to remain at their current low level until mid 2013, the forecast increase in write-offs of residential loans is modest, especially as loan repayment forbearance by banks will likely continue to dampen default rates.

“A worsening of credit quality and lower demand for credit will hit banks’ earnings from lending hard," said Blake.

"When you add regulatory pressure to split investment and retail banking operations and hold more capital into the equation, banks are likely to reconsider their business models and strip away their unprofitable activities.”

Insurance industry to show first significant signs of strain

Although the insurers have so far remained relatively healthy in comparison to other financial services sectors, this resilience will be tested in coming months. The ongoing Eurozone crisis will continue to increase the potential for credit-rating downgrades for UK insurers and there is a danger that insurers’ generally large debt and equity holdings in banks could require them to raise more capital in the long run.

“The continuing crisis in the Eurozone will put increasing long-term pressure on insurers’ capital positions," commented Blake.

"But for now the market should be watching the year-end results closely to see whether insurers, especially in non-life, maintain relatively high levels of dividend payouts in the face of an expected decline in net profits, as a way of signalling their financial health.”

UK to generate more than half the revenues from the FTT even if it opts out

The European Commission (EC) has not published detailed revenue estimates of the FTT at a national level, but the EC acknowledges they would be distributed unevenly in line with trading volumes at EU exchanges.

The Ernst & Young ITEM Club has used the information provided by the Commission to consider the impact on the UK in two scenarios, the introduction of the FTT across the EU including the UK and the scenario if the UK opts out.

“Taking the EC’s estimates at face-value, if the FTT is introduced across the EU, the UK financial sector would generate around 75% of the total revenues," Blake added.

“However, even if the UK were to opt out of the FTT, if a reverse charge mechanism was applied, we expect the UK financial sector would still contribute around 60% of total revenues. Moreover, these revenues would flow directly to governments in the Eurozone rather than to the UK Exchequer.”

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