A sluggish economy will take its toll on Britain's key financial services sector next year, forcing banks to write off more loans and restricting the supply of credit to consumers and businesses, accountants Ernst & Young said.

With the UK economy set to expand by just 1.5 percent in 2012 down from an initial forecast of 2.2 percent, banks' bad debts will be some 3 billion pounds higher than previously thought, E&Y said in a report published on Monday.

That will cap bank lending growth at 0.5 percent in 2012 and 2013, lower than the previous forecast of 0.8 percent, and trigger a hiring freeze across the industry, creating an additional headwind for the wider economy.

Given the extent to which highly paid employment in the sector underpins consumer spending, tax revenues, and house prices in the UK, the projections for financial services employment is concerning, said Dr Neil Blake, a senior economic adviser to E&Y.

British insurers also look set to come under pressure next year as cash-strapped consumers rein in insurance spending, with life insurers facing the additional challenge of a raft of European and domestic regulatory changes.

However, E&Y said British banks had put themselves on a sounder financial footing since the onset of the last financial crisis in 2007 by halving their reliance on volatile wholesale funding.

British lenders' direct exposure to potential sovereign default swaps in the eurozone is also lower than their European counterparts, while indirect exposure via credit default swaps may be overstated, the audit firm added.

The government holds 83 percent of Royal Bank of Scotland and 41 percent of Lloyds Banking Group after an abrupt drying up of wholesale finance forced it to bail both banks out in 2008, while rival lender Northern Rock was nationalised.

(Reporting by Myles Neligan; Editing by Erica Billingham)