Serious Money: Competition is hurting bank profits and in many countries the regulators are getting involved, which means that large mergers are highly unlikely to happen.
Most people would be extremely surprised if they knew how many bank shares they own. Anyone who buys popular tracker-type products or a broad unit-linked investment ends up owning a lot of banks.
A glance at the holdings of a typical pension fund will often reveal a lengthy list of banks of one type or another. The State's National Pension Reserve Fund (NPRF), a large part of which resembles an index-tracking fund, owns shares in more than 70 banks (the exact number depends on what we mean by a bank, according to the most recent information on its website. That number is doubled if we look at financial companies of all kinds.
Overall, the NPRF has roughly 21 per cent of its bets in financial firms. We all own shares in banks.
It is common to think that technology stocks are the dominant force behind market movements. But it is hard for markets to go up or down for long without the share prices of banks doing likewise. Indeed, if we add in pharmaceutical and oil stocks, we often find a list of equities that comprise well over half of any given market.
It is to these staid heavyweights that we must look for future market direction rather than the flakier tech sector.
Some bank shares have doubled recently. In the US, JP Morgan Chase is one example, as is Germany's Deutsche Bank. But both banks, and many others, have gone absolutely nowhere over the past half-decade - in some cases for even longer.
Banks generally perform broadly in line with the market over long periods of time, sometimes a bit better, sometimes a bit worse, but rarely do we see wildly divergent performance.
In the UK, banks are broadly back to where they were five years ago, the FTSE 100 has done slightly worse: it has gone nowhere since 1997.
If banks are an accurate barometer for the stock market, should we take encouragement from the rally of the past year? Or should we draw sombre conclusions from the wildly uninteresting longer-term performance?
The answer to both questions is "yes". A year ago, most markets and bank share prices were pricing in something not far away from the end of the world.
But poor performance over the past five or more years carries important lessons, as does the market's violent reaction to AIB's results a couple of weeks ago. The message is the same: smart investors know that fat profit margins being earned by many retail banks are under threat. It's mostly a story about competition but it also involves regulation.
In the US, UK, Canada, Australia and the Republic the common banking story over many decades has involved mergers. Banks grow their profits in one of two ways: they benefit from a growing economy and, every now and again, merge. Stick two banks together, fire half the workforce and see profits soar.
Banks are one sector that has reaped a technology dividend. And, by and large, it has worked. Banks are fabulously profitable enterprises, particularly in those countries that have had a long history of mergers. In Europe, where the authorities don't like merger activity because they like to keep foreign banks out and absolutely forbid cost cutting, banking is more fragmented and less profitable.
A key measure of profitability is return on equity. Think of it, roughly, as the investment return that bank shareholders can earn. In Britain, that number will be 27 per cent this year. In Europe, that number will be around 18 per cent. The two main Irish banks will be somewhere in the middle.
Perhaps the most important thing to know about banks' return on equity is that it has, generally, been falling. And that's why share prices have been languishing.
Competition is hurting profits. And regulators are getting involved. In Canada, for example, the merger trend was brought to a shuddering halt a few years ago by competition authorities.
In the UK, as well as telling banks to stop merging, the regulators have been nibbling away at high profit margins, with latest efforts directed at the money banks make during the clearing of cheques - that period when nobody except the banks seems to know where the money is.
Most banks have known for years that the party must end sooner or later. Hence the rush to diversify into asset management, investment banking and other often ill-fated ventures. Smart investors are looking for one of two things. Where they sniff greater-than-expected margin erosion - as in AIB's case - they will shun the stock. Hedge funds will short it.
If, on the other hand, they spot a bank merger coming, they will seek to exploit that. European banks are ripe for consolidation - but they have been for years.
Little is likely to change unless we see a big German bank getting together with a French institution. Then, as the saying goes, the game is on. But I wouldn't hold my breath. Imagine the authorities here allowing AIB and Bank of Ireland to merge. Imagine them letting Royal Bank of Scotland buy Bank of Ireland.
European domestic and cross-border banking mergers will only happen in extremis, if competition from the US - free from the same regulatory constrains - forces defensive action. Citigroup, and some others, are rumoured to be interested in buying Standard Chartered Bank, but such stories are the exception rather than the rule.
Being underwhelmed about banks doesn't necessarily spell doom and gloom for stock markets but it does represent a major headwind. I won't be recommending banks to my friends any time soon.
