British banks may face second credit crunch in the New Year

The worsening economic slowdown is increasing fears that Britain's banks will have to raise still more capital next year in a market starved of investors.

Investment bankers are preparing for a second round of capital raising by UK lenders on top of the £65bn already declared. Having rebuilt their balance sheets after toxic debt writedowns, the banks face an increasingly dire economic outlook that threatens to take ordinary loan impairments from individuals and businesses to levels not seen since the early 1990s.

Under those worst-case conditions, impairment charges at the domestic banks – Barclays, Royal Bank of Scotland and the combined Lloyds Banking Group – could hit £60bn next year, according to Credit Suisse analysts.

"There could be a second credit crunch for banks, with a whole new round of writedowns late in 2009 as the economy filters back to banks," a senior investment banker said. "They have so far only provisioned for the credit crunch – so they will need to undertake a whole new round of capital raising."

A trading update earlier this year from HBOS, which will be bought by Lloyds next month, made grim reading for the sector. Impairments from commercial and residential property shot up, and the bank warned of more bad news to come as unemployment, the biggest driver of bad debts, continues to rise.

The economy is slowing faster than expected, official figures showed last week, with the key services sector suffering most. The authorities fear a continuing spiral of economic pain as a lack of credit forces businesses and individuals into bankruptcy, triggering further losses for banks and still tighter credit availability.

The Governor of the Bank of England has said getting banks lending is the most important task for combating the recession and has not ruled out full nationalisation of the sector. Some industry analysts believe the Government could be forced to move early in the new year to enforce a further capital raising, this time to shore up credit for an economy moving sharply into reverse.

But with cash in short supply the banks will struggle to raise the funds. Royal Bank of Scotland's share offer failed last month despite its deep discount, leaving the Government owning almost 58 per cent of Britain's second-biggest bank.

Barclays turned to sovereign wealth funds for its recent £7bn capital raising because it did not believe institutional investors had the appetite to provide funds. But sovereign wealth funds are either less willing to provide cash to the sector as the economic downturn spreads to markets like Dubai, India and China, or are determined to extract a high price for their support, as Abu Dhabi and Qatar did with Barclays.

The UK authorities have not ruled out taking further stakes in the banks or even full nationalisation. The Government's holdings already include all of Northern Rock and a majority stake in RBS, and it is set to own more than 40 per cent of Lloyds Banking Group.

If the state is reluctant to spend more, the banks might have to turn to private equity, which has billions to invest but no access to the leveraged loans it traditionally uses to maximise returns.

The banks could try to head off that outcome by encouraging restructurings at businesses struggling to repay their debt, rather than letting them go bankrupt and crystallising losses. This would lead to a slew of debt-for-equity swaps and leave swathes of the economy owned by the banks. "A lot of banks have been looking at debt for equity swaps because new money is harder to come by than equitising a company's historic debt," a leading corporate lawyer said.