THE BOTTOM LINE: IF THERE was ever proof that the Government should reconsider its "two pillar" banking strategy, it is in the Central Bank's report this week on bank competition and the effect on SME lending.

The report said that despite Government measures such as a loan guarantee scheme and microfinance fund, the withdrawal of foreign banks from the Irish market since the crisis has led to increased concentration, and that small and medium-sized firms will find it difficult to access finance as a result.

The pillar strategy is best seen in practice in Australia where mergers among four systemically important banks are prohibited. The theory goes that if one pillar falls, there are three more still standing. The fact that there are four lenders also means a healthier level of competition can be maintained.

It is one of the perversities of this crisis that the Government has had to restructure a banking system looking over its shoulder at how the European Commission’s competition officials believe the changes will affect competition in a dysfunctional sector.

Concerns about the effect of State aid on competition and the delay in approvals from Brussels certainly contributed to the slow pace of change in Irish banking in the past. But competition is undoubtedly an issue. The Central Bank found that, in a crisis, foreign banks react more aggressively by retrenching at a higher pace than domestic banks.

The decision of part-nationalised UK bank Lloyds to exit the Irish market signalled the end of one of the top-five lenders to the SME sector – Bank of Scotland (Ireland), which had taken over commercial lender ICC Bank. The bank said at the time that it would not leave SME customers high and dry while they found new banking arrangements. However, at a time when there are fewer banks to move to, credit is costing more and terms and conditions are more onerous, SME customers remain in a tight spot.

The Government has set the two “pillar” banks – AIB and Bank of Ireland – targets of €3.5 billion each to lend to SMEs this year. However the bulk of new lending appears to be the refinancing of existing debt such as converting overdrafts into term loans or extending overdrafts to buy SMEs more time.

Jeremy Masding, the new chief executive of Permanent TSB, is proposing that that State- controlled bank be split along the lines of a good bank/bad bank so that it can be freed up to lend more into the economy. The bank advanced just €400 million in 2011 and is eyeing up new lending of up to €2 billion in its new, resurrected form.

Officials from the troika of the commission, the European Central Bank and the International Monetary Fund began marking their sixth quarterly report card on the bailout programme yesterday and the future of Permanent TSB is one of the main items on their agenda during this review.

Though there are concerns that cleansing AIB and Permanent TSB of unprofitable tracker mortgages could put Bank of Ireland at a disadvantage, officials are said more generally to like the idea of creating a strong competitive force in a restructured Permanent TSB to break a banking duopoly.

While it might be desirable that Permanent TSB – for the most part a mortgage lender – could be reworked into a broader bank with a wider purpose, it is unlikely to reinvent itself beyond anything other than a retail bank.

The Government was told last year by competition consultants Charles River Associates that the merger of EBS into AIB substantially lessened competition in the mortgage market, although it added that EBS had no prospect of standing on its own. The union of the two State-controlled lenders created the biggest player in the mortgage market with a book of €42 billion – a lender that aims to have a 50 per cent market share of new mortgage business this year.

Concentration in property got the Irish banks into their current mess. The disposal of overseas assets to raise cash and shrink balance sheets and mergers have increased concentration in Irish banking again.

Dominant market shares would help repair the Irish banks if they were charging for loans far above what they are paying for their money, but they are not. High funding costs and expensive Government guarantee fees have put Irish bank profitability in a vice.

This will put the squeeze on existing customers as the banks try to find a way of making more money again. Creating another pillar bank or encouraging foreign banks to set up more pillars would ease this pressure.