By Daniel Hunter

The Ernst & Young ITEM Club outlook for financial services predicts that the decline in total lending to the economy will sharpen this year despite government intervention.

Insurers face a perfect storm as weak economic growth and new regulation widens the gap between assets and liabilities, and, although asset management remains the strongest financial services sector, the outlook for assets under management (AUM) is downgraded in the face of ongoing instability in the Eurozone.

Corporate lending is forecast to shrink by 6.2% this year, a similar rate to last year, and the outlook for consumer credit has worsened since last quarter. In the Spring forecast consumer credit was predicted to shrink by 7.6% this year, but weaker-than-expected economic performance in the early months of 2012 means that a contraction of 10.5% is now forecast.

“Despite the government schemes that are coming into play, the contraction in overall lending this year will be even sharper than last year," Carl Astorri, senior economic adviser to The Ernst & Young ITEM Club outlook for financial services said.

"The Treasury’s ‘funding for lending scheme’ looks promising, but although it should help to lower banks’ cost of funding, banks will be very aware of companies’ and households’ heightened risk of default this year. Some banks may also be reluctant to access these schemes for fear of the stigma it could create in the markets.”

The downgrade of the economic growth forecast from 0.4% to 0% has marginally raised the forecast for corporate loan-write-offs to 2% of outstanding loans, which is the highest rate since the 1990s, but this is expected to represent the peak for non-performing loans for the UK in the current cycle.

“The economy is expected to regain some momentum in the second half of this year, albeit gradually, and so write-offs on corporate and consumer loans are forecast to reach their peak in 2012, with improved economic conditions in 2013 stemming the tide of non-performing loans. In contrast, the low-interest environment continues to shield banks and homeowners from increased impairments on mortgages,” said Carl.

AUM were predicted to grow by 10.7% this year but the lack of a solution to the Eurozone crisis has pushed this recovery out, the renewed forecast is for AUM to grow by 7% this year and recover to growth of 10.5% in 2013, hitting a new high of £764b next year.

Heightened risk aversion means that not all segments of the asset management industry will experience robust growth. Hedge fund AUM will fall by 4-6% this year as they struggle to lift returns beyond 1% during the Eurozone crisis. By contrast, bond AUMs are forecast to rise by 10% and Money Market AUM by 8% in 2012 as investors seek ‘safe havens’.

However, as the economy recovers and risk appetite returns, today’s safe havens investments are likely to reverse. Flows into bonds and money market funds are expected to slow rapidly or even turn negative as rising yields in the bond market cause capital losses and the equity market gains momentum.

“The asset management sector is still the strongest performing sector in financial services but it will change rapidly in 2013/14. Bonds and money market funds will lose favour as economic stability increases confidence and property and equities will make a comeback as investors start to look for higher return opportunities,” Carl commented.

The combination of low interest rates, higher hedging costs, lower business volumes and more onerous capital requirements as a result of Solvency II will hit insurers hard this year and next and profits look set to decline for the second year running.

“2012 is proving a tough year for the insurance industry. Insurers need to plan their businesses on the assumption that the low interest rate environment is here to stay for some time. They need to wean customers off the guarantees that are creating the asset and liability matching problems, prices need to rise for property and casualty insurance, annuity rates need to fall and distribution models for life insurers need to be reassessed,” added Carl.

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