A breakdown of how lending works shows profits up

How far can mortgage price cutting go, and what does it say about the future of financial services for customers?

The business of mortgage lending, though complex in some aspects, can be modelled in a fairly simple way. Like any business, the key issues are the returns required by shareholders and the way costs and profit margins work.

Say a bank makes a new mortgage loan of £100 (€127). Bank solvency rules mean that for every £100 lent in mortgage loans, at least £4 capital, or 4 per cent, has to be held by the bank. Up to half of this £4 could be capital in the form of subordinated debt or other capital which is not pure equity. A bank could have just £2 in shareholders' equity for every £100 lent.

Internationally, most banks adopt a target rate of return on equity of at least 15 per cent. This is a standard set basically by the capital markets. A bank which consistently delivered returns of less than 15 per cent would be viewed, generally, as under performing.

£100 of mortgage loans needs £2 of equity and shareholders require a 15 per cent return on that £2. That means 30p profit - or 0.3 per cent - on each £100 lent.

This simple model suggests that if our bank has a net interest margin - the difference between the rate it pays on deposits and the rate is receives on loans - of 2.5 per cent, it has plenty of cushion over the need to deliver a 0.3 per cent profit margin. But costs come into the equation too. There is the cost of selling and administering the loan, and the cost of defaults or bad loans, which the bank has to meet eventually.

Irish banks have in the past had costs absorb 70 per cent and more of income. To deliver the 30p profit on the £100 loan, net income would have had to pay the costs of 70p. The lowest net interest margin needed for mortgage lending would have been £1 or 1 per cent. Clearly, this is still lower than the net interest margin of 3 per cent, an overall margin typical of banks today. This margin must cover non-mortgage lending too, where the equity required for solvency is twice as much, and the profit target is 60p per £100 lent. With little scope to increase interest margins in open, competitive markets, it is easy to see why banks have wanted to cut cost ratios, even though it is a struggle when there is a large, installed branch network.

The events of the past few weeks in Ireland merely add minor confirmation of international trends in banking. A recent paper by the consultancy, McKinsey, illustrated that costs per transaction in personal banking were $2.50 for in-branch tellers, but were merely 24 cents for voice response units and 10 cents for Internet banking. It cited the example of Homeshark, a San Francisco on-line mortgage broker, which began as a one-room operation with three employees and has now become "the provider of choice for cost-sensitive, technology-savvy customers". That scale of cost reduction - one twenty-fifth of the traditional cost - means that the future of mortgage banking, and of most banking, is in automated processing. And under EU freedom of services, any efficient processor - the term "bank" may be too restrictive - is able to compete for mortgage lending in Ireland. This will mean fewer traditional bank jobs, branch closures and less customer contact. We can hail the advent of price competition among banks, but we must also get comfortable with the new way of buying personal financial services. Any remaining customers who value branches being close by and personal contact with bank staff will have to pay the price in a reduction of these aspects of banking service. Branch banking is too costly a service and will no longer be cross-subsidised by fatter than necessary mortgage lending margins. It is no accident that Bank of Scotland is competing in Ireland without the burden of an expensive branch network involving bricks, mortar and local jobs.

We will have to realise that the number of jobs it takes to service our financial needs will be much less than heretofore. Employment growth in Irish financial institutions will be on the back of two things: competitive, internationally-traded services, and tailored personal financial services for which customers will pay a premium.

One of the shames of the DIRT enquiry is its illustration that the response of some bank managers and bank managements to competitive pressures was unethical competition for deposits, rather than preparing their businesses to be efficient providers of financial services for the future. Mortgage competition is about a lot more than today's rates, and bankers know it.

Oliver O'Connor is managing editor, Fintel Publications