Banks to increase lending to SMEs in Europe despite the AQR

The outlook for banks across Europe is much brighter for 2014 according to the EY European Banking Barometer. While many banks are increasing loan loss provisions ahead of the Asset Quality Review (AQR), they also expect to be able to increase lending to most sectors and more than half of banks expect their own performance to improve in the next six months. The survey also shows that banks' focus is shifting from tactical cost-cutting to strategic business model efficiencies and encouragingly banks are starting to look at revenue growth.

This edition of the European Banking Barometer secured 184 respondents from 11 markets: Austria, Belgium, France, Germany, Italy, the Netherlands, the Nordics, Poland, Spain, Switzerland and the UK.

Robert Cubbage, EY's Europe, Middle East, India and Africa lead for Banking and Capital Markets says: "Even with the AQR on the horizon, European banks are more optimistic about their performance than at any time in the last 18 months. This reflects the improving economic outlook and a generally healthier banking sector."

Banks consistently positive about the economy and their own performance

Sixty-percent of banks think their overall performance will improve in the next six months. Only banks in Germany and Spain are less positive about their performance than they were six months ago. This renewed optimism is in part because banks are overwhelmingly more positive about the economy than they were six months ago. Fifty-six percent of the banks surveyed said they thought the general economic outlook in their market would strengthen and just 9% said it would weaken, in comparison to 25% and 24% respectively when we surveyed the banks before the summer.

Banks in Poland, Spain and the UK are most positive, with three quarters or more of respondents expecting the economy to improve and none expecting it to weaken. Banks in France are the most cautious with 34% expecting the economy to worsen.

Banks are also less concerned about the sovereign debt crisis than they were six months ago, with 35% of banks expecting the impact to diminish. Just 16% of banks in Europe expect the impact of the sovereign debt crisis to increase, in comparison with 35% six months ago.

Steven Lewis, EY;s Global Banking Analyst Leader at EY: "More than twice as many banks expect the impact of the European sovereign debt crisis to diminish than expect it to increase. This is a remarkable reversal of the results six months ago. This optimism is underpinned by a return to growth in the Eurozone, albeit tentative, as well as signs that countries at the heart of the crisis are regaining competitiveness. Spanish and Greek labor costs are becoming more competitive, while the Spanish and Italian governments are now running current account surpluses."

Banks are braced to increase loan loss provisions again

Banks have been consistently increasing the provisions they hold against loan losses year on year. This year, despite improving economic indicators, banks are still expecting to increase loan loss provisions. This is largely in response to the ECB's forthcoming AQR. Banks in Eurozone markets all expect loan loss provisions to increase again this year, and banks in Spain and Italy expect loan losses to increase the most. But in the UK, Poland and Switzerland, where the banks are not subject to the AQR, banks expect their loan loss provisions to decrease.

Steven says: "The AQR will be based on 2013 year-end data and as a result we could see a spike in Eurozone banks' provisioning in Q4 this year."

But they still expect to loosen lending criteria for most sectors, especially SMEs

Lending conditions for construction and real estate are set to tighten even more in the next six months, but for the majority of other sectors lending policies will relax, in some cases considerably. SMEs are expected to benefit the most, with more than half of banks saying their lending policies to the sector will be less restrictive.

Steven says, "By some margin, SMEs will see the greatest relaxation of policy around lending as the economic environment improves and the efforts of the European Investment bank to boost lending to the sector kicks in. Even in countries like France, Austria, The Netherlands and Spain, where lending is tightening considerably for other sectors, SMEs should have much better access to credit in the next six months.

"However, the outlook for lending to sectors where the banks are heavily exposed to bad loans, such as construction and commercial real estate, is pretty dire. And as more details of the AQR emerge, banks may have to resurrect wider lending constraints, particularly weaker banks in markets were the cost of funding is higher."

As well as SMEs, healthcare, manufacturing, energy mining and minerals, commercial and professional services, retail and consumer products, media and telecommunications all stand to benefit from less restrictive lending policies.

Signs that some markets are moving to a more American financing model

While lending policies are set to loosen, the availability of capital is still limited and companies are looking at alternatives. In the UK, The Netherlands and the Nordics for example, banks expect demand for debt and equity issuance to outstrip demand for corporate loans.

Steven says: "There has been speculation for some time now that the ongoing credit squeeze will push European markets towards a more American funding model with companies less reliant on bank loans. However, adoption is still patchy and it's clear that it will take a cultural change amongst corporate customers as well as the dynamics of supply and demand to stimulate this transition."

Banks focus on revenue growth as major cost reduction draws to a close

Tactical cost cutting has fallen from fifth to eighth place in banks' priorities since six months ago. Banks have significantly reduced their reliance on central bank funding in the last six months and 51% are planning to continue to repay funding in the next six months.  

The survey results reflect a clear shift of emphasis from tactical cost cutting to more strategic process redesign to improve the longer-term efficiency of the business. Banks are continuing to focus on their core markets and core business lines, with 42% expecting to sell assets outside their home market and 38% expect to sell assets outside of Europe. But, with healthier balance sheets, banks are now also beginning to focus on revenue growth. Fifty percent anticipate launching specific initiatives to promote growth in the next six months and 44% hope to access funding for growth from capital markets. 

Robert says: "A more stable economic environment and continued low funding rates have helped banks to stabilize their balance sheets and reduce reliance on central bank funding. Banks are still working through strategic cost reduction, but they are also now able to contemplate growth.

"Everyone is keen to chase private wealth and asset management, which are broadly seen as having better profit margins, but this is a small pool. The outlook for corporate banking and investment banking activity is also starting to pick up and while it is clear from the survey that regulatory compliance will dominate the agenda this year, we expect growth initiatives in these business lines to materialize at the end of 2014."