Over £1 billion has been wiped off the value of bank shares as investors reacted to the possible effect on profitability of the latest reductions in mortgage interest rates.

The shares of the main banks and financial institutions fell by 4 to 6.5 per cent yesterday, following the news late on Friday that AIB and Bank of Ireland were slashing mortgage rates to below 4 per cent.

The state's largest lender Irish Life and Permanent is now under heavy pressure to match the larger banks, following its smaller cut in the middle of last week, which left its main variable mortgage rate at 4.75 per cent.

Yesterday the market focussed on the falling profit margins on mortgage business which will hit the large profits the banks have been making on home loans in recent years.

Goodbody Stockbrokers has estimated that profits at Bank of Ireland and AIB will be hit by 3 per cent and 2 per cent respectively, as a result of Friday's cuts. However, profits at Irish Life and Permanent and First Active will be be worst affected, given their greater concentration on the mortgage market and their lack of exposure to corporate and other types of banking.

Goodbody has estimated that First Active's profits could be eroded by as much as 34 per cent, if it follows the larger banks and cuts its main variable lending rate below 4 per cent. Irish Life and Permanent profits would fall 8 per cent, with profits at the Irish Permanent banking division falling by 29 per cent.

Yesterday, AIB shares fell by 50 cents, or over 4 per cent to €11.45, while Bank of Ireland stock lost 55 cents, or 6.4 per cent - to close at €8.00. First Active lost 15 cents (4.8 per cent) to close down at €3.00, while Irish Life and Permanent lost 40 cents (4 per cent) to €9.60.

International investors are also concerned that new competition could follow in other areas of the Irish banking market, eroding margins in business and corporate banking. However, analysts say that it is mostly retail banking which is likely to come under pressure. In the immediate wake of the interest rate announcements, investors were taking the view that the sector as a whole was a "sell". According to one trader: "There are very few natural buyers, particularly for the smaller players." The new competition is also likely to lead to discussion about the future of some of the smaller players, with even some speculation among dealers that First Active could become an acquisition target.

Irish Life and Permanent is reporting its results today and an announcement can probably be expected.

First Active is in a more difficult position. It announced changes to its fixed rates last Friday but left its standard variable rate unchanged at 5.25 per cent for its customers. This is also now likely to be cut, although the bank is likely to wait and see what rates some of its other competitors announce.

EBS, which has traditionally been the cheapest lender in the market, also faces a difficult choice. However, it is also likely to announce cuts.