Quarterly economic update for the financial services sector

Insights from George Lagarias, Chief Economist, Forvis Mazars Economics Hub.

The financial services sector is poised for growth due to deregulation and lower interest rates, enabling banks to expand loan books and recapture market share from private investors. However, global economic challenges, including trade wars, persistent inflation and high debt levels, cloud the outlook. Risks include escalating trade tensions, geopolitical shocks and potential financial instability from deregulation. Central banks’ ability to intervene may mitigate crises, but long-term debt and trade disruptions pose significant threats to sustained growth.

Has the party started for financial services?

It is often stated that  a proper economic recovery  is not possible without the support of financial services. The years between 2008 and the pandemic certainly proved it. Average GDP growth between 1990 and 2009 was 4.1%, yet that number dropped by half a percentage point between 2011 and 2019 when growth was primarily driven by accommodative monetary policy. Conversely, banks, which had been heavily re-regulated in the wake of the global financial crisis, had significantly reduced credit creation through loans. Loan-to-deposit ratios in the U.S. fell from 95% to nearly 80%  within a couple of years. Following the demise of Lehman Brothers, private investors picked up the baton of business financing. Naturally, they would focus on higher-growth businesses, which is why in the decade that followed the Great Recession, it was the technology industry that exploded.

Deregulation and lowe interest rates

However, the world after the pandemic changed. Higher interest rates meant lower financing from private investors, so companies once again turned to banks. They, in turn, looked to the government to allow for more credit creation through deregulation. Since the election of a new Republican government in the White House, deregulation has picked up speed, providing a tailwind for the financial services sector, which will gradually be allowed to recapture market share from private investors. The UK has indicated that it will follow with similar deregulatory approaches and the EU, even reluctantly, will likely have to adapt.

The second tailwind comes from lower interest rates. The Federal Reserve, both on its own accord and on some prompting from the Executive branch, is focusing more on weak labour conditions, rather than building inflation pressures (at the time of writing, all components of U.S. inflation were rising, the first time in a year and a half). As a result, markets are predicting 0.75% lower interest rates until December, one cut in every Fed meeting in Q4. Lower rates are a mixed blessing for banks. On the one hand, they increase the market value of fixed income assets in the balance sheet and they improve loan demand. Funding costs also drop. On the other hand, they tend to lead to net interest margin compression as new loans are issued at a lower rate, but deposits usually do not reprice as quickly. Reinvestment on fixed income also tends to be lower. However, for banks that need to expand their loan books again, lower rates can be a way to recapture market share from private creditors and investors, so this would be a net positive. 

Slower growth

While lower interest rates and deregulation are indeed net positive for financial sector growth, overall economic conditions are hardly conducive. For one, tariffs and trade wars are lowering growth across the board. In February 2023, global growth for 2025 was projected at 3.2%. At the time of writing, this has fallen to 2.8%, with the U.S. losing nearly one percentage point in projected economic growth as a result of trade wars. European growth and UK growth are projected to be around 1%, although conditions are weakening.

It is not just lower demand which reduces real growth, but also higher inflation which eats into growth. U.S. inflation has been picking up, UK inflation persists despite negative growth pressures and European inflation also seems to be on the up.

Economic outlook – slower growth, higher inflation

We expect global growth around 2.8% for 2025 and roughly the same, expecting to slightly edge up – for 2026. Despite initiating a global trade war, the U.S. is projected to grow around 2% next year, with Europe and the UK a little north of 1%. Consensus expects inflation of around 3% on average by the end of the year in the U.S. (which would imply end-year inflation slightly higher than 3.5%), around 2% in the EU and 3% in the UK. For the next year, European and British inflation is projected to hover around 2%, while U.S. inflation is projected to be around 3%. Consensus probabilities for a recession are at a cycle low of near 25%-30%. Despite some rising unemployment, overall labour conditions are to remain tight, especially if no recession hits the global economy. Central banks in the U.S., EU and China seem to be focusing on growth and could maybe tolerate some trade war inflation as “transitory”.

What it means for financial services

In this environment, we would expect banks to increase loan books, but with overall lower net interest margins as interest rates fall.  Insurers may benefit from modest economic improvement and normalisation of investment returns if yields stabilise; however, “catastrophe exposures and (for reinsurers) cyclical pricing in property catastrophe markets remain important drivers of 2026 results” (Moody’s).

Disruption risks

The basis of our outlook is that trade wars will not expand beyond what has already been signed and that the U.S. and China (where negotiations are still pending) will eventually reach a deal. However, the U.S. President has asked allied nations to impose 100% tariffs on China and India for purchasing Russian oil. While we do not expect a proliferation of trade wars as our base case, we cannot say with any degree of certainty that further disturbance to the global trading system is out of the question. 

Thus, risks to the outlook are broadly to the downside, as policy uncertainty is still very high. Geopolitical shocks and trade frictions could quickly tilt outcomes worse. A global growth shock, sharper inflation than anticipated and potential funding stress if a sudden risk-off event occurs, could significantly deteriorate the outlook. Conversely, an easing of geopolitical tensions, trade deals across the board and the maintenance of cheap funding could improve the overall outlook.

Deregulation risks

Beyond 2026, we see a rise in longer-term risks, due to the deterioration of the global trading system and financial services deregulation. The former (less trade and more friction) may lead to structurally lower growth and higher inflation, as well as shortages. The latter (deregulation) is seen historically as short-term good but it is closely linked to financial instability at some point in the future. Financial and banking crises very often follow deregulation efforts, as some degree of excesses is always to be expected in such cases. This could be anywhere between three and seven years off, on average.

Debt risks

An even broader longer-term risk is debt. We believe that we are now in a mature part of a debt cycle. Standing at over 324% of Global GDP, total debt is high and accelerating. Both the U.S. and China, the key competitors in a global race for influence, technological supremacy and strategic resources, have subordinated fiscal discipline to the longer term goal of geopolitical prevalence. As a result, the debt buildup is accelerating. This risks currency destabilisation (which is why gold reserves have been rising) which could have a significant impact on the financial sector.

Balancing the picture

However, we must note that some of these worries are longer-term and may never materialise. Central banks have become adept stewards of economic stability, with a lot of expertise gained in the wake of the Global Financial Crisis. They will likely not hesitate to very quickly pump money into the system if they feel a crisis looming, to avert the kind of explosive sell-off that usually metastasises into a recession for the real economy. Likewise, they can lower interest rates, even into negative territory, if economic conditions deteriorate significantly. As such, they can absorb financial shocks and can somewhat reduce the impact of economic shocks.

Overall, the picture is one of broadly balanced and contained risks, but with a variety of outcomes that we find very difficult to pin a probability on. Tail risks have a higher probability than average, but they still remain far from base case scenarios. We do see the gradual deterioration of the global liberal economic and political order, which will definitely impact all aspects of the economy. However, we also believe that central banks have the ability to put temporary backstops, allowing policymakers to consider consequences and ease their approach (as the U.S. President did after a market crash following his global tariff announcement), or even reverse course.

A brief look at the history of the financial sector shows that they would likely focus less on those potential tail risks materialising and more on the opportunities stemming from deregulation. As the first and primary recipients of any central-bank-led rescue effort, commercial and investment banks, as well as insurers, all of whom have been very well recapitalised and stress-tested over the past 15 years, know that they can tolerate some risk, especially if it allows them to escape the low-growth pattern of the past few years.

Key trends financial services should watch in the months ahead

Deregulation, debt and disruption are going to be the key drivers for the economic and financial world in the foreseeable future., but those are big risks that usually take long to materialise. In the more immediate future, financial services have deregulation and possibly a reduction of reporting to look forward to.

In the next few months governments may look to financial services to increase credit and balance challenges to growth. CEOs should be ready to trim regulatory expenditure and take a strategic approach to expansions to keep up wih the competition. Alongside this, they need to remember that deregulation comes not as a result of more accountability, but as a way to boost failing growth. With long term risks, therefore, rising precipitously, management also needs to make sure that their firms are resilient enough to weather them when and if they finally materialise.