By Daniel Hunter

The Ernst & Young ITEM Club outlook for financial services predicts that lending to corporates will drop to the lowest level since 2006 this year, despite government intervention. However, the outlook for financial services in 2013 and beyond is more positive as the industry slowly shows signs of turning a corner.

Corporate lending is forecast to shrink by 4.6% this year, dropping to £429b by the end of the year - the lowest level since 2006. Nevertheless, this rate of contraction is slower than the 6.1% decline of 2011. Positive growth is forecast to resume from 2013, but corporate loans will not recover to 2008 levels until 2016.

“The good news is that 2012 is likely to be the last year of such marked deleveraging in the UK; the bad news is that, once again, SMEs will bear the brunt of it," Carl Astorri, senior economic adviser to The Ernst & Young ITEM Club outlook for financial services said.

"Government schemes to increase lending may help a lucky few but, as banks are encouraged by regulators to store up more capital and to look again at their forbearance policies and so-called bad-loan books, most small business are going to continue to feel the squeeze.”

The available evidence suggests that rejection rates for SME loan applications have risen recently. Surveys from the Office for National Statistics’ (ONS) and Warwick Business School suggest that loan rejection rates averaged around 11% between 2005 and 2008, whereas the rejection rate in mid-2012 averaged around 38% according to evidence from the Federation of Small Businesses and the SME Finance Monitor.

These loan rejection rates may provide an indication of the ‘financing gap’ facing SMEs over the coming year. Data from the Bank of England indicate that gross lending to SMEs amounted to £44.2b in the year to Q1 2012. If this lending data reflects a rejection rate for credit of 38%, then lowering the rejection rate to the pre-crisis level of 11% would imply the need for additional loan facilities worth around £19b.

“The figures suggest that the British Business Bank’s lending capacity could be exhausted in less than a year," Astorri added.

"Its impact will also be reduced by competition with private sector lending activity: even if the Government aims to lend at market interest rates, it is unlikely to be able to avoid displacing existing lending activity. Indeed, we expect the Business Bank will have to compete for projects that are commercially viable, and so we do not think the scheme will have a tangible impact on the economy.”

The Bank of England’s Credit Conditions Survey for Q3 2012 indicated that the supply of residential mortgage loans had increased significantly following the introduction of the Funding for Lending Scheme in July, but so far there is little evidence that lower funding costs are being passed on to borrowers.

“In light of the current weakness in the housing market and the economy more generally, it is therefore not surprising that lending has remained lacklustre," said Astorri.

"We remain sceptical about the ability of the scheme to stimulate lending growth, and expect residential mortgage loans to increase by just 1.3% in 2012, little changed from the 1.2% expansion in 2011.”

In 2013 total banking assets are set to remain broadly stable after years of deleveraging and UK bank’s income should stabilise before positive, if moderate, growth resumes from 2014. For the insurance industry the contraction in profits will slow from 31% in 2011 to 9.5% this year and will then start to slowly recover from 2013 as nominal GDP growth doubles and makes price rises easier to achieve.

As 10 year bond yields rise slowly from their low of 1.5% in August, bond AUM growth will slow to 4% in 2013 before turning negative in 2014 as rising yields cause capital losses.

“As the market begins to stabilise and investor confidence grows we expect AUM in riskier asset classes to pick up and ‘safe-haven’ asset classes to start to lose their appeal; the bond has had its heyday as an investment class and we expect equities to return to the fore in 2013,” Astorri said.

“Profits may start to recover in 2013 and we expect a 7% rise in equity prices, which will help to improve investment returns, but there is significant over capacity in the insurance market that insurers will be struggling to achieve top line growth through any means other than M&A and so we expect deals to continue.”

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