Bank Balance Sheet Downfall Next Year to Outdo 2008 Financial Crisis

July 04, 2012 /

The Ernst & Young Eurozone financial services forecast (EEFS) draws attention to the delayed impact of the current Eurozone turmoil on financial services and the role they will play in the economy during 2013.

Andy Baldwin, Leader of Financial Services for Europe, Middle East, India and Africa at Ernst & Young, comments: “Investors are frustrated with short-term quick fixes to the sovereign debt crisis and are looking for a more fundamental solution. The Eurozone financial services sector continues to be hit by a combination of the deteriorating economy and the recurrent crises of confidence in the market. While the effect of this on bank balance sheets in 2012 is worrying, the real impact of this year of Eurozone turmoil will not be seen until 2013, when non-performing loans will hit harder than many are expecting.”

Non-performing loans

The downgrade of the forecast for Eurozone GDP, with a contraction of 0.6% now anticipated in 2012 and modest growth of just 0.4% in 2013, means that the outlook for non-performing loans (NPLs) has worsened again. In March, the forecast predicted that this year NPLs would rise to their highest level since the creation of the common currency. The forecast for NPLs at the end of 2012 is little changed (6.2% of outstanding loans), but we now expect NPLs to continue rising to a peak of 6.5% in 2013 – a record high for the common currency.

Marie Diron, Economic Adviser to the Ernst & Young Eurozone financial services forecast said: “NPLs tend to lag the economic cycle and are a ticking time bomb for the Eurozone economy. The fact that the EEFS forecast for Eurozone GDP has been downgraded again has worsened the forecast for NPLs, pushing the peak out to 2013. Many banks are also carrying high levels of loan forbearance, which is masking the true extent of their non-performing portfolios. As the economy continues to worsen, a larger portion of these loans will be pushed into NPL status, forcing banks to realise their losses and constricting further lending.”

Bank balance sheets to shrink faster than during the financial crisis
The forecast predicts that the Eurozone’s banks will shrink their balance sheets by €1.6tr in 2012, as the result of disposals of non-core assets and a contraction in lending activity. In particular, the contraction in corporate lending and consumer credit will be even more severe than the EEF envisaged last quarter. It is now expected that corporate loans will contract by 4.8% this year while consumer loans will fall by 6.6% – each representing the fastest pace of contraction for these loan categories on record for the Eurozone.

Marie said: “This will have a significant impact on the wider Eurozone economy; it represents a sharper shrinking of balance sheets than during the 2008/09 financial crisis. It is in part reflective of lower demand for loans but it will exacerbate the current credit shortages -larger firms will be able to draw down their cash balances or access alternative sources of funding, but smaller firms will struggle to access funding.

“While lending in Germany will grow slowly, reduced or restricted lending across other Eurozone economies means that corporate sector loans for the region are not forecast to bounce back until 2015.”

Continuing historically low interest rates mean that the Eurozone life insurance industry has a gap to plug between investment returns and the higher return guarantees commonly embedded in existing products.

Andy added, “Insurers are struggling to fund products sold in better times. The dividends customers expect from products sold with guaranteed returns cannot be matched by the investment returns available to insurers now or in the foreseeable future and the higher required capital requirements of the forthcoming Solvency 2 regime are likely to compound the situation. The challenge for insurers will be funding the gap on the existing book while directing customers to products with fewer guarantees and inevitably a more volatile return profile – at a time when customers want capital preservation and certainty of return, not more volatility.

“Insurers are looking to optimise their asset class mix to bridge the gap. The irony is the some of the best returns are probably available from selected sovereign debt – precisely the asset class many regulators want insurers to reduce their exposure to.”

The forecast is for just 1.4% growth in Assets Under Management (AUM) during 2012. In 2011 the value of assets managed by the Eurozone asset management industry fell by over 7% on the previous year, which reflected a 12% fall in fund of fund assets and a 16% fall in equity assets as the equity market fell 8% and investors withdrew assets.

Although the first quarter of 2012 saw AUM recover, rising by almost 6%, it probably fell again in the second quarter as another phase of the Eurozone debt crisis depressed equity markets and caused the yields of peripheral bonds to rise again. Given the macro-economic background it doesn’t look like AUM will recover the losses of 2011 this year.

Marie said: “Investor caution is likely to bolster flows into multi-asset and absolute return funds in the short term but the rising requirements for funding pensions suggests that pensions could absorb more than 50% of the increase in savings flow over the next 20-30 years. Pension funds could therefore expand toward 50% of retail funds under management.”


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