Law firm profitability remains heavily exposed to an income source which will dry up if the government forges ahead with plans to seize the interest on client money.
Interest still commonly accounts for at least 20% of a firm’s trading surplus, according to the NatWest Legal Benchmarking Report, one of the sector’s most respected financial bellwethers.
Headline growth is stalling, the survey also found, with many more firms reporting a fall in partner profits following the post-Covid boom. Median PEP rose just 2% in 2026, down from 23% in 2025, a statistically significant drop given that broadly the same cohort of firms took part.
Lord chancellor Alex Norris has yet to announce whether he will implement his predecessor David Lammy’s interest on lawyers’ client accounts scheme (ILCA), the cash from which would be used to fund justice. But as the Gazette reported last month, his department has already advertised for two senior civil servants to lead what amounts to a hypothecated tax raid.
Some 112 firms responded to this year’s survey, both large and small. Half reported that between 5% and 28% of their PEP arose from interest profits in 2025-26, down from half reporting between 9% and 35% last year.
‘Exposure of law firms to interest income has reduced in 2026 compared with the position we saw in 2023 to 2025,’ the report says. ‘This has arisen from a combination of slightly reduced base rates and increased payments on interest across to clients under the SRA Accounts Rules.’ Nearly one in three firms said an ILCA scheme would inflate the cost of legal services.
‘This income stream has long been part of the financial model and its prevalence today is broadly in line with pre-2008 levels [before the financial crisis, following which the base rate crashed]. The experience of the legal sector between 2008 and 2012 shows us that when law firms lose this income source, the repercussions include financial failures of law firms and increasing prices.
’Interestingly, 11% of respondents felt that the financial failure of law firms is likely to be the primary consequence of these changes. Whilst not the dominant response, if that were indeed the case for 11% of the legal sector as a whole, we would be looking at a substantial number of law firm failures. In turn, this could lead to a significant increase in the number of regulatory interventions required to protect clients.’
Firms have been working hard to improve margins but have been hit by the employers’ national insurance rise, which reduced margins by 1% to 2% at many.
Productivity remains a financial bugbear. Only 15% of firms reported that fee-earners log over five chargeable hours per day. Nearly a third reported less than four hours and one in eight said fee-earner productivity was actually declining. ‘This data clearly points to a challenge for law firms and the first line of attack in terms of both understanding the cost of the work firms undertake but also to enable them to improve profit margins,’ the report says.
Elsewhere, the report charts a big upswing in the use of artificial intelligence. Just 5% of firms said they were not using AI - down from 50% in 2025. However, most have taken no action to recoup their AI investment.
Law firm appetite for private equity is also on the up, with 40% saying they would consider external investment compared to 29% in 2024.
Despite the combination of pressures, 84% of firms expect income to rise in 2027. The report’s author Andrew Allen, of accountants PKF Francis Clark, said: ‘Law firms have shown considerable resilience, with optimism increasing despite a more subdued year for fee and profit growth. The speed of AI adoption is particularly striking, but the financial model has yet to catch up. Pricing, management, capacity and service design will be critical if firms are to generate a return from their investment.’
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