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MARKET COMMENT
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The banking sector is the largest in the FTSE All-Share, comprising just over 16% of the total index's market value. That means bank valuations significantly affect the overall direction of the UK stock market. Over the past year the FTSE All-Share Banks Index has increased in value by over a fifth. During that time the overall Index has dropped by nearly a tenth. If banks had followed this trend, investors would have been much worse off. Banks have seriously outperformed lately. This seems strange, though, as most commentators have been warning that increased competition amongst lenders and financial providers will force banks to chop their profit margins. Consolidation This has been offset by a wave of mergers and proposed offers. Over the past year alone the Royal Bank of Scotland (LSE: RBOS) has taken over NatWest, and Barclays (LSE: BARC) has bought the Woolwich. Meanwhile Lloyds TSB (LSE: LLOY) is in the process of bidding for Abbey National (LSE: ANL). The Competition Commission is looking at this offer. And the Halifax (LSE: HFX) wants to combine forces with the Bank of Scotland (LSE: BSCT). These consolidations are designed to reduce costs and thus prop up banking profits. In addition the emergence of new e-banking products and providers, such as Egg (LSE: EGG), should also enable costs to drop and margins to improve . This leaves three former building societies looking vulnerable: Alliance & Leicester (LSE: AL.), Bradford and Bingley (LSE: BB.) and Northern Rock (LSE: NRK). Domestic banks probably wouldn't be allowed to take over these groups but foreign operators may find them tempting. Operations Operationally though, have these banking mergers and manoeuvres enhanced profits? Today Barclays issued a first quarter trading statement, which showed that on the bottom line things are progressing well following the Woolwich acquisition. £80m worth of savings are still envisaged. Larger banks are increasing the volumes of their business, either by acquisition or aggressive pricing. This expansion makes up for the lower operating margins. The question now is what will happen to the minnows. Investors also have to see whether it's worth buying shares in the predators, like Barclays. The sector as a whole has a forward price to earnings ratio of only 14. That's lower than the market as whole. The average dividend yield is 4.2%, greater than the market average. On that basis it still seems very worthwhile holding banking shares in the long run.