ECB rates pressure is good and bad

European Central Bank pressure on the Central Bank to get on with reducing Irish interest rates is good and bad news for the Irish financial institutions. Lower interest rates are on the cards and that is generally bad news for banks and building societies. As interest rates fall their margins, or profits from lending and raising funds, tend to tighten. One major bank has calculated that every half a percentage point cut in interest rates wipes about £15 million off after-tax profits. As banks have to cut the rates at which they lend to borrowers their profits from lending start to fall. At the same time the banks cannot cut to the same extent the interest rates offered to depositors if they want to keep a retail funding base. That means downward pressure on profits.

But in the short term, the latest moves to get Irish interest rates down are likely to give banks and building societies an opportunity to increase profits. The Central Bank may well cut rates to bring Irish wholesale money rates closer to the German rates of 3 per cent.

But given the Bank's concerns that lower Irish rates will feed inflation, the Irish financial institutions may be discouraged from passing on the full fall in money market rates to their customers. For example a two percentage point cut in market rates may result in only a one percentage point cent drop in mortgage or business lending rates. That will mean the financial institutions will be able to increase the profit for some of their lending business in the short term.

What they are likely to do is to "tweak" their matrix of lending and borrowing rates to increase their margins in the short term. But in the longer term where customers compare value offered, profits at the financial institutions will suffer as a result of lower market interest rates. Customers will be concerned how the financial institutions will react to the pressure on core margins. They could see the introduction of higher charges or charges for "free" services such as the Bank of Ireland decision to abolish free banking for customers who maintained an account balance of £100.