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Since the European Central Bank decided to buy euro-area sovereign bonds in an attempt to prevent financial contagion, there has been a growing sense of confidence that the worst of the debt crisis is behind us. Risk assets have risen and demand for safe-haven assets has waned, as the demand backdrop in the major economies outside of Europe showed signs of sustainable improvement. There have, however, been a number of important reminders of the recoverys fragile nature. The recent Italian general election and a raft of worse-than-expected economic data from core European countries had already left their marks, and then last weeks Cypriot debt crisis further underlined that the Eurozones economic recovery will follow an uneven trajectory. However, in some ways the reaction to the Cypriot crisis was encouraging: while we came as close as ever before to a nation exiting the Eurozone, the response to the crisis limited contagion. At the time of publication, the impact of the crisis on the financial markets had been comparatively limited. This demonstrated that the major European economies are fairly well insulated from national crises in smaller states. That said, the events of last week should draw attention back to the fundamentals of capital and liquidity. Regulators have arguably focused on more populist targets in recent months, of which the EUs recent move to restrict bankers bonuses is a prime example. While few financial services professionals would take issue with the need to better align bankers behavior and remuneration, the likely outcome of the EUs decision will be to increase fixed or base remuneration levels. It is hard to reconcile reducing banks flexibility on cost management, while increasing the volatility of earnings, with the original goals of CRD IV. Looking forward, restoring growth and stability to the fragile Eurozone economies remains a priority for politicians and regulators alike. As the principal mechanism for distributing investment capital to the wider economy, the financial
Andy Baldwin
Head of Financial Services Europe, Middle East, India and Africa
services sector will need to play a vital role in the eventual recovery. There is a sense that the industry is close to turning a corner. The three Rs of regulation, restructuring and returns continue to dominate the banking sector, as lenders focus on optimizing risk-weighted assets, reducing their cost base and improving returns on capital. Despite another year of contraction being forecast for Eurozone business loans and consumer credit in 2013, credit conditions are expected to improve gradually. Non-performing loans are also set to peak this year, before improving in 2014. There are emerging signs of life for the general insurance sector, with car sales and house prices rising and the low interest rate environment continues to benefit asset managers. However, the forecast for financial services is mixed. Northern states will perform better than Southern ones, and while the systemically important financial institutions (SIFIs) continue to improve and strengthen, the near-term outlook for smaller national banks across the Eurozone appears less certain. If we extrapolate the developments in Cyprus, it would appear that the bail out rules for banks in smaller states have changed. The liability of back-stopping a failing bank has shifted from taxpayers to creditors, increasing the likelihood that some banks will be allowed to fail. This is likely to have two consequences: first, to force the financial markets to price in the risk, and second to encourage larger depositors to switch cash and assets back to the safe havens. While this new landscape may generate some temporary uncertainty among creditors, the ultimate effect will be to limit contagion risks and strengthen economies across the Eurozone. We hope that you find the following forecasts for the key financial services sectors informative and thought provoking. To keep up-to-date with Eurozone developments, visit our website, www.ey.com/eurozone, or follow us on Twitter, @EY_Eurozone.
Contents
Published on 2 April 2013
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Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013
Executive summary
Overview
The process of bailing out Cyprus was a timely reminder that the path to a more integrated and stable Eurozone will be an uneven one. Nevertheless, fears of a Eurozone breakup are still lower than they were for much of last year and markets remain calm. That calm is a recognition that the major Eurozone economies appear to be insulated from events in Cyprus, and that the risk environment is normalizing as markets become more discriminating. There are lessons to be learned from both the terms of Cypruss bailout and the way in which it was negotiated. First, ECB liquidity support should not be taken for granted. Second, banks that are not large enough to be systemically important cannot expect to be bailed out. They are much more likely to be wound up or forced to merge with a stronger institution. Third, senior bond holders should assume that they will be wiped out in future bailouts. And finally, large depositors are also at risk of paying a price in future bailouts. There are lessons of particular significance for smaller Eurozone countries with weaker banking systems made up of non-systemically important institutions. These countries need to wean their banking systems off ECB support and strengthen them. Weaker banks are likely to be restructured or wound up in an orderly fashion. Despite the events in Cyprus, at the time of going to print it seems that the gradually improving outlook is still on the cards for financial services. Non-performing loans (NPLs) appear to be reaching a peak and a pickup in lending for investment and consumer credit is on the horizon. Improving world trade has also contributed to greater confidence in the economic outlook. This confidence should gradually unlock corporate investment and recruitment plans that have been on hold for some years. It should also make investors a little more comfortable in holding risk assets like equities and less focused on safe-haven assets like bonds. Compared with the situation last summer, various announcements by the European Central Bank (ECB) in support of troubled economies, and an overhauled bailout package for Greece, have also helped bolster confidence that the Eurozone will survive. Nevertheless, progress towards a banking union and the shift in policy from austerity to growth is slow. It seems that Cypruss bailout has highlighted that further action will be needed to convince markets that the authorities are committed to full banking union and a Eurozone-wide deposit guarantee scheme. Closer fiscal union and Eurozone bonds are still distant prospects. Italian voters rejection of the austerity measures implemented by the outgoing technocratic government has raised huge question marks over future policy in other peripheral countries, especially Spain. More positively, some of the peripheral economies have made progress with reforms, which should help reverse the decline in competitiveness seen over the past decade. For example, productivity has improved in Ireland and Spain, helping to drive stronger export growth. But with households feeling the squeeze of lower incomes and rising unemployment, the peripheral countries are likely to continue in recession this year and in some cases into 2014. Although the risk of a Eurozone breakup is lower than it was last summer, the recovery will remain gradual in the short term. The public and private sectors are continuing to reduce their debt levels in most countries and unemployment is still rising. Eurozone GDP is expected to fall by 0.5% in 2013, much the same as last year. A return to growth is forecast for 2014, but progress will be slow, with average expansion of just 1.3% a year for the rest of the decade. The risk of a lost decade for Europe remains. Despite the signs of improvement, we expect business investment to shrink by 2% in 2013, although it should then recover slowly to grow by around 3.5% a year between 2014 and 2017. Private and public consumption are also expected to fall this year (by 0.7%) as consumers continue to cut back their debt levels and governments attempt to reduce budget deficits. Public sector reforms are also under way. Tax rates have been increased, tax bases have been broadened and tax collection is being made more efficient and effective, particularly in the peripheral countries. Public sector wage bills and welfare payments are being cut. Stronger competition laws and reduced bureaucracy will smooth the way for new businesses to be established.
Table 1 Forecast for the Eurozone economy (annual percentage changes unless specified)
2012 GDP Consumer prices Unemployment rate (level) Government budget (% of GDP) Government debt (% of GDP) ECB main refinancing rate (%) Exchange rate ($ per ) Source: Oxford Economics 2 Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013 -0.5 2.5 11.4 -3.3 91.3 0.9 1.28 2013 -0.5 1.8 12.2 -2.5 94.4 0.8 1.27 2014 1.1 1.6 12.2 -1.9 95.9 0.8 1.21 2015 1.4 1.4 11.8 -1.5 96.7 0.8 1.17 2016 1.5 1.4 11.4 -1.2 96.8 0.8 1.17 2017 1.6 1.5 10.9 -0.9 96.5 0.9 1.17
Sector highlights
Banking
We expect 2013 to be a year of transition for the banking industry as NPLs peak and lending finally bottoms out before growing in 2014. Although the risk of another credit crunch has been averted, the banking system remains fragile and is not yet in a position to drive an upswing in the Eurozone through faster lending growth. We have downgraded our forecasts for lending and asset growth in 2013 on the back of a slightly weaker outlook for the Eurozone economy and evidence that deleveraging accelerated at the end of 2012. Although deleveraging will continue this year, we believe that the most destructive phase has now passed. After contracting by 856b last year, we expect total assets in the Eurozone banking sector to fall by a further 500b in 2013. Credit conditions are likely to remain tight for some time, weighing on investment and consumer spending. Last year lending to non-financial businesses and households fell by 1.7%, and we expect the contraction to continue this year, albeit less sharply. Lending should start to pick up again in 2014, with an expansion of 2.9%. Bank earnings continue to be blighted by economic weakness, regulatory pressures and rising bad loans. We expect NPLs to reach 7.2% of total loans at the end of this year, a euro-era high. Nevertheless, with growth forecast to return in the second half of 2013, non-performing loans should reach a peak towards the end of the year and start to trend lower from 2014 as economic conditions improve. Another response to the constrained earning environment will be management action to cut costs and restructure operations. This reaction will be crucial, as investors will increasingly make choices between banks according to their strategic responses.
Insurance
Low interest rates, volatile financial markets, regulatory changes and weak demand mean that the business environment for the life insurance industry remains tough. We expect life premiums to rise by just 1.6% in 2013, which is an improvement on last years estimated 7.3% fall. Premium growth should pick up faster between 2014 and 2017, to 2.6% a year. But this remains a historically low average and reflects again the risk of a lost decade of Eurozone economic growth. Car sales and house prices are both starting to rise and corporate profits are growing more quickly. This should enable non-life premium growth to accelerate from an estimated 1.1% in 2012 to 1.9% in 2013 and 2.6% in 2014. Although profitability for life insurers is expected to improve as prices rise, profits in 2017 will still be around 25% below 2008s peak. There are signs that pricing may be stabilizing in some markets and for some business lines, but price rises are still far from broad-based. Price increases are also likely to be more difficult to achieve in the future, given the increased use of price comparison sites across the Eurozone. Our forecasts suggest that there are potential business opportunities for insurers able to meet growing saving needs, and offer insurance against longevity and the increasing demand for health care protection as the population ages.
Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013
Sector highlights
Asset management
Total Eurozone assets under management (AUMs) rose 11.6% in 2012, driven by growth in bond and equity funds. AUM growth is expected to slow in the coming years. Initially the slowdown will be limited, as investors become more optimistic that the Eurozone will survive. However, given that we continue to expect the Eurozone to risk experiencing a lost decade of low growth, we believe AUM growth will be held back between 2014 and 2016. Over the next few years, we expect cash to continue to flow out of lowyielding money market funds into higher-yielding asset classes, such as equities, bonds, and multi-asset funds. As investors become more confident that the risk environment is normalizing gradually, we expect AUM growth to become less focused on the safe-haven of bonds and more focused on risk assets like equities and multiasset funds. Multi-asset fund AUM growth has outpaced both Eurozone-focused hedge fund and fund of fund AUM growth over one, three and five years. By the end of 2017, we expect multi-asset funds to be running 40% more assets than the other two fund types. Aside from the desire for higher yields, multi-asset funds are benefitting from demand from smaller pension funds that wish to outsource asset allocation as the investment landscape becomes more complicated and the regulatory environment more onerous.
Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013
Banking
Banks access to wholesale funding markets is continuing to improve, and private sector deposit flows in the periphery appear to be stabilizing, allowing a gradual transition away from central bank funding support (Chart 1). This could, of course, change given the imposition of a levy on large deposits as part of the bailout of Cypruss banking system. But, so far, markets do not seem particularly alarmed by this development. A further signal of the gradual rehabilitation of the banking system came with the payback of long-term refinancing operation loans in February. Although it was below market expectations, policy-makers efforts to reduce stigma probably had some impact. While the risk of another credit crunch has fallen, the banking system remains fragile and is not yet in a position to drive an upswing in the Eurozone through rapid lending growth. Amid evidence of accelerated deleveraging at the end of last year, and a weaker outlook for the Eurozone economy, we have downgraded our forecasts for lending and asset growth in 2013. Credit conditions are likely to remain tight for some time, which will weigh on investment and consumer spending. The ECBs latest bank lending survey, conducted in January 2013, showed that banks were not yet ready to ease credit standards (Chart 2). Given that lending fell 1.7% in 2012, we expect lending to non-financial businesses and households to contract by a further 0.5% this year (previously -0.2%). Positive growth in lending should finally resume in 2014, with an expansion of 2.9%. The gradually improving risk environment has contributed to a decline in financial fragmentation in the Eurozone. But, there is still a pronounced north-south divide in the cost of bank borrowing. Tight credit conditions and continued economic recession will result in a particularly sharp contraction of lending in the peripheral economies this year. For example, lending in Spain is forecast to contract by 5.1% in 2013, in contrast with positive growth of 0.8% expected in Germany.
Chart 2
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Chart 1
Chart 3
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100 800 0 600 2 Germany -200 2007 2008 2009 2010 2011 2012 2013 400 0 2007 2010 2013 6
France
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Source: Oxford Economics, World Bank Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013 5
Banking
Bank earnings continue to be blighted by economic weakness, regulatory pressures and rising bad loans. We expect NPLs to peak at a euro-era high of 7.2% of loans this year, up from an estimated 6.7% at the end of 2012 (Chart 3). On-going recession in the periphery means that the near-term outlook for credit quality appears weak for these countries. In Italy, we expect NPLs to climb to 10.2% of outstanding loans in 2013, while in Spain they are forecast to reach 12.8%, notwithstanding the recent transfer of problematic assets to the bad bank (SAREB). Nevertheless, with growth forecast to return in the second half of 2013, non-performing loans should reach a peak towards the end of the year and should start to trend lower as economic conditions improve. Banking industry results for 2012 were generally weak and the outlook for 2013 remains challenging, with a substantial risk of further litigation for mis-selling products or breaching regulations. Nevertheless, revenues should stabilize as the Eurozone economy strengthens later in the year. The more stable financial environment should also promote a gradual turnaround in fortunes for investment banking divisions, as trading income improves and M&A activity picks up. In the current low-yield environment, banks that can increase dividend payouts will be more attractive to investors. But average dividend payout ratios among banks in the Eurozone will be constrained by the need to conserve capital. Management action to cut costs and restructure will be crucial, as investors increasingly differentiate between banks according to their strategic responses to the economic and regulatory challenges. Although deleveraging will continue this year, we believe that the most destructive phase has now passed. After contracting by 856b last year, we expect total assets in the Eurozone banking sector to fall by a further 500b in 2013.
Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013
Insurance
We estimate that Eurozone life premiums fell 7.3% in 2012 (Chart 4). Sales in Italy and Germany declined for a second year running. Sales in France, where most business is single premium savings, declined sharply, in part because banks offered substitute products with more attractive terms. We expect this effect to be less pronounced in 2013, given that many French savers now hold up to their maximum limit in banking products. The life industry faces continued challenges from low interest rates, volatile financial markets, regulatory changes and weak demand. This is especially true for mainstay life insurance savings and accumulation products. We expect Eurozone life premiums to rise by just 1.6% in 2013, as household incomes expand by less than 1% and employment falls by 1.4 million. We expect premiums to grow by an average of only 2.6% a year between 2014 and 2017. This is a slow pace of growth by historic terms and reflects the risk of a lost decade of weak Eurozone economic growth. Under our baseline forecast, we do not expect the European Central Bank (ECB) to increase interest rates until the second half of 2017. Low rates will continue to squeeze solvency for some years to come, driving further consolidation in the industry. Low interest rates are a particular challenge for insurers that have large legacy books of guaranteed return business. We estimate that non-life premium income rose just 1.1% in 2012 (Chart 4), and most of this reflected price increases rather than sales growth, as the Eurozone economy contracted by 0.5%. Premium growth should accelerate to 1.9% this year and 2.6% in 2014 as economic conditions improve. Car sales and house prices should start to rise again and corporate profits should pick up further.
Chart 5
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-60 1982 1986 1990 1994 1998 2002 2006 2010 2014
Chart 4
Chart 6
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3 2001 2003
Source: Oxford Economics, Haver Analytics Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013 7
Insurance
Although profitability is expected to improve as prices rise, even by 2017 insurers profits will still be around 25% less than their peak in 2008 (Chart 5). That is despite a continued focus on streamlining systems and processes to cut costs. There are signs that pricing may be stabilizing in some markets and for some business lines, but it is still far from a broad-based improvement. Several market leaders have introduced modest price rises in their commercial books, and motor insurance prices have improved even in markets with severe profitability issues like Italy. Price rises are likely to be more difficult to achieve than in the past, given the increased use of price comparison websites across the Eurozone. Our forecasts suggest that, as the population ages, there are potential business opportunities for insurers to grasp. For example, they can provide savings products and offer insurance against longevity and increasing needs for health care protection. By 2017, we expect gross household wealth to rise by over a fifth and that the number of people aged over 65 will rise by 9% over the same period. If insurers can fully harness these opportunities, their businesses are likely to grow more rapidly than assumed under our baseline forecast. There are concerns, particularly among risk managers, that the economy could gather pace more quickly than anticipated under our baseline forecast, causing the ECB to increase rates more quickly. Although we think this is quite unlikely to happen, we have used Oxford Economics global macroeconomic model to build such a scenario. Despite the low probability, the effects are sufficiently large to warrant response planning by insurance companies. This is particularly true for insurance companies classified as global systemically important insurers (GSIIs) when the Financial Stability Board and national authorities, in association with the International Association of Insurance Supervisors (IAIS) publishes the list in the next few months. Under this alternative scenario, the Eurozone does not shrink this year and grows by 1.7% in 2014, which is faster than our baseline forecast. Inflation then hits 2.8% by the end of 2014, causing the ECB to increase interest rates from 0.75% to 1.25% in 2015, rather than keep them on hold until the middle of 2017. Ten-year Eurozone government bond yields would rise from 3.4% in mid-2014 to 4.7% by the end of 2015 (Chart 6). The rapid rise in interest rates and higher financial stress would hit insurers through both their bond-heavy balance sheets and their businesses. Lapse rates would be likely to rise, for example, as customers switched into alternative products offering higher yields, and new business would suffer as the economy slows.
Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013
*Car registrations and company profits refer to the sum of Germany, France, Italy and Spain
Asset management
Hedge fund and money market assets under management (AUMs) fell last year, but total Eurozone AUMs rose by 11.6%, exceeding our forecast of 9.6% growth. Bond, equity and fund of fund AUMs all grew by more than we were expecting. Bonds accounted for two-thirds of AUM growth as cash flowed into German, French and Italian funds, but out of Spanish ones. However, the biggest surprise came from multi-asset funds, which grew by 30% rather than the 23% we had forecast, reflecting investor desire to outsource asset allocation. Eurozone-wide AUM growth is expected to slow in the coming years. Initially, the slowdown will be limited as further progress toward securing the Eurozones future continues to attract money in the short term, enabling AUMs to grow by 6.8% in 2013. Further out, AUM expansion is likely to be held back to just 4% a year between 2014 and 2016, as a result of deleveraging, slow economic growth and low investment returns. Investors will look increasingly to rapid-growth markets for higher returns. Over the next few years, we expect cash to continue to flow out of low-yielding money market funds into higher-yielding asset classes such as equities, bonds and multi-asset funds. And as investors become more confident that the risk environment is normalizing gradually, AUM growth should shift from safe-haven bonds toward assets like equities and multi-asset funds. As the Eurozone economy recovers gradually, bond yields are expected to rise in Germany and France, bond AUMs in the peripheral economies should benefit. Peripheral bond markets offer higher yields than German bunds and the potential for capital gains if spreads narrow. But this additional return comes with higher risks.
Chart 7
Multi-asset fund AUM growth has outpaced both Eurozone-focused hedge fund and fund of fund AUM growth over one, three and five years. Eurozone-focused hedge funds had a tough year in 2012, with AUMs falling 11%. Sharp declines in the Netherlands, France and Italy more than offset the growth in Spain and Germany. By contrast, US-focused hedge funds saw their assets increase by 3%.
Chart 8
Germany Spain
Italy
Chart 9
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100 Hedge funds 0 2001 2003 2005 2007 2009 2011 2013 2015 2017
Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013
Neither Eurozone-focused hedge funds nor fund of funds (particularly fund of hedge funds) have yet recovered to pre-200809 levels. In the case of hedge funds, this partly reflects investor disappointment that they did not offer the hedge against the equity bear market that they had in the early 2000s. But it also reflects a lack of investor appetite for Eurozone assets. That said, it is important to remember that the industry is not a homogenous asset class. Many funds and strategy approaches continue to thrive. In the case of fund of funds, the decline is mainly due to a combination of increased investor focus on fees and
concerns about standards of due diligence. In 2007, the year before the financial crisis struck, hedge funds and fund of funds between them managed 50% more money than multi-asset funds. By the end of 2017, we expect the tables to have turned, with multi-asset funds running 40% more assets than the other two fund types. Multi-asset funds are also benefiting from demand from smaller pension funds wanting to outsource asset allocation, as the investment landscape becomes more complicated and the regulatory environment becomes more onerous.
Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013
11
Germany
Key issues and highlights
German banks lending to the non-financial corporate sector shrank in the final quarter of last year for the first time since Q3 2010. This probably reflects weak credit demand, as companies are not reporting difficulties accessing credit. While this does not suggest an impending credit crunch, falling lending volumes will be a concern for banks that are already struggling with lower margins amid intense competition. GDP growth of just 0.7% in 2013 could even temporarily dampen the activity of the banks strongly performing Mittelstand divisions until the economy reaccelerates in 2014. German insurance businesses are performing better than their counterparts elsewhere in the Eurozone. We estimate that non-life premiums grew three times faster than the Eurozone average last year, and life premiums fell only 2.3% compared with a Eurozonewide fall of 7.3%. We expect the relative strength of the German insurance industry to continue this year, given that its economy is stronger than elsewhere. Non-life premiums should increase by over 4% and life premiums by around 1.5%. AUMs in German-focused funds grew by over 6% in 2012, but this was only around half the pace of growth in the wider Eurozone. This underperformance reflects the comparatively weak growth of bond and equity funds. We expect more relatively restrained growth this year under 7% but there will be a switch from bonds to equities as increasingly confident investors are attracted away from the safe-haven of bunds.
*UCITS and non-UCITS assets Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013 13
Netherlands
Key issues and highlights
The high level of household indebtedness in the Netherlands remains a concern for the banking sector, which is trying to manage its large exposure to mortgage debt both at home and in the Eurozone periphery. Against this background, we expect lending growth to businesses and households to slow to 0.3% this year from 4.5% in 2012. The Netherlands was the second toughest non-life market in 2012, with an estimated premium decline of 3.6%, compared with a Eurozone-wide rise of 1.1%. The environment is likely to remain difficult. The economy is expected to continue contracting in 2013, with employment falling a further 0.9% and house prices declining by 3.8%. Consequently, we expect non-life premium growth to average just 0.4% over the next two years. By contrast, the Netherlands experienced a much smaller decline in life premiums than the Eurozone average in 2012. Its estimated drop of 2% was well below the Eurozone average decline of 7.3%. We expect this relative strength to continue over the next two years, with average premium growth of 4.6%. Netherlands-focused funds saw AUM growth of 6.2% in 2012 as equity AUMs grew by almost 7% and bond AUMs were up 5.3%. This more than offset a 32% decline in money managed by Netherlands-focused hedge funds. With the Netherlands equity and bond markets expected to perform worse than the Eurozonewide markets, we expect AUM growth to slow to 3.8% in 2013.
*UCITS and non-UCITS assets Ernst & Young Eurozone Forecast: Outlook for financial services Spring edition 2013 15
*The forecast rise in NPLs will be limited by the transmission of assets to the Asset Management Company (AMC)
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