UK banks facing toughest conditions since 1990s

Britain's banks and building societies are facing their toughest conditions since the early 1990s and should prepare for the environment to remain tough for the foreseeable future, the financial watchdog said yesterday.

In its annual Financial Risk Outlook, the Financial Services Authority said market turmoil in the second half of last year had raised fundamental questions about some banks' business models and warned that restricted access to some types of funding could force them to shrink their mortgage businesses.

Britain's banking sector was rocked last September by the near-collapse of number five mortgage lender Northern Rock, whose dependence on capital markets to support lending left it high and dry after the summer's credit crunch and forced it to turn to the Bank of England for emergency funds.

The FSA, which has come under fire for its role in the Northern Rock saga, also warned that tighter lending standards would add to pressure on indebted consumers.

"We therefore expect to see a growing number of consumers experiencing debt-repayment problems this year," it said.

It also warned that, with financial firms under pressure to generate returns in a tougher environment, there could be a rise in high-risk activities taking place without full assessments - and an increase in financial crime.

The FSA also warned that a drop in UK commercial property prices could mean impairment charges for banks this year.

In last year's outlook, when the economy still looked set for a fifth straight year of growth, the FSA, among other priorities, told firms to test "extreme-risk scenarios" and alerted the market to the danger of illiquid financial instruments - both borne out in the last 12 months.

In its 2008 report the FSA warned of a "less benign environment" and said financial markets could be more vulnerable to external shocks, with the impact on firms bigger than in previous years.

"The operating environment for firms remains difficult and it is likely these conditions will persist, particularly if investor confidence in some markets and financial institutions remains low," the FSA said.