Growth rate holds key to bank share performance

Investor - An insider's guide to the market: A comparative study of the Irish banking system in the most recent edition of the Irish Banking Review concludes that Irish banks are among the most profitable in Europe and that the competitive position of the Irish banking system is one of medium concentration.

In most European countries a small number of financial institutions tend to control a large proportion of their respective markets.

Although the financial services market in Ireland has two very large players - AIB and Bank of Ireland - there are also several other very significant companies that add to the competitive landscape.

Irish Life & Permanent competes across the full range of retail financial services and has particular strengths in mortgages and long-term savings products. Anglo-Irish Bank has grown rapidly over the past decade and focuses on the small and medium sized business sector.

In addition several overseas-based financial institutions are very active in the Irish market. Ulster Bank, now owned by Royal Bank of Scotland, has a long-established Irish business.

More recently, Bank of Scotland has entered the mortgage market, while Northern Rock has established a niche deposit business. Bank of Scotland, in particular, has been very aggressive in the mortgage market and does seem to have been an effective catalyst in the intensification of competition in the mortgage market.

From the perspective of investors in Irish financial stocks it is clearly good news that Irish banks are highly profitable. It is also encouraging that the market is reasonably competitive.

While competition should act to reduce profit margins, it also tends to promote greater levels of overall efficiency and it can also increase the size of the total market.

For example, when Bank of Scotland entered the Irish market, it competed by offering lower rates on its mortgages and hence accepted a lower profit margin than the incumbent institutions.

The local institutions were forced to compete and the result is certainly a mortgage market that now exhibits lower profit margins than heretofore.

However, it is an extremely active and rapidly growing segment of retail financial services and one that still generates very healthy profits.

For investors, the key issue is whether the Irish banks are capable of maintaining high levels of profitability in the future. Broadly, this will depend on three main factors:

1. Commercial competitive pressures.

2. The actions of the regulatory, competition and fiscal authorities.

3. The performance of the Irish economy.

Regarding competitive pressures, it is difficult to envisage a wholesale change in the competitive landscape. Extra competition from international institutions will probably continue to occur on a niche basis.

The entrance to the marketplace of an overseas institution offering the full range of financial services is extremely remote. Therefore, the incumbent institutions will have time to respond to additional competition and should be capable of lowering costs to at least ameliorate any lower profit margins that may emerge.

The cost-income ratio, which expresses costs as a percentage of income, of the main Irish banks is around 57 per cent. Anglo-Irish Bank has a ratio of only 30 per cent, which is in large part due to its focus on a narrower segment of the market than the larger banks.

This ratio indicates that Irish banks are reasonably efficient but they should also be capable of limiting the damage to profitability of increased competition by chipping away at their respective cost bases.

The competition and regulatory authorities in Ireland and elsewhere are becoming more forceful in promoting consumer interests and in pressuring institutions to offer better value products and services.

Segments of the market such as services to small business that are perceived to have low levels of competition are receiving special attention.

These pressures may well lead to some erosion of profit margins on a selective basis but on their own are unlikely to severely damage overall bank profitability.

A much greater threat comes from taxation policy as evidenced by the recent introduction of extra taxes on bank profits. Given ongoing pressure on the public finances, higher taxation of banking profits on a permanent basis is a very real threat.

These risks to profitability seem to be factored into current share prices. As the table shows Irish banks offer good investment value on the basis of price/ earnings ratios (PER) and dividend yields.

Bank of Ireland is trading on a PER of just under 10 while Irish Life & Permanent offers a dividend yield of 4.2 per cent. A European bank such as ABN Amro is rated more cheaply but this reflects the fact that European banks are far less profitable than Irish banks.

The key to the share price performance of the Irish banks remains the future performance of the overall economy. The Celtic Tiger of the 1990s enabled Irish banks to grow rapidly and enhance their profitability. As long as the economy sustains even moderate rates of growth Irish financial stocks should be capable of delivering profit growth sufficient to satisfy their shareholders.