By Daniel Hunter

The return to growth in the Eurozone economy is fuelling a recovery in key drivers of profitability for financial services, with companies looking to borrow again and cash flow for households and businesses improving.

But the road ahead is not without obstacles according to The EY Eurozone Financial Services Forecast (EEFSF). In particular, the upcoming Asset Quality Review (AQR) and the insurance industry’s vulnerability to changes in interest rates present challenges.

“The Eurozone has emerged from its longest recession in at least three decades and, although GDP is expected to fall by 0.5% this year, activity will gradually pick up. As a result the growth in supply and demand for financial services is starting to return," Marie Diron, Senior Economic Adviser to the EEFSF, said.

Andy Baldwin, Global Head of Financial Services at EY, adds: “Over the summer we saw signs that a sustainable economic recovery in the Eurozone may finally be underway. But a number of challenges remain before we will see a return to profitability and, more importantly, stability in financial services. Not least the unintended consequences and legacy of well-intentioned regulation.”

After contracting for seven consecutive quarters, business investment is expected to pick up again this year. Improving GDP growth and credit conditions are gradually feeding an increased willingness to borrow. After a contraction of 2% in 2013, Eurozone banks are forecast to lend €4.6t to business in 2014 — 3.8% more than in 2012.

Growth in business lending is forecast across all the major Eurozone economies in 2014. In Italy it is forecast to grow 3.8%, in Spain it will grow 3.2% and in France and the Netherlands it is predicted to grow 2.7%. Signs that exports are at last beginning to revive will drive particularly strong growth in lending in Germany - 5% in 2014.

Consumer credit conditions eased in Q2 2013 for the first time since 2007. Consumer lending is predicted to grow by 1.7% overall in 2013, but this growth will be centered in Germany and France, where lending will increase by 3% and 2.6% respectively. In Italy, Spain and the Netherlands lending to consumers will not start to grow until 2015.

Residential mortgage lending is already expanding again this year in Germany, France and the Netherlands but not until 2014 in Italy and 2015 in Spain.

“The forecasts show that cash flow is improving and companies are ready to borrow. But, somewhat ironically, just as credit demand starts to recover, the banks are preparing for the AQR and the further balance sheet pressures this may cause," Baldwin said.

"Whether the AQR will allow banks to begin the transition to growth agenda or will trigger a further round of restructuring and capital raising is hard to say, but it has the potential to push recovery out to beyond 2014 and potentially even further in some markets.”

Bank deposits are growing rapidly at a forecast rate of 3.2% in 2013 and 3.6% in 2014, considerably higher than the 0.9% growth seen in 2012.

Deposits are growing across all the major markets. In France they will grow 3.8%, up from 3% in 2012; in Germany they will grow 3%, up from 1.7% in 2012; in The Netherlands they will grow 6.5%, up from 4.2% in 2012; and in Spain they will grow 2.1% this year, after shrinking 3.9% in 2012. In Italy however, while growth is still strong at 5% it is below last year’s rate of growth which was 7.9%.

Non-performing loans will peak at 7.8% of total loans in 2013, falling to 4.6% in 2017. And, while total bank operating income (profit realized after taking out operating expenses) will improve by just 1% this year, it is set to rise by 7.1% in 2014, as banks put the worst of the provisioning behind them.

Robert Cubbage, Banking and Capital Markets Leader for Europe, the Middle East, India and Africa (EMEIA) at EY comments: “Operating income growth has been anemic or negative for the last four years but a number of factors should contribute to increasing profitability in most markets next year. As economic recovery and a steeper yield curve boost lending and net interest margins, banks’ operating income is forecast to increase considerably in 2014. If the forecasts hold good, banks’ operating income should sustain growth of around 7% for the next three years.”

Interest rates are forecast to remain low until H2 2017, when the ECB is expected to start raising the rate slowly from the current 50bp to 100bp by the end of 2017.

Andreas Freiling, EMEIA Insurance Leader, says: “European insurers remain very vulnerable to interest rate changes. While rapid interest rate rises could hit profits, growing longevity risks mean that low interest rates are putting balance sheets under ever-greater pressure. If the ECB keeps rates at their current levels until 2017, this will create a serious challenge to the life industry. Another two years of very low rates will pose an existential threat to some European insurers.”

Although Assets Under Management (AUM) grew just 2% in H1 2013, assets in pan-Eurozone funds are still forecast to grow by 6.1% this year to €4,817b. However, this is just half the 12% rate of net expansion in 2012, and average AUM growth is expected to reduce further to 3.9% between 2014 and 2017, well below the historic average of 6.7%.

The forecast for AUM growth across the Eurozone varies considerably, reflecting investors’ exit from safe haven bonds in France and Germany as they search for value in peripheral European markets. Driven by investment in bonds, total AUM growth remains strong in Italy (8% yoy) and Spain, (15.8% in 2013 and 9.6% in 2014).In contrast, after growth of 6.3% in 2012, assets in The Netherlands are expected to stagnate this year, as the country is seen as a low-yielding core market in comparison to the periphery.

While total AUM growth in Germany this year is strong ( 6.7%), it tails off from 2014. However, after several tough years for German property funds, AUM is forecast to increase 2% this year and build steadily to reach 4.4% annual growth by 2017.

In France total AUM will fall 4.4% this year and another 1.6% in 2014, settling at an anemic 1-1.8% growth for the following three years. This reflects investors exiting French bonds but also outflows from money market funds, which make up half the French market.

Roy Stockell, EMEIA and Asia-Pac Leader for Asset Management at EY, says: “While the movement in AUMs primarily reflects movement in and out of bonds, neither bonds nor equities will offer managers an easy route to growth. Instead, managers will continue to broaden their horizons and many are keen to explore setting up funds as lending platforms, for infrastructure and potentially SMEs, which promise much better returns than low-yielding bonds.”

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