By Simon Miller

European banking balance sheets are expected to shrink by €1.6trn (£1.3trn) this year as non-core assets are ditched and lending activity contracts.

According to Ernst & Young (E&Y) further rating downgrades were likely to contribute to an intensification of funding pressures, and banks will respond by seeking to limit
their reliance on volatile wholesale markets by raising retail deposits.

As a result, E&Y expects average loan-to-deposit ratios to fall from 113% in 2011 to 108% in 2012.

In its latest forecast for the European financial sector, E&Y added: "Intense competition will increase the rates banks have to pay to attract deposits, especially for those institutions perceived to be weak, and this will put pressure on margins."

However, despite the record contraction, things are expected to get worse in 2013 with non-performing loans (NPLs) in the eurozone forecasted to rise from 5.6% of total loans last year to reach a euro-era high of 6.5% during 2013. In Spain, NPLs are expected to surpass the 1994 peak of around 9% in 2013.

The report also found that corporate loans in the eurozone were expected to contract by 4.8% this year.

"This, along with uncertainty about the economic outlook, will dampen business investment. Corporate sector loans are not forecast to surpass their pre-crisis peak of €4,827bn until 2015," the report noted.

It added: "Difficult financial market conditions will dampen profits in investment banking divisions during the remainder of the year, while prospects for retail divisions will be constrained by loan book shrinkage and the need to attract deposits. Overall operating income for the region’s banks is therefore forecast to show only very modest positive growth of 1.5% this year."

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