Rate cuts may cause bank shares to suffer

The unexpectedly large cut of 0.5 per cent in short-term interest rates from the European Central Bank (ECB) to an historically low 2.5 per cent has added yet another twist to the house price spiral in the Republic.

The Irish Permanent was first off the blocks to reduce the mortgage rate, but by only 0.25 per cent and announced it would not be cutting the rates of interest paid to savers. Other financial institutions are likely to follow suit in due course.

It does seem that we have finally reached the point where interest rates paid to depositors have hit a level where they simply cannot fall any further. Competitive pressures will lead to small falls in lending rates but even here the scope for further reductions seems to be very limited.

Furthermore, the ECB made clear in the accompanying statement that it did not foresee any further reductions in European interest rates. The hope is that the current very low level of euro interest rates will be sufficient to revive the flagging European economy.

Of course, for bank managements this further cut in interest rates presents something of a headache as they see their profit margins being eroded. To hold on to deposits they cannot afford to reduce deposit interest rates, but they are being forced to reduce the rates that they charge borrowers. Bank customers will shed few tears at this prospect, but for private investors who may have a large proportion of their portfolio invested in bank shares it raises some fundamental questions regarding their future share price performance.

Bank shares have been stellar performers over the past three to five years with share prices more than trebling over the past three years alone, outperforming the overall market by more than 50 per cent. This rise in share prices has been driven by a much improved financial performance from banks. Irish banks have been able to sustain returns on equity of over 20 per cent for a number of years now which compares very favourably with their international peers.

The booming Irish economy has played a big part in generating extra profits for the banks even as lower interest rates have reduced their profit margins. The continuing strength of the economy also has a very favourable impact on the quality of banks' loan books since it reduces dramatically the incidence of bad debts.

With medium-term economic forecasts for the Irish economy pointing to continued growth, bad debts at banks are likely to remain at low levels.

Therefore the only cloud on the horizon would seem to be the ongoing downward pressure on banking profit margins. Already the stock market would seem to be beginning to reflect this shift in the competitive environment.

Although banking shares in the Irish market have risen moderately year-to-date, they have under-performed the overall market by more than 4 per cent. Industrial shares such as CRH and Smurfit would seem to be receiving greater interest from investors.

In the context of the very high valuations currently afforded banking stocks - the p/e ratio is more than 17 and the dividend yield is barely over 2 per cent - future returns from banking shares are certainly likely to be much more modest than in previous years.

Only time will tell whether the continued buoyancy in the economy will be sufficient to offset the increased pressure on profit margins in a low-inflation and low-interest rate environment.