The market punished A&L for announcing underlying operating profits of pounds 455m, at the bottom end of the range of analysts' expectations. Most had been expecting nearer pounds 470m and rival banks have reported higher- than-expected profits.
Traders were also annoyed by a fall in A&L's profit margins, affected by a price war in the mortgage market. A&L has sought to grab market share by offering competitive mortgage rates and keeping a tight rein on credit.
While the strategy has succeeded, boosting market share from 3.4 to 4.2 per cent, analysts were surprised to see profit margins shrink to less than 3 per cent.
Shares in Alliance & Leicester dropped from 891p to 840.5p, wiping pounds 127 from the value of the average retail investor's holding, now worth pounds 2,100.
Richard Pym, finance director of A&L, said the company would return the surplus capital to shareholders by buying its own shares in the market after April, whenever it judges the action would increase earnings per share.
Mr Pym said the bank decided against a special dividend paid direct to shareholders. "That would give the money back to some shareholders who didn't want it - it could throw some shareholders into a higher tax band," he said.
He disappointed the market by adding that the group would not necessarily spend the entire pounds 740m it held in surplus capital, and could spread the buyback over as much as three years.
The move follows recent returns of capital announced by Halifax, which is passing pounds 1.5bn back to shareholders by changing its capital structure, and the Woolwich.
Yesterday some analysts questioned whether the mortgage bank's one million retail shareholders would benefit from the mooted buyback, which may have little impact on the value of their windfalls.
A year ago, Halifax announced a pounds 1bn return of capital using the same method that A&L is proposing to use. In the year since then, its share price has fallen from over 950p to 767p yesterday.
However, others welcomed the move. Gavin Oldham, managing director of the Share Centre, a retail broker, said: "The excess capital hasn't been working for the shareholders and it has effectively been diluting the earnings per share. And if the company doesn't have the luxury of the excess capital it will wake up to the business challenges."
Privately, industry observers believe the recent spate of returns of capital could stem from a growing fear that the Government could introduce a new windfall tax on the "excess profits" of banks. Many bank executives remember a similar tax levied on banks in the mid-1980s, when they were judged to have made excess profits because of high interest rates used to curb inflation.
However, Don Cruikshank, appointed by Gordon Brown, the Chancellor, to run the Government's banking review, has indicated that a windfall tax on banks was unlikely to form part of his recommendations.
Separately, Mr Pym said the bank was planning cost cuts which would entail job losses but refused to say how many of the bank's 7,000 staff would be affected.