ONE of the most serious challenges facing Irish banks and financial institutions is European Monetary Union (EMU). The main issues for the banks are the loss of income from a sharp reduction in foreign exchange transactions and the costs associated with introducing a new currency.

Senior management teams at all the main banks have been engaged for much of 1996 in formulating plans to replace lost income. The banks are already feeling the pinch in lost foreign exchange earnings as exchange rates in Europe converge in the move towards EMU.

The Economic and Social Research Institute has forecast that the banks will lose about £100 million a year from the reduction in foreign exchange business though this figure will be lower if Britain opts not to participate in EMU.

Banks, building societies and insurance companies will face significant costs in introducing a new currency. These will include staff training, marketing and information technology systems. The ESRI has estimated the cost at about £130 million and stated that it will be incurred mainly by the clearing banks.

However, most of the cost involved will be once off, spread over three years and some will be spending on replacing technology that would have been necessary even without EMU.

The expected increase in economic activity as businesses benefit from lower transaction costs within EMU should offset some of the losses of exchange earnings. Areas being considered to replace lost foreign exchange income include risk management in a larger and more liquid euro market.

EMU is not the only issue exercising the brains of bankers. Other issues being addressed include ongoing developments in technology, the cost of operating extensive branch network structures and the impact of the low interest rate environment on savings. The banks are also looking for opportunities to increase fee and commission income and for acquisition and expansion opportunities.

But 1996 was a good year for the Irish banks and building societies. Against the background of a strong domestic economy, low inflation and low interest rates there was good demand for loans and for fee generating banking services. Strong economic statistics - car sales, retail sales and house sales are all reflected in the strong demand for loans from the private sector. Business development has ensured a steady demand for investment finance. In a strong economy asset quality has been good.

The low interest environment brought its own problems for the banks - the cost of funds continued to rise as savers were no longer content to leave money sitting in low interest demand accounts. The switch from these accounts to the more expensive (for the banks) term deposits put pressure on banks net interest margins.

While a significant amount of savings still remain in the lowest interest paying demand accounts, switching by customers into higher interest accounts is expected to accelerate if interest rates remain at low levels.

With intense competition in mortgage and other lending markets, opportunities to compensate for the loss of margin on the funding side are limited. So the banks may need to become more innovative to keep the cost of funds down.

With large shares of the Irish market the two main banks, AIB and Bank of Ireland, have been looking outwards for expansion opportunities. Bank of Ireland expects to pay £600 million to acquire Britain's ninth largest building society, Bristol and West, in mid 1997.

On completion, the deal will boost Bank of Ireland's total assets by about 40 per cent to £29 billion with about 55 per cent of total assets in low risk mortgages. The acquisition is expected to boost earnings by about 10 per cent in 1998/99.

In the US, Bank of Ireland has swapped full ownership of First New Hampshire for a 23.5 per cent stake in the larger Citizens Financial Group. Citizens majority shareholder Royal Bank of Scotland is pursuing an acquisition strategy for its US operation which should benefit Bank of Ireland.

AIB continues to look for a suitable acquisition in the US to add on to its successful First Maryland operation. It is aiming to have a US operation with assets of $20 billion by the end of the decade. AIB is developing its lucrative funds management operations in Asia and the Far East.

In a toe dipping foray into eastern Europe, AIB now owns 36 per cent of WBK Bank in Poland and has an option to acquire an additional 24 per cent stake. In a market which is potentially very lucrative, AIB is advancing cautiously.

The TSB saga continued throughout 1996, though the Minister for Finance, Mr Quinn, said towards year end he was determined that decisions would be made in the lifetime of the current Government. At TSB the uncertainty makes it difficult to plan future development.

Awaiting a Government decision, National Australia Bank and Ulster Bank say they remain interested in acquiring TSB. Irish Nationwide Building Society has its hat in the ring and Irish Permanent, whose shares have outperformed the market, has also expressed an interest.

During 1996 Irish Permanent acquired a small mortgage operation in Britain in a strategic move to expand in that market as it improves. Among the building societies, First National expanded its mortgage operations in Britain.

In the insurance sector, the collapse of investment and insurance intermediaries lead to questions about the regulation and legislation covering the sector. Legislation, expected early in 1997, includes a Bill to extend the powers of the credit unions.