Brown faces nightmare of pre-poll credit downgrade

S&P rates UK alongside Chile and Portugal because of weak economy and debt

Standard & Poor's yesterday issued its most strongly worded comments yet on the state of Britain's economy and banking system, raising the prospect of a credit downgrade just before the general election.

The loss of Britain's prized AAA rating would represent a serious blow to Gordon Brown in the lead-up to the vote and would almost certainly cause a run on the pound and a sharp increase in the cost of servicing Britain's enormous public-sector deficit.

Explaining its decision to drop Britain's banking system from Group 2 out of 10 to Group 3 – alongside the likes of Chile and Portugal – S&P said: "In our opinion, the weak UK economy will continue to hinder the credit profile of the UK banking industry. We believe this factor affects the profile of the UK banking system more than it influences the banking systems of most other major mature market economies in Europe and around the world, notably Canada, France, and Germany in BICRA Groups 1 and 2."

As yesterday's comments swept around the City the pound fell and the stock market lost ground as strong gains made by the banking sector in the morning session were rapidly reversed. Such a banking downgrade from S&P was the harbinger of a credit downgrade in Ireland, coming three months prior to the loss of the country's AAA rating. While Britain's economy has suffered less than its neighbour, that sets an alarming precedent, and its rating remains on "negative" outlook.

Contrary to what the banks have been saying, S&P said it believed that domestic bad debts would not peak until later this year and would remain at high levels throughout 2011. But the weak economy, it said, would hamper banks' ability to grow earnings to cushion them against this. S&P said the state bailouts of Lloyds and Royal Bank of Scotland badly damaged banks' reputation in Britain and not enough had been done to reform regulation.

"In our view, enhanced regulatory oversight and reform of the framework for financial stability remains incomplete," its report said.

The credit agency also gave a gloomy view of Britain's economy, saying: "We view UK economic risk to be high relative to other major, mature banking systems. This reflects the sharp decline in economic output and our expectation that the unwinding of the high level of debt (of the government, households, and certain industrial segments) will weigh heavily on relative economic growth prospects and banks' financial performance.

"We believe that it will be a number of years before these economic risks recede, and further near-term downside risk remains. Even then, we expect credit risk to remain somewhat higher in the UK relative to many comparable systems. This reflects the dynamics of the UK housing and mortgage markets, which in our view leads to boom and bust cycles in residential real estate, and a more volatile business cycle."

The FTSE 100 finished the day at 5145.7, down 71.7. The pound, which had been trading at$1.6236 just before the comments were released, swiftly fell to $1.6141, although it remained up against a weak euro.

In the banking sector Barclays, after touching a high of 281.8p on the day, closed down 1.9p at 264.95, while Lloyds Banking Group closed at 50.75, down 0.1p, after hitting a high of 52.8p. RBS, which had hit 34.24p, up 1.27p, closed at 32.57, down 0.42p. HSBC finished at 660p, down 3p, although its earnings mainly come from Asia, so such a report has much less impact on its shares.

S&P reiterated its warnings on the state of Britain's public finances, saying that public debt could reach 100 per cent of GDP by 2013 if action is not taken. "A government debt burden of that level, if sustained, would in Standard & Poor's view likely be incompatible with a 'AAA' rating."

Despite the recent surprise fall, S&P also forecast that unemployment will start rising again this year.