The debate has moved on significantly from last quarter when we were concerned about the downside risks of individual disorderly defaults but, as long as decisive political action was taken, our overall forecast predicted that the euro zone could still deliver modest growth. Unfortunately, achieving political consensus took too long to stave off the recession completely and the forecast is now for the euro zone to suffer negative growth in Q4 2011 and fall back into recession in Q1 2012.

Although the near-term forecast for the euro zone has worsened, political progress has been made. The European Central Bank (ECB) three-year loans will buy financial services firms and governments in the euro zone much-needed time for the austerity measures to improve the deficit positions across the euro zone, and it is clear that, without the ECB’s stabilising move at the end of 2011 the recession could have been a lot deeper.

As we embark on 2012, we need to think beyond the media hype around the euro zone and consider the impact on the underlying fundamentals for financial services; namely liquidity, market volatility, low interest rates and increasing competition between the sectors, as well as from outside of the euro zone; and we also need to consider how these interplay with the existing regulatory change agenda being implemented across the market.

On liquidity, our forecasting models and analysis indicate that, despite the ECB action, banks will continue to face ongoing funding pressure. From the take-up of the ECB loans, new funding only makes up about a third of the total, all of which need to be backed by collateral, meaning that unsecured wholesale markets are likely to remain closed. An interesting area to watch in the months ahead will be how much of the new funding finds its way into sovereign bonds – and which countries benefit. It is clear that politicians would like this to happen to help drive down funding costs. However, despite the ECB intervention, we expect pressure on the capital and liquidity regulatory agenda for banks and insurers to continue unabated.

Shareholder pressure to scale back investment in selected wholesale and trading areas, coupled with increased regulation of derivatives trading and clearing houses, will likely increase funding costs across the sector. This in turn is forcing institutions to compete for retail deposits and investments, which is eroding profit margins across the board.

Despite the political progress made, market sentiment remains fragile and, as a result, capital markets remain volatile. This, coupled with low interest rates, will make return on investment unpredictable, putting pressure on asset managers and insurers to achieve the yields they have forecasted. Fears about the health of the system and the volatility of the markets are also spreading to end consumers and there is a risk that a negative feedback loop develops, whereby poor performance further depresses retail inflows. Having already fallen by an estimated 12 per cent in 2011, assets under management are expected to decline further in 2012.

Given the above, relationships between the financial services sectors in the euro zone are changing, but the dynamic of the region’s relationship with emerging markets is also shifting. Once we factor in all of the regulatory and market pressures, not to mention the proposed financial transaction tax, we believe the relative attractiveness of the euro zone will increasingly be a strategic discussion topic for the executives of many international financial services firms.

It is likely that the attention of stronger, better capitalised banks, insurance and asset management institutions will increasingly be drawn in the longer term to higher-growth markets.
However, in the here and now, the capital squeeze especially for the euro zone banks will see a continuation of the current trend to repatriate some of their capital. This is a worrying development for many Eastern European economies as nearly three-quarters of lending in Eastern Europe depends on euro zone parent entities. However, these firms should carefully consider their long-term strategies in emerging markets, as well-timed competition from Asia Pacific and domestic institutions could well exclude them from these markets permanently.

Banking forecast
The negative feedback loop that has developed between stress in sovereign funding, stress in bank funding and stress in bank solvency is likely to result in diminished lending capacity from euro zone banks over the coming year. In the absence of more forceful policy interventions, we believe that banks will remain shut out of unsecured wholesale funding markets in coming months and counterparty concerns will remain elevated, resulting in ongoing strains in the interbank lending markets.

Investors are likely to remain concerned over bank solvency in the euro zone because of the risk of additional write-downs on sovereign debt holdings and the likelihood of a renewed deterioration in credit quality as the economy falls back into recession.

Fears about the health of the banking system are also spreading to domestic households and businesses. Over the past two years, both Greece and Ireland have experienced an exit of retail deposits that has intensified the liquidity squeeze in these countries. The pace of outflows in Greece has accelerated more recently, with 5.4 billion euro withdrawn in September and 6.8 billion euro in October.

Greeks appear to have pulled more money from their accounts in response to fears that Greece could possibly leave the monetary union. These fears have now eased, so the pace of withdrawals should slow in coming months, but deposit outflows are likely to continue amid concerns over the health of the Greek banking system.

Concerns are now focusing on the Italian and Spanish banking systems, where annual growth in retail deposits has fallen close to zero. In light of the difficulty in obtaining funding from wholesale markets, banks in Italy, Spain and Portugal are being forced to compete aggressively for retail deposits. For example, it is common for banks in Spain to offer savings products with annual interest rates of four per cent, significantly above the Euribor rate to which domestic mortgage rates are linked. With the ECB expected to keep its benchmark interest rate at one per cent throughout most of 2012, this is likely to compound the pressures on Spanish banks.

Banks are also facing increases in costs linked to pressure on banks to raise capital following the EU summit in October 2011, when EU leaders agreed to recapitalise the region’s banks on the basis of new stress tests conducted by the European Banking Authority (EBA). The stress tests, which were updated in December 2011, have identified a capital shortfall of 115 billion euro for European lenders as a whole, with the vast bulk of the recapitalisation requirements falling on Greece (30 billion euro), Spain (26.2 billion euro), Italy (15.4 billion euro) and Germany (13.1 billion euro).

Although the EU strategy aims to break the feedback loop between sovereign and bank risk, the plan is dangerously procyclical. With equity prices at such low levels, most banks are expected to avoid share issues to achieve the new capital ratio targets. But the deteriorating earnings outlook will also make it more difficult for banks to use retained earnings to reach the targets, so it is increasingly likely that they will resort to dividend cuts and balance sheet shrinkage, the latter being most easily achieved by cutting back on lending. This will further constrain the supply of credit and undermine the already weak euro zone economy.

At the same time, demand for new loans is also likely to weaken, as we now expect economic growth in the euro zone to slow sharply to just 0.1 per cent on average in 2012, down from 1.6 per cent in 2011. Taken together, these supply and demand factors drive our expectation for total loans in the euro zone to contract by 0.9 per cent in 2012, a sharp downward revision to our previous expectation for positive growth of 1.2 per cent this year. On the other hand, this still represents a less severe contraction of credit than occurred in the aftermath of the financial crisis in 2009, when total bank loans fell by around 2.5 per cent.

We now forecast lending to businesses in the euro zone to contract by 0.8 per cent in 2012, a sharp downward revision to our previous expectation for positive growth of two per cent. On the supply side, funding constraints are likely to be felt most acutely by small and medium-sized enterprises (SMEs), as these loans demand high levels of regulatory capital.

Conversely, demand for new loans from larger corporates is likely to prove lackluster, as they have accumulated significant financial buffers of funding that will help to sustain them through the economic downturn. However, SMEs are often high-growth businesses due to the more radical innovations that they bring, so the emergence of increased financial barriers to their growth could be especially damaging for the euro zone economy’s growth potential.

Impact on Eastern Europe
As the deleveraging cycle intensifies in the euro zone, one of the consequences is likely to be increased market fragmentation and a reduction in cross-border flows of capital. Banks in the euro zone hold net foreign assets of about 900 billion euro and it is likely that they will seek to repatriate a significant amount of these assets as their balance sheets shrink.

Several individual banks have announced their withdrawal from specific countries in recent weeks. In addition to economic considerations, banks are facing pressure from home regulators to narrow their geographic ambitions and retreat to their home territory. For example, the Austrian bank supervisory authority recently instructed the country’s banks to limit future lending in their Eastern European subsidiaries to what they can raise in local deposits.

The retreat of euro zone banks to their home countries is likely to pose the greatest challenges to those emerging market economies that depend heavily on foreign banks for credit provision. Using Bank of International Settlements data to examine the foreign claims of European (excluding UK) banks, it is possible to map the geographic concentration of lending and the countries that would be most exposed to a withdrawal of credit by euro zone banks.

The greatest challenges would be faced by Eastern Europe, where euro zone bank claims total around 34 per cent of GDP, rather than Latin America (17 per cent) or Asia (four per cent). Nearly three-quarters of lending in Eastern Europe depends on parent entities domiciled in the euro zone.

Although many countries in Eastern Europe offer attractive medium-term economic prospects, whether foreign banks withdraw from these markets will depend more on the health of the parent group than the local subsidiaries. Although other foreign banks may take up some of the slack, it will be difficult to replace lending from euro zone banks in the short term, given their dominance in most Eastern European countries other than Russia.

During the financial crisis, European (excluding UK) bank lending to Eastern Europe contracted by 19 per cent, despite the "Vienna Initiative," a co-ordination framework that brought together public and private sector stakeholders to prevent a large-scale and uncoordinated withdrawal of foreign banks from the region. As part of that framework, parent groups maintained agreed exposure levels, which limited the extent of deleveraging.

But the exodus of foreign bank lending may prove deeper and more sustained this time, especially as home country regulatory authorities are now actively encouraging parent banks to retreat from Eastern Europe.

Although the Czech Republic stands out as having the greatest reliance on lending from euro zone banks, local subsidiaries are not heavily dependent on parent funding lines, so deleveraging pressures are likely to remain contained. Credit shrinkage is likely to be much more severe in Hungary, where non-performing loans are also rising rapidly, compounding the pressures on foreign banks to cut their exposure to the country. And while several euro zone banks have emphasized their continuing commitment to the Polish market, deleveraging in Romania and Bulgaria is likely to be significant due to the presence of Greek bank subsidiaries.

As economic conditions across Eastern Europe deteriorate, foreign banks with subsidiaries in the region are also facing increased political risk as policy-makers seek to cushion the impact of debt repayments on voters, with the result that lenders may have to absorb higher losses.

The resulting shrinkage of credit is likely to push several Eastern European economies into recession. Over the medium term, these events could also result in more permanent changes to the banking landscape in these countries, as they seek to accelerate the development of domestic banks and diversify external sources of lending. Euro zone banks that seek to re-enter these markets in the future may therefore find that competition has become a lot tougher.

The full report is available on Ernst&Young's website.