Lloyds Banking Group stunned the City today after warning of £10 billion in annual losses at struggling HBOS.
The announcement by Lloyds - which rescued HBOS at the height of the financial turmoil last autumn - sent shockwaves through markets.
The taxpayer, which owns 43 per cent of the bank, was left with paper losses of more than £2.5 billion at one stage as Lloyds' shares tumbled up to 40 per cent within minutes of the announcement. They closed the day down more than 30 per cent.
Lloyds said HBOS's assets had been hit by falling markets and announced £7 billion in writedowns at HBOS's corporate division - around £1.6 billion higher than it expected last November.
This follows a "more conservative" assessment of HBOS's corporate division, which is heavily exposed to hard-hit housing and commercial property sectors.
Lloyds chief executive Eric Daniels said: "HBOS's 2008 results have been adversely affected by the impact of market dislocation, which accelerated significantly in the last quarter of 2008, and the additional impairments required on the HBOS corporate lending portfolios."
The massive losses at HBOS throws a fresh spotlight on the handling of risk at the bank.
This week Sir James Crosby - a former HBOS chief executive - resigned as deputy chairman of the Financial Services Authority (FSA) over claims he sacked a head of risk for warning the bank was "going too fast". Sir James denies the allegations.
Mr Daniels added the losses "primarily reflect the application of a more conservative recognition of risk and the further deterioration in the economic environment".
HBOS's financial pain contrasts with the £5.71 billion in underlying profits which the bank made for 2007.
But market confidence in HBOS collapsed last autumn and the Government waived competition rules to allow the bank to be taken over by Lloyds TSB, creating a UK "super-bank".
The taxpayer has pumped a total of £17 billion into the two banks to shore up their balance sheets.
Despite the surprise warning today, Mr Daniels said the group had a capital position "significantly in excess" of its regulatory requirements.
He added that Lloyds TSB will make pre-tax profits of around £1.3 billion for 2008.
He said: "Whilst we recognise that the short-term outlook is more challenging, Lloyds Banking Group has the largest UK financial services franchise, with excellent long-term earnings potential."
The warning over HBOS comes a month after Royal Bank of Scotland, which is 68 per cent owned by the taxpayer, warned of annual losses of up to £28 billion.
RBS's huge slump into the red has been caused by a sharp rise in bad debts and a writedown of up to £20 billion on its disastrous acquisition of Dutch bank ABN Amro at the top of the market in 2007.
RBS shares also plunged more than 17 per cent in the wake of the Lloyds warning, leaving taxpayers more than £1 billion down at one stage.
But Barclays - which has received no support from public funds so far - earlier this week posted pre-tax profits of £6.14 billion for 2008, down just 14 per cent on 2007 and better than expected by the City.