New era means banking sector faces uncertainty

"A bank voting for Economic and Monetary Union is like a turkey voting for Christmas," one seasoned banker said when asked to outline the positive aspects of the euro for the financial services sector.

Whether they like it or not, the banks, building societies and other financial services companies are faced with the introduction of the euro on January 1st, 1999.

For companies in the financial services sector the introduction of the euro will have a number of immediate negative effects. They will lose the income earned on foreign exchange transactions within the euro area, they are already coping with heavy one-off conversion costs, and, competition in the sector from foreign based providers should increase.

In addition the preparations for the introduction of the euro have accelerated the trend towards a new lower interest rate environment in which profits from traditional lending and deposit taking operations have come under pressure. And the formation of one euro currency area is expected to accelerate the already evident trend towards mergers and consolidation in the sector.

While the negative effects are mainly up-front the potential positive effects of a single European currency are largely longer term and more difficult to quantify. The benefits for companies in the financial services sector will depend on the extent to which the existence of a single currency through the euro zone accelerates economic growth and development within the zone.

For customers of Irish financial services companies, a single currency zone may mean a wider choice of products and prices if foreign providers come into the Irish market. This is because the removal of the disincentives of operating in foreign currency zones should encourage more cross-border operations by financial services companies.

Among the quantifiable negative effects of the introduction of a single European currency is that of loss of revenue from foreign exchange transactions. About two-thirds of all bank income from foreign exchange comes from the spread between the buying and selling prices of the currencies being exchanged. The remaining one-third comes from handling commissions charged by the banks for carrying out the transaction.

About 20 per cent of the Irish banks' foreign exchange income comes from translating currencies which will be within the new euro zone, with about 60 per cent from the sterling area. It is estimated that the introduction of the euro will reduce foreign exchange income by £40 million to £50 million and that the figure would double if sterling became part of the euro zone. The issue is not unique to the Irish banks. All the banks within the euro zone will lose some foreign exchange revenue when 11 European currencies are replaced by just one currency. Arguing that they will lose the income from the buy-sell spread on foreign exchange transactions while their cost base for dealing with foreign exchange transactions remains almost the same, the banks will be allowed to increase their commission charges on these transactions as a compensation.

One banker explained that a euro cheque drawn on a German or other mainland European bank and paid to a customer of an Irish bank will still have to be processed through the German clearing system incurring the same costs as before the euro.

Falling interest rates throughout Europe as the euro zone countries moved towards the integration of their currencies have put banking margins under pressure. Profits on the traditional lending and deposit taking side of banking come from the spread between what is charged for loans and what is paid for deposits.

As interest rates fall that spread is squeezed because it becomes progressively more difficult to cut payments to savers while competition should force lending rates down. While lending rates to customers have not yet come down as much as wholesale market rates would indicate, further reductions may be forced by foreign providers cherry-picking lucrative market areas. In this scenario banks and building societies would be forced to reassess their loan and deposit portfolios and customers could see the introduction of charges for maintaining and operating small savings accounts.

Despite tighter margins the financial institutions would benefit if, as expected, the introduction of the euro leads to increased economic activity. As customers and potential customers respond to the lower interest rate environment, a higher volume of lending would compensate the financial institutions for a lower margin on the business.

Another negative area for financial institutions is the one-off cost of preparing for the single currency. The cost of converting software for the Irish banks has been estimated at about £100 million over a five-year period to 2002.

Another issue for European banks in the run-up to the euro has been the new reserve rules laid down by the European Central Bank. Banks and building societies have complained that their competitiveness against banks operating outside the euro zone will be damaged by the new reserve requirement for European commercial banks. While the new reserve levels set at between 1.5 per cent and 2.5 per cent of deposits are lower than the existing 3 per cent level set by the Irish Central Bank, the base of deposits used to calculate the reserve required is wider so the level of reserves will increase for some banks. The requirement to hold reserves ties up funds which could otherwise be used to generate profits. The banking industry has lobbied against reserving pointing out that in Britain, which will be outside the euro zone, there is no reserve requirement on commercial banks.

Of some comfort to the Irish financial institutions will be a recent survey which indicated that far fewer people would be willing to switch from a financial services provider, even for a 10 per cent saving, than from the providers of other goods and services.

However, the report - "Euronomics: The Competitive Impact of the Euro" - found that up to a quarter of all adults would be willing to buy mortgages, loans and insurances from other EU countries. The survey, from Amarach Consulting, found that men are more likely to look elsewhere for life assurance than women - 64 per cent of men compared with 36 per cent of women would buy from foreign providers.

Single males are more likely to look abroad for mortgages or pension policies, the survey found.

Internet users are far more likely to look elsewhere for products and services so the combination of the new common currency and technology will provide an extra boost to cross-border shopping. But the propensity among financial services customers who are Internet users to switch suppliers is lower than for other services. More than 60 per cent of Internet users would buy a car from abroad compared with 37 per cent of nonusers. But only 38 per cent of Internet users would switch mortgage providers compared with 24 per cent of non Internet users.

For the Irish financial institutions the advent of the euro will provide new business opportunities but there will be threats and challenges too as they enter uncharted waters.