With low operating costs and home loan debt surpassing all expectations, Irish financial institutions are top of EU profitability league, writes Una McCaffrey

All across the Republic, hordes of disgruntled bank customers are heading to the airport to catch flights to Lithuania.

There, with the benefit of knowledge contained within this week's banking report from the European Commission, they know they will find the banking nirvana they desire.

Transactions will be cheaper than they are at home and the banks will, by extension, be creaming less off their customers' pressurised incomes.

The only problem might be that this same income might be a touch lower in Lithuania than it would be at home. But it might be worth it, depending on how desperate they are to shake up the Irish banking sector.

This commission's report suggests that banks in the Republic could indeed benefit from a bit of an exodus of customers. This might be the only thing to persuade them that their charges are, depending on your perspective, too high and that by extension, their profits are excessive.

To be precise, they are the most profitable out of the banks in all 25 EU states, by some distance. A mass exit of customers is unlikely to happen of course, with the laziness of the average customer going a long way to ensure the continued success of the banks they love to hate.

There is also the slightly more acceptable argument that the Irish banks are not the only authors of their good fortune - the theory that the economic backdrop makes it impossible for banks not to generate super-profits.

This latter line was the one put forward earlier this week by the Irish Bankers' Federation (IBF), the representative group for the industry. The IBF said that a buoyant economy and a profitable banking sector "go hand in hand", as simple as that.

This view was echoed the day after the report was issued by Scott Rankin, an analyst at Davy, who greeted the research with a touch of irony.

"So, Irish banks are among the most profitable in Europe, according to a new report from the EU Commission? Well that's news: we are 12 years into a boom, the Irish have the lowest bad debt charges in Europe and, for the moment, tighter capital levels/higher gearing. . . and let's not forget the tax rates too."

Rankin does not judge the commission's report to "merit much comment" because it is "well-trodden ground".

He is probably right, at least from the financial analysis perspective, with reports such as that of the commission adding little to analysts' estimates of banks' likely earnings and shareholder returns. But perhaps consumers and business banking customers might benefit from a closer look at the commission's study on profits.

The research concluded that Irish banks generated a pretax profit in 2004 that was more than half of their total retail income.

The closest any other country's banks came to this was a profitability ratio in the early 40s in Latvia. Next came Finland, with closer to 40 per cent, followed by Spain and Sweden.

The UK (the market closest to the Republic in structure) had a profitability ratio of closer to 30 per cent.

So what of the strong economy, strong banks theory? Were all of the most profitable banking sectors located in fast-growing economies in 2004?

Figures supplied by Eurostat, the EU's statistical agency, show that the most buoyant economy in 2004 was the aforementioned Latvia. So far, so good for the theory.

Next in 2004 came Estonia, which unfortunately did not feature in this week's banking report. In third and fourth place were Lithuania and Slovakia respectively, both of which had healthy profitability ratios above 30 per cent.

The Republic, which as we recall is top of the profitability league, came sixth in growth terms in 2004. This seems like a reasonable correlation, particularly in light of the years of boom of which Rankin speaks.

Less obvious, however, is the link between economic growth and banks' profits in Spain and Finland, the second and third most profitable places to have a bank. Spain was twelfth and Finland just fifteenth in the growth stakes. Sweden was an unimpressive sixteenth.

This simplistic analysis suggests that the link between banks' profitability and economic growth is thus not as strong in all countries as it is in the Republic.

This leaves us to delve further into the commission's report to see if there is any other reason for the large profits of our dear banks.

The report notes, rather ominously, that "anecdotal and preliminary evidence would suggest a possible identification of country clusters where the margins and spreads are consistently larger than for other country clusters".

"The four countries demonstrating the highest margins or

spreads are, in decreasing order: Greece, Portugal, Italy and Ireland."

Finland was, however, at the opposite end of the spectrum in some cases. The commission warns that interpretation of this data as an indicator of competition should be "nuanced".

This brings us to the cost of actually banking in the various EU countries. As the accompanying tables show, this can vary rather wildly, as one moves from country to country and from product to product.

For example, a credit card in Belgium in 2004 was likely to cost the consumer just €19, while in the UK, this rose to €137. The EU average was €65, with the Republic's banks not exactly busting their competitive gut with an average of €105.

It must be recognised that credit cards are unusual products, with levels of usage and acceptance (and thus income for banks) shifting according to home country.

A more average product might be the mortgage, at least in the EU-15, where private property ownership is no new thing.

The average cost for the older EU states in 2004 was €1,126, with the Republic coming in at a respectable €1,079. The increasing levels of mortgage competition that kicked in at around this time were, it seems, having an effect.

The area where competition has intensified more recently is current accounts, with all the main providers now offering some form of "free" product. Even in 2004, however the Republic was relatively competitive in current accounts when compared to its EU neighbours - the Irish banks charged an average of €102, compared to the EU-15 average of €133 and the EU-25 average of €119.

This leaves us with two products to compare: deposit accounts and consumer loans. In both cases, the Republic's competitive star wanes substantially, with bank income generated from Irish customers much higher than that drawn in from their EU counterparts.

Luxembourg is top of the table for deposit accounts because of its large share of foreign clients, although "confidentiality" considerations means the actual figure can't be revealed. Cyprus is next but the figure is again secret. The average for those states that do reveal a number is €69, while the Republic comes in with a much larger €86.

This presumably brings us closer to explaining the large profits of our beloved banks.

The cost of a consumer loan also provides some explanation, with the Irish charge of €668 in 2004 dwarfing the EU-25 average of €367. A similar differential is shown for SME loans, although SME current accounts were apparently more competitive.

Eamonn Hughes, a banking analyst with Goodbody Stockbrokers, points out that competition for loans has been increasing of late, probably because there is space for this to happen.

He has built in "further margin erosion" for the main banks in the future but, equally, believes that earnings per share will grow on average by 14 per cent at both AIB and Bank of Ireland over the next two years. This is to come against an expected backdrop of slowing volume growth, "severe margin pressure" and a weakening credit outlook.

Specifically, in a recent report, Goodbody has built in a 33 per cent decline in mortgage spreads over the next three years, a 21 per cent reduction in consumer spreads and 19 per cent erosion in commercial spreads.

Merrion Stockbrokers took a similar line in a May report, with its analysts also expecting "double-digit earnings growth" over the next two years, along with margin attrition in some segments. The release of €16 billion in SSIA funds are cited as one driver of earnings, along with good old economic growth.

There is another factor, however, which goes some way to explaining the high profits of Irish banks compared to their EU colleagues: their cost base.

The commission found that the Republic stood third from the bottom of the cost-income ratio table, meaning its banks had the third-lowest operating costs as a share of retail income.

More striking is the observation that cost efficiency can be a direct correlation of consumption patterns. In other words, some member states might show high consumption of products that are cheap to supply and thus generate easy income.

The main example of such products offered by the commission is, you've guessed it, mortgages.

With Irish mortgage debt surpassing all expectations at every turn, perhaps this is the best rationale for our banks' profits that the research can provide.