Rate hike: ECB president Jean-Claude Trichet

Despite the drastically worsening economic conditions over the past 18 months, bank customers have actually enjoyed a rosy period for interest rates. The unusual market situation in Ireland – where desperate banks have been overpaying for funding and undercharging for lending – created a situation where people could earn far more, euro for euro, on deposit accounts than they were paying on their mortgages. Savvy customers took advantage of the arbitrage situation while banks drifted further underwater with each cut in the ECB rate.

But all that is about to change. Brokers, bankers and bank analysts alike have all recently begun to talk up the inevitability of higher margins to get banks out of trouble and back to profitability. Davy Stockbrokers said recently it expects to see "margin expansion" over the next 18 months, with banks cutting deposit rates and cranking up borrowing rates to increase the spread between what money costs and what money earns for them.

"The era of reduced interest rates is coming to an end – all indications are they are going to rise," said James Cumiskey, chair of the mortgage sub-committee for the Professional Insurance Brokers Association (PIBA). "Brokers accept margins will have to increase."

The move on rates is already underway at a number of banks, especially those under foreign ownership.

For instance, Bank of Scotland Ireland – the owner of Halifax – has raised the rate it charges on some standard variable mortgage customers by 0.9%, in a sign that the bank is trying to reclaim eroding profit margins.

While the lender had announced early this month that it was increasing its prices for new mortgage business by 0.9%, the bank also put up rates on those existing customers who did not have either a tracker mortgage or a "price promise". By putting up rates on these unprotected borrowers, it is recouping some of the hit it is taking on its less flexible loans, many of which are losing money right now.

But the issue isn't limited to BOSI. Ulster Bank and National Irish Bank are struggling in the same way, as are AIB, Bank of Ireland and the rest of the sector. It's one of the reasons, bankers say, that lending is still very sluggish – there just isn't enough money to be made in the current rate environment. And something has to give.

Tracker mortgages, a product pioneered in the Irish market by BOSI, have put severe pressure on margins since the ECB began reducing base rates in October. With the real cost of money remaining stubbornly high, loans that track the base rate are returning less than they cost to fund. Where banks have been pressurised to lower variable rates in line with the ECB, the same problem occurs.

Moreover, banks have had to offer high deposit rates since the beginning of the credit crunch to make up for a lack of funding from other sources. In many cases, banks are paying out on deposits more than they are collecting on loans.

Because of the series of cuts in the ECB lending rate, lucky borrowers on trackers, for instance, can be paying as little as 1.5%-2.0%. Meanwhile, anyone who locked in a fixed-term deposit rate earlier this year could be earning as much as 6% on lump sums with Anglo Irish Bank or Irish Nationwide.

Consequently, banks are looking for ways to make that money back on other products. That means rate rises on loans and meaner returns on deposits.

"Banks have to get back to higher margins and the only tool they have is rates," said Karl Deeter, operations manager for Irish Mortgage Brokers, one of the largest independent brokers left in Ireland. "So they need to raise rates on those people they can raise rates on, like those with SVRs [standard variable-rate mortgages]."

People on standard variable-rate mortgages – about three-quarters of the market – are vulnerable because they are not protected by any kind of price guarantee. The banks can raise or lower these rates at will, whether the ECB makes a change or not. This is one of the key levers the banks now have to generate better returns on their lending.

"Don't be surprised if you see rates start to rise again," said Deeter. "At such a low base rate, the increased margin wouldn't be detrimental to most, and it's a perfect opportunity, along with several other key measures we will probably see such as the removal of interest on current accounts, decreased margins on deposits, and increased credit costs in other areas, such as cards and personal loans."

This is one reason, along with the prospect of inflation in the coming years, brokers are trying to get customers to look at fixed rates of five years or more. But customers for the most part aren't heeding the advice. Already, though, the banks are starting to raise rates on fixed products, too, in anticipation of inflation and, ultimately, ECB tightening.

None of this sounds good, but bankers say there could be a silver lining to higher prices – greater availability of loans.

"It's a matter of basic economics," one senior banker told the Sunday Tribune. "The reason banks are not lending much is because margins are not high enough."

In other words, banks will lend more and devise new mortgage products when the price outlook becomes more favourable for them. A 0.5% increase in the margin is the consensus estimate for what it will take for the market to get moving again.

Depending on your perspective, that's either blackmail or a return to sound lending practice. The reason we are in this mess, after all, is because loans were priced too low and sold at high volumes for too long. Then the banks got stuck overpaying for deposits when they could no longer fund those loans because of a short-term funding crisis. Now loan prices will have to go up to compensate for the increase in risk and bad debts.

It hardly seems fair.

"Banks need to think carefully about where they levy the pain," said PIBA's Cumiskey. "The taxpayer has taken on a big burden to keep banks in existence. They can't just go for the easy touch after they lent recklessly."