Euro zone banks hoarding cash ahead of ECB stress tests: EY

Banks hoarding cash ahead of the European Central Bank (ECB)'s new "stress tests" are holding back vital funds from euro zone businesses, according to consultancy EY.

EY now predicts that lending in the region will rise by only 0.5 percent in 2014, down from an earlier estimate of 1.6 percent. It attributed the softening outlook to banks' caution ahead of the ECB asset quality review, which will test the ability of 128 major financial institutions to withstand economic stress.

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EY warned that slowing growth in lending could hamper the 18-country group's ability to recover from the recent financial crisis.

"Given how dependent consumer spending and SME (small and medium-size enterprises) financing are on bank lending in the euro zone, the AQR (asset quality review) could have a material economic impact," said EY's head of financial services, Andy Baldwin, in a report out on Monday.

"The hope is that it clears the decks for banks to support more sustained growth, but, if there is a large capital shortfall, the AQR could deliver a material knock – not enough to drive the region back into recession, but enough to prolong low growth or stagnation."

EY said that a lending constraint of 0.4 percent or more would weaken euro zone economic growth next year – currently seen at 1.8 percent by the European Commission. However, EY warned that a softening bank lending could see that cut back to as little as 0.7 percent.

"The near-term effects of this spring-cleaning on lending are already having an impact," said EY's Robert Cubbage in the report. "It is likely that some banks will adapt their business models by providing less direct lending to corporate customers in favor of advising them on accessing finance from a range of different sources."

European banks no longer in denial: Pro

Speaking at his monthly press conference, ECB President Mario Draghi said he had started to see some signs of improvement in lending to SMEs.

"In particular, even though lending rates remain higher in the stressed countries than in core countries, and higher for small and medium-sized enterprises (SMEs) than for corporates, we saw some convergence in lending rates, some timid, I would say, mild convergence," Draghi said.

(Read more: Draghi hails 'great progress' after banking union deal)

Baldwin added that governments needed to encourage consumer and business lending from non-bank sources. "The possibility of a further slowdown in bank lending to the real economy only makes it more important for European governments to stimulate long-term funding from other sources," he said.

—By CNBC's Katy Barnato. Follow her on Twitter: @KatyBarnato