Ireland has been a stunning example of the damage caused when a financial system collapses. A massive property and mortgage bubble fueled an economic catastrophe that destroyed the nation's financial system, economy, and fiscal solvency. What has emerged is a system driven by two main pillar banks. But potential actions by Royal Bank of Scotland Group (NYSE:RBS) could have a major impact on the future of banking in this recovering nation.

Pillar banks, aka the survivors
Ireland's pre-crisis financial system flooded a large group of major banks with profits, but none of these could survive the crash without government assistance. Since Ireland still needed banks, the government took the approach of saving the strongest ones and winding down the financial institutions in the worst situations (strongest is a relative term here; both still required billions in government cash).

From the other side, two have emerged: Bank of Ireland (NYSE:IREBY) and Allied Irish Banks (NASDAQOTH:AIBYY). Despite both being pillar banks, their situations are far from the same.

Bank of Ireland is making progress in reducing the amount of government ownership in itself. B of I repurchased 1.3 billion euros in preferred stock owned by the government, thereby removing a restriction on the bank from paying dividends on its common stock. While the government retains a 14% stake in B of I, it currently holds a 99.8% stake in Allied Irish Banks. With so many shares issued to the government in exchange for capital, Allied Irish shareholders have been diluted into oblivion. Those still interested in Allied Irish should take a look at my previous article which discusses how Allied Irish could be the most overvalued bank in the world.

The current banking system
Right now, Bank of Ireland and Allied Irish Banks dominate the Irish banking system, but some high level individuals think that should change. Finance Minister Michael Noonan has voiced support for a third major bank in the system as a way to get credit flowing again. But it's not just government officials who acknowledge the need for more banks: Bank of Ireland CEO Richie Boucher said the Ireland "probably" needs more banks than it currently has in its economy.

Changes from RBS
Royal Bank of Scotland Group is comprised of many subsidiaries, one of which is an Irish bank called Ulster Bank. Though not as big as Ireland's other pillar banks, Ulster Bank has still produced losses and has been a general drag on RBS.

Recent reports suggest that RBS is searching for a tie-up between Ulster Bank and another Irish bank. Potential candidates include the Irish units of Danske Bank or KBC. Another possibility is a tie-up with Permanent TSB, the banking side of Irish Life and Permanent before IL&P was split up to raise capital.

If Ulster Bank can create a tie-up with any of these other banks, it could become a third bank capable of matching Bank of Ireland and Allied Irish in the Irish market. Despite the increased competition, there could be a positive effect for Irish banking, as a third player would allow more credit to flow into the economy again, boosting growth in the process.

A third Irish bank
Ireland's post-crisis financial system was not built around two banks that were good; rather, it was built around the two banks that were the least bad. As Ireland looks to get its economy moving again, the addition of a third major bank could provide a boost to growth. Investors in Ireland should keep an eye out to see whether RBS can change the setup of the Irish banking industry.

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Alexander MacLennan owns shares of Bank of Ireland (Irish listed). This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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