Likely shake-up in sector suggests holding strategy for bank shareholders

Consolidation across the Irish financial services sector is a topic that receives ongoing consideration among business leaders and public representatives.

A strong and vibrant financial services sector is always a prerequisite for any economy that wishes to grow and develop. On balance, the Irish financial services sector has kept pace with international developments in providing a wide range of financial services to customers.

For investors, Irish banking stocks have delivered handsome returns in the form of dividends and capital appreciation over a long period of time. The dominant position of the two large banking groups - AIB and Bank of Ireland - has occasionally led to calls for greater competition through the fostering of a third banking force.

However, in recent years the entry into sectors of the retail market by institutions such as Bank of Scotland and Northern Rock has injected an extra element of much needed competition.

Furthermore, Irish Life & Permanent has grown strongly through acquisition in recent years and its stated objective is to become the leading supplier of retail financial services to the Irish market.

There now seems little doubt that the degree of competition across the Irish financial services sector will continue to increase over time.

The current problems being faced by AIB have again thrown the spotlight on the Irish banking market.

The scale of losses suffered by AIB through the activities of their Baltimore trader is sufficiently large to weaken the banks capital-adequacy ratios.

However, of more significance is the damage that the revelations are doing to the credibility of the bank's senior management.

A strong management team is the best defence to a takeover and, in this regard, the chances of AIB retaining its independence have been damaged.

Speculation concerning the possibility that AIB may become a takeover target has enabled the share price to recover most of the ground lost in the aftermath of the revelation of the foreign exchange losses at its Allfirst subsidiary.

One possibility that has received some attention is a merger of AIB and Bank of Ireland. On competition grounds this will be viewed as anathema in many quarters.

However, the majority of investment analysts would take the view that the two Irish banks are simply too small to survive as independent entities in the context of the broader European banking market. Would one large dominant Irish-owned player be better for the market and the economy than several smaller institutions owned by overseas entities?

The table compares the size of the Irish banks with a selection of European banks by market capitalisation. A merger of AIB and Bank of Ireland would create a bank with a market capitalisation of €22 billion.

The competition authorities would almost certainly insist on divestment and/or downsizing several businesses to ensure that adequate competition was maintained.

Subject to this proviso, it can be seen that the combined entity would be quite large in a European context. It would still be much smaller than the giants of the industry such as Royal Bank of Scotland, capitalised at €82 billion.

However, it would be comparable in size to Abbey National and BNP Paribas, and a little smaller than ABN Amro. It is interesting to note that the latter two banks are the result of mergers of banking institutions within France and the Netherlands respectively.

The Republic is a much smaller market than either the Netherlands or France and the dominance of a combined AIB and Bank of Ireland here would be very substantial.

It is impossible at this stage to predict what the eventual shape of the Irish financial services will be.

From the point of view of stock market investors, the fact that such a debate regarding the eventual structure of the Irish banking market has emerged will probably serve to underpin share prices. Whilst speculation concerning an acquisition of one of the main Irish banks has emerged on various occasions in the past, they all have come to nought.

The time may now be more propitious and a big shake-up of the Irish banking scene sometime in the next few years now seems highly likely. Therefore, investors in Irish financial shares would be well advised to maintain their current holdings.