Shareholders at the Bank of Ireland EGM in Dublin last month, where they were asked to put more money into the bank to help it to raise funds. Both of the big two banks have cut corporate deposit rates while increasing the returns paid to debt investors in a bid to raise capital

The challenges to bank profitability are by now well-known. Catastrophic loan losses, high funding costs and low levels of new business have badly damaged bank earnings in the past two years. Analysts see the big two banks, AIB and Bank of Ireland, continuing to lose money this year and only breaking even in 2011, before returning small profits in 2012 and finally achieving "normalised" profits in 2013.

The theory is that Nama will take care of the worst bad loans; funding costs will come down as balance sheet risks diminish and new business will come back at keener prices as the economy begins to recover.

A key part of the plan is recapitalisation to new, higher levels required by the regulator, which will give comfort to investors and depositors, thereby establishing a sound platform for new growth.

But some of the capital fixes being employed by the banks will actually hurt bank profits in the long term.

Bank of Ireland, for instance, generated a €405m capital gain after completing a €2.9bn debt exchange earlier this year. The bank swapped €1.6bn of securities at the average discount of 26% to face value and pocketed the gain. The real sweetener in the deal, though, was the high coupon: the bond will pay 10% interest until it matures in 2020. At that price it will be virtually impossible for the bank to recoup those payments in terms of profits.

"While increased coupon payments on the new securities have negative implications on the bank's profitability going forward... Bank of Ireland's decision to reduce capital shortfall in the near-term was ultimately the right one to take in the current circumstances," said Dolmen head of research Oliver Gilvarry in a note highlighting the bond.

The bank isn't doing this to be nice to debt investors. The bank is doing it because the Financial Regulator has told it to hit 8% core capital levels by the end of the year. This has forced management to find capital wherever it can. If that means capital-generating – but costly – bond exchanges, so be it.

Bank of Ireland is not alone in offering high rates of return to debt investors. AIB has a high-risk bond paying a 12.5% coupon until 2019. Even at shorter terms AIB is issuing bonds at rates that are very attractive to investors. One senior bond, maturing in 2014, is paying a 5.625% coupon – well above deposit rates over a similar period.

Both the main banks have severely cut the amount they pay for corporate deposits in recent months, making debt investments like the AIB senior bond a very attractive alternative.

While the banks do need to reprice deposits to help rehabilitate their margins, the cost is being shifted to relatively high-priced bond issues.

As with high deposit rates, high coupon payments eat into margins, making it harder to generate profits. And lower profits means less future capital generation.

Yet cutting deposit rates can also be read as a sign of stability in the two big banks. After all, Anglo Irish Bank and Irish Nationwide, the two most damaged banks in the country, continue to pay the highest deposit rates – three times what Bank of Ireland and AIB pay corporate customers, according to Dolmen's latest weekly interest rate survey.

Bank of Ireland is leading the way in this area. With its €3.5bn capital plan now complete after the close of its rights issue period last week (with a 94% take-up), it can focus on building back its net interest margins (see link to article under the heading 'Related Articles' to the right of this web page).

According to a recent investor presentation, the bank is going to keep an €82bn "core portfolio" backed by customer deposits while it runs off €53bn in non-core loans – some of which will end up in Nama – backed by wholesale funding.

"The closer you move to deposit funding, the better," said Kevin McConnell, head of research at Bloxham. "Obviously the capital markets are in a chaotic state."

Still, Bank of Ireland has €61bn in wholesale funding as against €85bn in customer deposits. As the wholesale funding rolls over and gets replaced with more expensive issues, profit margins will erode further. This will make it a real challenge for the bank to return to normal profits by 2013. The same is true all across the sector.