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Sharp fall in financial services activity

Written by Adrie van der Luijt

Monday, 07 January 2008

The two-year-long run of strong growth in financial services went into reverse over the past three months, as business volumes in the sector fell at their fastest rate since March 1991.

The latest financial services survey from the CBI and PricewaterhouseCoopers LLP shows that, as the credit squeeze continued, income values fell sharply and business sentiment worsened, while costs continued to rise.

Yet despite all this, several sectors of the industry managed to increase their profitability over the past three months, and are still hiring staff and planning to invest more, particularly in IT.

Business volumes shrank heavily in the three months to early December. Ten per cent of respondents said that volumes had grown, while 44 per cent said they had decreased.

The net balance after rounding of -33 per cent is the lowest since March 1991 (-44 per cent) and markedly worse than expected (-11 per cent). Firms expect this slide to continue in the coming three months, though at a slower rate.

Surprise rise in profitability

A drop in business with private individuals and financial institutions was behind much of the slowdown in business volumes, though demand from individual consumers is expected to stabilise over the coming three months.

Lending to companies held up rather better, and is expected to pick up again over the next three months.

A balance of 11 per cent of firms reported a drop in income from fees, commissions and premiums, which was broadly as expected, but income from net interest, investment and trading fell at the fastest rate since the survey began in 1989 (a balance of -36 per cent). Both are expected to fall further in the next three months.

Firms reported a surprise fourth consecutive quarter of growth in profitability, with a balance of +6 per cent slower than last survey's +14 per cent but better than the predicted -14 per cent. This, however, is not expected to continue into early 2008.

Behind the aggregate picture there were big differences in volumes and profitability by sub-sector. The slowdown was felt most keenly by securities traders and building societies. While banks saw business fall quite sharply and profitability dip slightly, fund managers and insurance brokers fared much better.

One-off survey questions on the financial market conditions reveal that they are having a direct impact on several key aspects of firms' operations and that they do not expect the storm to clear soon.

Ability to raise funds

Seven out of ten respondents believe the squeeze will last longer than six months. A majority believe that further deterioration in credit conditions is likely over the next six months, with 24 per cent saying the likelihood was high, and 65 per cent saying it was medium.

A survey-record proportion of financial services firms (24 per cent) felt that their ability to raise funds would be a constraint on their growth over the next 12 months.

This was a particular concern for building societies, with 92 per cent of respondents from that sector flagging it as an issue. A record high of 36 per cent of banks were also concerned that fund raising ability would constrain expansion.

Business sentiment among financial firms has worsened further in the past three months, with a balance of 49 per cent saying they are less optimistic about the overall business situation in the sector than they were in September.

Total operating costs (excluding cost of funds), which had been expected to fall slightly, grew for a fourth quarter running (a balance of +17 per cent), but are predicted to slow.

Average operating costs per transaction grew at their highest rate (+19 per cent) since December 1990 (+25 per cent), but firms think they will stabilise.

Average spreads, the difference between the rates at which money is borrowed and lent, narrowed again (a balance of -15 per cent) and are expected to compress further in the next three months.

The value of non-performing loans, or bad debt, was unchanged from the previous survey, although it is expected to rise in the coming quarter.

Planned increases in capital investment

Despite the shock of the credit crunch, new jobs continue to be created, though the rate of growth has been slowing over the past year, and is expected to come to a near standstill over the next three months.

An indication of the resilience of the sector lies in planned increases in capital investment, which are higher than three months ago and above their long-run averages, particularly for IT, where plans are at their strongest since September 1997.

The main spur to invest remains to increase efficiency, and a much lower level of respondents now say they are investing to expand capacity.

Ian McCafferty, CBI chief economic adviser, said that there has been a clear turnaround within the financial services sector after two years of strong growth.

“The credit squeeze has delivered a sharp shock to business volumes over the past three months, and it seems that difficulties are likely to persist for some time yet,” he added.

"This is however a very resilient sector that sees better prospects over the horizon, and it is encouraging that profitability, job creation and investment plans are all still positive,” McCafferty concluded.

Andrew Gray, banking partner, PricewaterhouseCoopers LLP, said that the financial services industry was concerned about the lasting implications of the credit squeeze and how long these ripples will be felt.

“Although results have revealed that 70 per cent of respondents feel that it will take at least six months for market conditions to return to a normal level, this will be dependent on the health of corporates and on how current market conditions spread beyond financial services," according to Gray.

Analysis by sector

Banking

Business volumes fell quite strongly after a year of consistent growth and, since total operating costs excluding cost of funds advanced, banks’ average costs per transaction increased at their fastest rate since the end of 1990.

Profitability fell slightly after a rather nondescript performance in 2007. Banks’ investment intentions for the year ahead are very positive, particularly for land and buildings, but there was a record level of concern (36 per cent) that further business expansion could be curbed by an inability to raise funds.

Building societies

Building Societies were unanimously less optimistic than they were three months ago, the first time this has happened in the history of the survey, as the volume of business fell. It is expected to decline at a faster rate next quarter.

Profitability fell at its fastest rate since September 1992, even though there was a large increase in spreads. This implies that firms are right to expect that faster falls in the volume of business next quarter will cause faster falls in profitability.

Longer term signs are encouraging, however, with plans to spend much more on IT in the coming year and ongoing further headcount expansion.

John Hitchins, UK banking leader at PricewaterhouseCoopers, said that the credit squeeze has led to a sharp fall in confidence in the banking sector.

He pointed out that the lack of liquidity had dented business volumes and a steep rise in interest funding costs, as well as a fall in the price of some asset classes, had reduced profitability slightly. Hitchins said that one encouraging feature was that business with corporates was on the up.

"Banks are split down the middle as to whether we will see markets return to normal in or beyond the next six months. Banks are, however, predicting non-performing lending to grow and this is likely to be in both the personal sector with mortgages refinancing at higher rates and the corporate sector where there are early signs of growing delinquencies," Hitchins concluded.

General insurance

Business volumes fell and are expected to do so again next quarter, though the level of business was considered to be close to normal.

Profitability grew strongly this quarter, reflecting higher spreads and premiums paid, and a big rise in business with private individuals. Last quarter’s lack of growth in business with individual customers now looks like the outlier in a much improved trend evident in the past year.

Life insurance

Life companies increased their profitability by cutting costs, though not quite at the pace seen in the third quarter. Business volumes fell heavily, however, led by falls in business with individuals and companies, contributing to a mood of pessimism about the overall business situation.

Clare Thompson, UK insurance leader, PricewaterhouseCoopers LLP, said that the results of this quarter were mixed across general insurance and remained more optimistic than the life insurance sector.

She added, however, that there was some divergence in sentiment between personal and commercial insurers, a result of varying business environments, rather than the implications of the credit squeeze.

Thompson said that personal lines of business were performing better than their commercial counterparts who have seen premium rates fall over the second half of 2007.

She added that the life insurance sector was reporting further increases in profitability this quarter, underpinned by a sustained focus on cost cutting and greater efficiency.

“Pessimism still mires this sector, however, and the credit squeeze is likely to have a more direct impact on its revenues, particularly if we see a sustained downturn in the UK housing market,” Thompson said.

She added that spending on IT was expected to increase over the next year in order to improve efficiency and profitability. Thompson concluded that the survey results had caught the first sign of a major new stream of regulatory spending, which was likely to be based primarily on Solvency ll and IFRS Phase ll.

Securities trading

Securities traders were unanimously less optimistic than they were three months ago, as the volume of business they saw contracted at a record rate, ending a year of growth before that.

The sharpest contraction in business was with financial institutions. As total costs increased a little, and incomes fell, the impact of fewer transactions on profitability was severe.

Further steep falls in profitability and volumes are anticipated for next quarter too.

Fund management

Fund managers reported robust growth in business volumes, fees, commissions, employment and profitability, very strong investment plans for IT in the year ahead, and the slowest growth in total costs since December 2004.

This improved picture was at odds with their lack of optimism, which reflects the greater volatility and more turbulent outlook for financial markets.

Pars Purewal, UK investment management and real estate leader at PricewaterhouseCoopers, said that there were certain asset classes, such as real estate, especially commercial property, which present a risk despite generally positive volumes and performance by major asset classes.

“Potentially significant deterioration in values is expected in the real estate asset class over the coming year and this risk could lead to further destabilisation. Product development is, however, on the rise and is an area of strong growth," Purewal added.

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