But plans to hand over supervision of the Eurozone’s largest banks to the European Central Bank (ECB) are a vital and concrete step towards full banking union and addressing the region’s structural problems. By reducing systemic risk, the single supervisory mechanism should further improve confidence in the Eurozone’s financial sector — helping to unlock credit markets and improve the flow of capital so vital to the Eurozone’s longer-term economic growth prospects.
The news comes at a time when demand within the Eurozone has fallen. The regulatory backdrop has played a key part in this downturn, as banks have shrunk loan books and raised capital to meet the standards for Basel III. As we now expect Eurozone GDP to contract by 0.2% in 2013, policy-makers will need to focus significantly more on growth rather than austerity measures to avoid the risk of a Japan-style “lost decade” of negligible economic growth.
For the region’s corporates we see a divergent operating environment between those focused on a moribund domestic market and those exposed to faster external growth rates with the balance sheet to exploit them. Shrinking domestic demand will inevitably hit overall corporate profitability and drive further rises in Eurozone banks’ bad debts. Non-performing loans are expected to hit 6.8% for 2012 as a whole, peaking at a euro-era record of 7.6% of total gross loans in 2013.
Unsurprisingly, rising bad debts are driving ever-tighter lending standards. This puts further downward pressure on loan books already shrinking to meet capital ratio requirements. For Eurozone banks the overwhelming challenge continues to be one of improving returns and reshaping their businesses under the Basel III framework. We expect further changes to banks’ capital mix in 2013, including a marked improvement in loan-to-deposit ratios.
But while bond issuance will continue to outpace loan growth in 2013, the headline figures disguise a sharply contrasting two-tier market in which small and medium-sized enterprises (SMEs) struggle to access finance. Bond investors may be picking up the slack created by shrinking bank loan books for larger multinationals, but they have significantly less interest in providing finance to smaller companies.
However, there are signs of progress on this front. Policymakers have acknowledged that loan growth to SMEs within the Eurozone stems as much from smaller banks as it does from the larger global banks. As argued by some commentators, these larger banks benefit from implicit government backing, which results in easier and cheaper access to credit.
Addressing this anomaly and easing credit conditions for smaller and regional banks could help to improve the flow of capital to the wider economy significantly.
For the Eurozone’s insurers, the main focus in the coming months will also be on optimizing the business mix in a changing regulatory environment. Cost savings and improving efficiency remain a fundamental part of this ongoing process. Already delayed, the failure to agree key aspects of Solvency II is making long-term decisions difficult at a time when the backdrop to new business and profitability remains constrained. Recession and austerity measures are slowing down demand and increasing price pressure across all lines of business. In particular, the reduction in major consumer trigger-events, such as house and car purchases, continues to weigh on new business levels.
In contrast, the immediate outlook for the region’s asset managers looks brighter. The sector should prove to be one of the few beneficiaries of consumer caution due to higher savings and investment rates. We see another year of positive growth for assets under management (AUMs) in 2013, with total assets expected to rise 6.5% after a 9.6% jump in 2012. The growth is likely to be driven by solid market returns and a gradual shift from low-yielding savings accounts into higher-yielding bond and cautiously managed mixed asset funds.
We hope you find the following forecasts for the financial services sector informative and thought provoking. Keep up-to-date with Eurozone developments: visit our website.
Introduction word by Andy Baldwin, Head of Financial Services, Europe, Middle East, India and Africa
Overview
Growth in the Eurozone will be held back for an extended period and unemployment will continue to rise this year — peaking at close to 20 million. As the Eurozone undergoes painful but necessary restructuring, we expect two years of recession — 2012 and 2013 will see GDP contracting by 0.4% and 0.2% — before growth returns from 2014 onwards. Even then progress will be slow, with average expansion of just 1.3% a year for the rest of the decade. However, the future of the Eurozone now looks more secure. ECB action has eased the threat of an imminent breakup. A banking union looks more likely and the policy mix is at last shifting from austerity to growth. A deal reached in November 2012 has sustained Greece’s position for now, allowing the next tranche of bailout funding to be released.
But more progress is needed. Despite an agreement to establish a common Eurozone banking supervisor in mid-December 2012, the framework for a full banking union remains incomplete. To complete the framework, a single resolution mechanism and a Eurozone-wide deposit guarantee scheme also need to be put in place. In addition, more detailed plans and a precise timetable for closer fiscal union need to be established. Euro-bonds are still a distant prospect, and we have yet to see how the Growth Pact will be implemented. Until these issues are resolved, business confidence will remain changeable. progress; for instance, productivity has improved in Ireland and Spain.
This has helped boost competitiveness and is reflected in strong export growth. However, this progress comes mainly as as result of employing fewer workers which also has negative consequences. In the short term, household incomes will be squeezed, deepening and prolonging the domestic recessions in these countries.
One welcome shift in policy is the revival of the Growth Pact. This envisages supply-side reforms that should have longer-term benefits, and it extends policy beyond the current emphasis on austerity. The idea that deficit-cutting can boost growth has been largely contradicted by recent evidence. Even the International Monetary Fund (IMF), a long-time advocator of fiscal reform to drive growth, now recommends a more balanced approach. Without abandoning its general principle of reducing public deficits, the IMF suggests a slower pace and stresses the need for broader economic reforms. Continued uncertainty about the future budget of the EU means that the measures contained in the Growth Pact are unlikely to alter prospects for demand and growth in the short term.
The most effective boost to growth would come from an end to uncertainty about the future of the euro. This would unlock investment and recruitment plans currently placed on hold by companies that are waiting to see what happens.
Sector highlights
Banking
• We believe that deleveraging by banks in the Eurozone is around two-thirds complete. Banks pose less of a systemic threat to the economy, but they are not healthy enough to drive growth. To help ensure the longer-term health of the Eurozone banking system, the framework for a full banking union needs to be completed.
• Average loan-to-deposit ratios have fallen, but still have some way to go. Before the crisis, ratios were as high as 124% in 2006. They have now come down to 111%, but are likely to fall to 106% by the end of 2013 and 104% in 2016. Although this will reduce vulnerability to wholesale funding drying up, loan-to-deposit ratios would still be significantly higher that the current average ratio of 70% for commercial banks in the United States.
We expect a rise in non-performing loans. Credit quality in the euro region has deteriorated more sharply than expected, pushing non-performing loans to a euro-era high of 7.6% of outstanding loans next year. But they should fall back to 5.6% in 2014 as economic conditions in the region improve.
• Banks will be reluctant to lend and demand for credit is expected to remain subdued this year. The weak economy and uncertain policy environment continue to dampen confidence. Following an estimated 1.3% contraction of loans to nonfinancial businesses and households in 2012, we expect lending to the private sector to fall by a further 0.2% in 2013. Positive growth of 2.9% is then expected in 2014.
• Credit contraction will be particularly severe in the peripheral economies, where fiscal austerity is dampening loan demand and credit conditions are tightest. Lending in Spain is forecast to decline by 4.4% in 2013; by comparison, private sector loans in Germany will grow by 1.8%.
Insurance
• We think that 2013 will see the bottom of the profit cycle in insurance, although subsequent recovery will be slow. Even by 2016, we expect profits to be less than half the 2007 peak. Consolidation will therefore continue, as will the implementation of controls to improve profit margins. The industry has suffered from a prolonged period of low interest rates, poor business conditions and extraordinarily costly natural disasters. Profits fell by 7% in 2011, and we expect a further decline of 5% overall in 2012, before starting to recover this year.
• Life insurers are being hit particularly hard by the headwinds battering the Eurozone insurance industry. With the working-age population slowly declining and nominal personal income growth expected to be just 1.5% in 2013, life premiums will increase by just 0.5% in 2013, following a cumulative fall of 8% in 2011 and 2012. The Italian life market has been particularly badly affected, with a 25% fall in premiums over the last two years. We expect a further fall of 4% in 2013 as Italian households continue to see their real incomes eroded. Premiums should eventually pick up as incomes begin to rise again, but even by 2016 they are likely to be 25% lower than 2008 levels.
Non-life premiums are likely to rise just 1.8% this year and 1.9% in 2014, as the Eurozone economy is expected to contract for the second consecutive year in 2013. This is substantially below the historic average of 6.2%, reflecting an environment in which insurers find it difficult to maintain price increases. Motor insurance will suffer especially, with car registrations declining by almost 5% in 2013 and then growing by just 0.9% in 2014.
Asset management
• We have raised our forecast for growth in Eurozone-wide AUMs in 2012 from 8.8% to 9.6%. This incorporates a slightly stronger end to the year than we expected for risk assets. Bond and equity funds have benefitted from an increase in investor optimism about the Eurozone’s chances of surviving intact.
• AUM growth is expected to slow in the coming years. Initially the slowdown will be limited as further progress towards securing the Eurozone’s future should continue to attract money into Eurozone assets in the short term, enabling AUMs to grow by 6.5% in 2013. However, in the longer term, deleveraging and slow economic growth, combined with low investment returns, will hold AUM expansion to just 4% on average between 2014 and 2016. The strongest equity AUM growth is expected to be in the periphery, because these markets attract value investors who believe the euro will survive. However, investors will need stable funding and strong conviction to hold their positions through the volatility that will inevitably occur from episodes of heightened market concerns about a Eurozone breakup. This will increasingly force investors to explore rapid-growth markets, alternative asset classes such as property and infrastructure, and noncorrelated strategies for higher returns.
• Yields are expected to rise in the “safe-haven” bond markets of Germany and France, as fears of a Eurozone breakup gradually dissipate. As yields rise, total bond returns and AUMs are expected to fall in the core markets. By contrast, bond AUMs are expected to rise in Italy and Spain as spreads narrow and investors return to the Italian and Spanish markets following the ECB’s commitment to cap yields.
