The real effect of the ongoing funding crisis in the banking industry will begin to be seen shortly, as overall bank lending contracts for the first time since 2009, according to The Ernst & Young ITEM Club Outlook for financial services.

SMEs, commercial real estate and personal customers who fall outside of standard credit terms will be hit particularly hard, it warns. The growth of payday loan companies and alternative corporate funding vehicles is also set to continue at pace, as the paralysis of bank lending opens up the market further to alternative or ‘shadow’ banking at both ends of the market.

After expanding by an estimated 4.3% in 2011, the ITEM Club expects total bank loans to contract by 2.2% in 2012, with just 0.9% growth forecast in 2013.

The contraction in corporate loans is expected to be particularly sharp, with a 5.7% fall forecast for 2012. Financing conditions are likely to be particularly tight in the construction and real estate sectors and smaller companies will be particularly badly affected.

“Funding for small and medium-sized enterprises is likely to be particularly difficult to obtain as banks seek to reduce credit risk," warns Neil Blake, senior economic adviser to the Ernst & Young ITEM Club. "The average interest rate on smaller loans, of £1 million or less, is already double that charged on loans of £20 million or more, and we expect this trend to continue. As these young companies tend to be high-growth businesses, this will have adverse knock-on effects for economic growth.”

With banks expected to further tighten lending conditions, consumer credit will also continue to shrink rapidly, contracting by a further 5.4% in 2012, and won’t hit 2011 levels again until 2014. However, whilst banks and building societies’ unsecured lending to individuals has contracted by 23% (£34 billion) since 2007, net lending by alternative high-cost consumer credit providers has risen by 42% (£29 billion) over the same period.

“The contraction in consumer credit is driven by lack of demand to an extent, but we just need to look at the phenomenal rise in payday loans to see that the focus on decreasing demand masks a shift towards alternative providers. Households that fall outside of the credit terms of traditional lenders are increasingly looking toward other credit providers, regardless of the cost. With banks expected to further tighten lending conditions, we expect the shift towards alternative lenders to continue unabated,” says Neil.