DUBLIN, NOV 11 - Bank of Ireland said on Friday its deposits rose 3 percent in the four months to end-October, improving its funding position, although the country's largest lender said trading was still tough.

The bank said its profit margins should stabilise in the second half versus the first, but further margin recovery would face headwinds in a prolonged period of low interest rates.

We have made good progress on restructuring and strengthening our balance sheet, nevertheless trading conditions remain challenging, the bank said in a statement.

Continued intense competition for deposits in the Irish market, the elevated cost of wholesale funding pending further deleveraging of the balance sheet, along with the high cost of the Government guarantee have maintained ongoing pressure on the group's cost of funding.

Shares in the bank, which traded at almost 10 euros at the height of Ireland's Celtic Tiger economy four years ago, were 5.8 percent higher at 0.09 euros by 1330 GMT.

The sole domestic lender to avoid falling into state hands following fresh investment in July, Bank of Ireland is one of only two Irish banks to have so far refused to bow to political pressure and pass on European Central Bank (ECB) interest rate cuts.

Ireland's bank chiefs were hauled in front of Ireland prime minister this week over their refusal to pass on the ECB's recent 25 basis point rate cut and the government has threatened to pass legislation forcing them do so.

However, local lenders have been increasing rates on standard variable mortgages to compensate for losses on tracker mortgages that automatically follow changes in the ECB rate. Such tracker products account for over half of all Irish mortgages and are a strain on the banks due to their high cost of funding and the low ECB rate.

Bank of Ireland also partly blamed another politicised issue -- the speculation over potential wide ranging measures to tackle home loan arrears -- for further deterioration in the arrears of its Irish mortgage book in August and September.

SOLID STATEMENT

Ireland has pledged to shrink radically its domestic banking sector after a disastrous binge on property loans, and Bank of Ireland has to sell 10 billion euros in loans and accept repayment of another 20 billion euros worth by the end of 2013.

After announcing last month that it had sold or accepted repayment of 5 billion euros (4.34 billion pounds) of loans, the bank said on Friday that it was in advanced talks on further sales.

Its loan to deposit ratio has improved by 9 percentage points to 153 percent since the end of June as a result of the deleveraging and a rise in its Irish and UK deposit book to 67 billion euros from 65 billion at end-June.

The June figure included 3 billion euros of deposits temporarily placed with the bank by the country's debt agency and withdrawn in July in line with the 3.85 billion euros capital the bank has raised this year.

The deleveraging was also reflected in a reduction of around 10 percent in wholesale funding from 61 billion euros at the end of June that the bank said included a significant reduction in drawings from monetary authorities.

Deposits at banks servicing the domestic economy are down nearly 150 billion euros from Oct 2010, the month before Ireland entered an EU-IMF bailout and the sector is still dependent on funding from the European Central Bank and Irish central bank.

Irish-based banks' reliance on emergency funding from the European Central Bank (ECB) and Ireland's central bank fell to 148.6 billion euros at the end of October from 153.6 billion euros the previous month, data on Friday showed.

Ireland's other bailed-out banks have also seen deposits rise for two straight months in August and September, the latest central bank data showed.

Against the background of uncertainty, this is a solid statement showing that Bank of Ireland is making good progress in restructuring its balance sheet, Emer Lang, analyst at Davy Stockbrokers, wrote in a note.

News that asset quality overall remains broadly in line with expectations is encouraging, although the bank cautions that its Irish residential mortgage book and commercial real estate markets are issues.

Bank of Ireland added that it had a core tier one ratio, a key measure of financial strength, in excess of 15 percent and reiterated its expectation that total impairment charges had peaked and will reduce.

The pace of that reduction though will be dependent on the future performance of its Irish residential mortgage book and commercial real estate markets, the bank said.

(Reporting by Padraic Halpin; Editing by Jon Loades-Carter. Editing by Jane Merriman)