By Marcus Leach

Early optimism for the financial services sector in 2011 has vanished as the industry in the UK faces forecasts of sluggish growth.

This significant change in fortunes has potentially serious implications for the recovery prospects of the wider economy according to the Ernst & Young ITEM Club Outlook for Financial Services.

The ITEM Club Outlook for Financial Services is a companion to the main ITEM Club Forecast which examines in more detail the implications of ITEM Club’s economic projections for the health of the UK financial sector and whether the sector is in a position to support the UK’s economic recovery.

As well as an uncertain UK economic outlook, continuing concerns about European sovereign debt crises, the impact of the Independent Commission on Banking (ICB), reduced access to funding and global and European regulatory reform are all impacting the health of the financial services sector in the UK.

Lending to both households and large corporates is likely to be curtailed, which will have a knock-on effect on the progress of the UK economy; the funding implications of the ring fencing proposals put forward by the ICB alone stand to reduce GDP by up to 0.3%.

ICB ring fencing to increase the cost of lending to large corporates by 1.5%
The ITEM Club forecasts that the ring fencing proposed by the ICB would have the following effect on the lending markets:

- The cost of wholesale funding to the investment banking divisions would rise by around 100bp (1%);
- The loss of an implicit government guarantee and restrictions on cross-funding between retail and investment banking divisions would result in financial markets demanding a core Tier One Capital Ratio from investment banking divisions of around 14%; and
- This would result in an increase in the cost of bank lending to large UK corporates of up to 150bp (1.5%).

ITEM’s analysis suggests that the impact of this on the wider UK economy is likely to result in a loss of up to 0.3% of GDP.

“These predictions are not based on a worst case scenario, they’re based on moderate assumptions about the extent of ring fencing and don’t assume that the cost of funding to the retail element of banks is affected," Neil Blake, economic advisor to the Ernst & Young ITEM Club said.

"Depending on what is announced next week, we will need to consider the knock on impact not only to the banking sectors but to the UK economy as a whole.

“The market reaction to the ICB report is going to be instrumental in determining the knock-on effect to the wider UK economy— the greater the restrictions on cross-funding between the retail and investment arms of banks, the more severe we expect the reactions of the financial markets to be and the greater the effect on large corporates and, as a result, UK GDP.”

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