* Bank makes 327 mln euro profit vs 395 mln loss year ago
* Sees net interest margin growing further than 2.05 pct
* Core Tier 1 capital up to 13.2 pct ahead of stress tests (Adds details, analyst quote)
By Padraic Halpin
DUBLIN, Aug 1 (Reuters) - Bank of Ireland turned a profit for the first time in five years, tracking a sectoral rebound, and flagged stronger future profitability as the Irish economy improves.
The country's only lender to escape nationalisation reaped the benefits from higher income and a big fall in provisions, as Allied Irish Banks (AIB) showed when it also reported a better-than-expected first half profit this week.
Ireland's economy grew by 2.7 percent in the first quarter this year after being stuck in neutral for most of a three-year international bailout, triggered by the banking crash that saw some lenders fail and most others pushed into state hands.
The bank's net interest margin - an important measure of profits from lending, that grew sharply last year - rose a touch to 2.05 percent and was expected to keep rising, chief executive Richie Boucher said.
"Even in the darkest times, I always believed that Ireland would recover, the bank would recover. We've a new set of challenges and opportunities but I'm seeing momentum in the businesses," Boucher told reporters.
"It's a classic recovery driven by exports, consumption and coming through in domestic confidence and employment levels. We have seen a pick in credit demand, defaulting has reduced, all pointing to a slow but broadly-based recovery in the economy."
Boucher said all businesses were now contributing to group profit and that credit demand in Ireland had improved notably in the second quarter as sectors hit hardest by the crisis, such as hospitality and construction, showed signs of life.
The sharp rise in car sales in the first half of the year - half of which Bank of Ireland provides finance for - represented a multi-year statement of confidence by consumers, chief financial officer Andrew Keating said.
The economic outlook in Britain, where Bank of Ireland has operations through a partnership with the country's post office network, also continued to improve.
The bank, which said in March it had been profitable at the start of the year, the first Irish lender to signal to do so, made an underlying pretax profit of 327 million euros ($437.8 million) versus a 395 million euro loss a year ago.
That was ahead of the 241 million forecast by six analysts surveyed by Reuters. The bank's shares were 1.5 percent higher at 0.27 euros by 0705 GMT.
Boucher will take a break this month to receive treatment for colon cancer and said on Friday that he felt invigorated about coming back to work in September.
Ahead of stress tests by the European Central Bank later this year, the bank's core Tier 1 capital ratio, a measure of financial strength, rose to 13.2 percent and it said it expected to continue to generate capital.
"While the return to profitability was well flagged, the organic capital generation is stronger than we anticipated. The substantial increase in new lending flows in Ireland and UK are also very positive," Davy Stockbrokers analyst Diarmaid Sheridan said.
"The results across the sector are stronger than we would have expected."
But like other national lenders, Bank of Ireland's net loan book contracted further, to 83 billion euros in the six months to June, as repayments still outweigh drawdowns. The bank said it was confident the pace of reduction would continue to slow.
AIB, still 99.8 percent state-owned and whose rescue cost taxpayers more than 20 billion euros - more than four times Bank of Ireland's, said on Wednesday that growing its loan book was the major challenge to keep momentum building.
Bank of Ireland, which has to cut its reliance on the state to leave Dublin with only a 14-percent stake, said bad loan charges would also keep trending down after falling by over 40 percent to 444 million euros in the first half.
Its proportion of homeowners in arrears for more than 90 days fell again to 7.0 percent, from 7.4 percent in June, the lowest in the industry, while buy-to-let mortgage arrears rose to 18.5 percent but neared stabilisation, the bank said. (Editing by Louise Ireland)