City set to slash full-year forecasts for banking sector

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The Independent Online

Full-year earnings forecasts for Britain's banks are set to be downgraded, analysts warned yesterday, as the sector began to try to make sense of the credit crunch and its long-term effects.

Some analysts see earnings downgrades as inevitable after a month in which wholesale funding prices rocketed and the corporate debt market seized up.

"It's something I'm conscious I've got to do," one analyst said.

Britain's banks have prospered in recent years amid a credit boom in retail and corporate banking. Retail banking has got tougher as interest rates have squeezed heavily indebted consumers, and now the panic in the debt markets has stalled the corporate credit bonanza.

The turmoil started in the US, where defaults rocketed on sub-prime mortgages lent to people with little chance of repaying. The panic spread because these mortgages had been packaged up as bonds and sold round the world, and this caused investors to reassess their approach to risk and run scared from complex debt products that had boomed in recent years.

No one is predicting a rout similar to the early 1990s, when Barclays, Midland and others were rocked by huge bad debts. But the markets' adjustment to the new reality will make it harder for banks to make money on many fronts.

"While it is feasible that conditions will settle in the near term, a return to pre-July conditions which were very favourable to the banks will take a lot longer," said another analyst.

Barclays and Royal Bank of Scotland, with their debt powerhouses, are the banks most exposed to the drying up of the corporate credit market. At interim results presentations this month, both banks pointed to the diversity of their businesses, with RBS saying a pickup in foreign exchange had helped offset weaker fees from loan syndication.

But some analysts doubt other businesses can fully make up for the reduction in huge fees the banks made from underwriting and syndicating corporate debt.

Bank shares have been on a roller-coaster in the past few weeks as investors have panicked about the short-term fallout from the credit crunch. But analysts say there will be long-term fundamental effects that will bring the growth bonanza of the past few years to an end.

Even assuming the market settles down, the cost of funding in wholesale markets is likely to stay higher, crunching margins and limiting asset growth, particularly for smaller lenders such as Northern Rock and Bradford & Bingley. The former raised the cost of its sub-prime mortgages by up to 1.25 percentage points yesterday, following increases in the cost of funding such lending.

For the big banks, fee revenue from corporate and investment banking will be squeezed as debt-financed mergers and acquisitions slow down, and they may struggle to sell private equity investments, which have been major contributors to recent earnings.

Another avenue of growth that may be cut off is banks' activities in the asset-backed commercial paper (ABCP) market. The UK's big banks have set up funds that sell ABCP, which is cheap short-term debt, and then use the money to invest in long-term higher-yielding assets. But with investors wary of any debt linked to losses in the sub-prime mortgage market, the market for commercial paper has dried up. With investors demanding higher returns to invest in ABCP, banks may be forced to fund these investment vehicles themselves, as HBOS decided to do on Tuesday with its huge Grampian ABCP conduit.

Jitters over these funds continued yesterday as Standard Chartered became the latest bank to bear the brunt of investor nerves. The Asia-focused lender's shares dropped almost 5 per cent, making it the biggest faller on the FTSE 100, on concerns about how exposed it was to its $18bn (£8.9bn) Whistlejacket structured investment vehicle. But the company said the fund was conservatively managed and that, unlike some similar funds at other banks, the group's responsibility for its funding was limited.

The financial world returns to work on Tuesday. Bob Diamond, the head of the Barclays Capital investment bank, and others have predicted that with the financial world back at its desks deals will start up and market sentiment will ease in the early autumn.