Investors have long regarded financial stocks as providing attractive long-term returns but with a degree of risk that is somewhat lower than average.

Banking and insurance shares typically pay an above-average dividend yield and managements generally seek to grow dividends at a steady pace over time.

Therefore, in the current highly uncertain economic and financial environment investors could well be tempted to increase their exposure to financial companies. Now that Ireland forms part of the euro zone, Irish investors have a wide choice of euro-denominated banking and insurance stocks to choose from.

The financial sector of most European stock markets is large, reflected in a financial sector weighting by market capitalisation of 25 per cent on a pan-Europe basis. The Irish market fits into this pattern with approximately 30 per cent of the ISEQ's market capitalisation represented by financial shares.

Despite their more defensive characteristics, banking and insurance stocks have in fact performed quite poorly so far this year. The financial sector has not suffered anything like the precipitate falls experienced by the TMT sectors. Nonetheless, many financial stocks have witnessed share price declines of 10 per cent to 20 per cent over recent months.

A key explanatory factor in this regard is the increased risk to banks of a rise in the incidence of bad debts over the next 12 to 18 months.

Banking profits are closely linked to the progress of the overall economy within which they operate and overall revenues are very closely associated with economic and financial market conditions.

The banks' loan books still account for more than 50 per cent of revenues and a growing economy enables banks to enjoy strong growth in their loan books that generate growth in net interest income. The Irish economy over the past five years is a prime example of rapid economic growth fuelling a lending boom.

As economic growth slows down, so too does lending growth and hence net interest income begins to grow more slowly. However, of much greater concern is the tendency for bad debts to increase as times get more difficult. It is the potential for rising bad debts that is the critical factor that is currently weighing on banks' share prices.

It is impossible to predict the extent of any future deterioration in an economy's bad debt experience. The outlook for each banking stock still needs to be analysed in the context of its own geographical area. This reflects the fact that cross-border mergers and acquisitions in the sector up to now have been infrequent.

The majority of deals have occurred between banks and/or insurance companies within the same jurisdiction. Nevertheless, the current economic slowdown in the US, and fears that this will lead to a global recession, is impacting on banks worldwide since all economies will be affected.

Indeed, the impact of any global recession would be very significant on the Irish economy. Compared with the European average, international trade forms a very high proportion of Irish GDP. Furthermore, a large proportion of the workforce is employed by subsidiaries of foreign multinationals. Therefore, the impact of a worldwide economic slowdown would have adverse consequences on Irish economic growth.

A further negative is the foot and-mouth crisis that is already damaging the agricultural and tourism sectors. A combination of a prolonged US downturn and the adverse consequences of the foot-and-mouth crisis could well lead to a significant deterioration in the bad debt experience of the Irish banking sector.

It is likely that a sustained rise in the share prices of the Irish financial stocks will have to wait until the near term economic outlook crystallises.