Eurozone crisis plunges UK into second credit crunch

A second credit crunch is gripping the British economy as Europe's debt crisis sends bank funding costs soaring, the Bank of England warned today.

Its latest financial stability report said the woes besetting Europe's financial system are filtering through to Britain's banks, casting a cloud over the UK's flat-lining economic recovery.

With bank profits hit by billions in writedowns on the debts of struggling eurozone nations, its gloomy report warned: "There are early indications from market contacts that some banks may be starting to pass on higher funding costs to household and corporate customers through higher prices."

European banks are looking to slash their balance sheets by as much as €2trillion (£1.7 trillion) to bolster their financial position and withstand the sovereign debt storm but their action risks triggering an "adverse feedback loop", Governor Sir Mervyn King warned.

He said: "An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. That, in turn, will weaken banks' balance sheets further. This spiral is characteristic of a systemic crisis."

The warnings come a day after the Bank of England joined the Federal Reserve, the Bank of Japan, the European Central Bank, the Swiss National Bank and the Bank of Canada in offering to pump billions of dollars of loans into banks.

The emergency move is a bid to ease a growing crisis where US banks have been increasingly reluctant to lend to their peers in the eurozone because of the danger of defaults in the region.

The Governor is working with the Treasury and Financial Services Authority on a "range" of contingency plans for a worsening eurozone crisis which threatens to push the UK back into recession. He refused to discuss what form the plans would take but added: "There are many ways the future could play out. Maybe it won't break up, maybe it will continue in various forms, but maybe there will still be questions of default."

King called on UK banks to provide a bigger buffer against a worsening eurozone storm through slashing pay and dividends rather than starving the economy of much-needed credit.

King's ECB counterpart Mario Draghi added today that the 17 euro countries must co-ordinate budgets to avoid a repeat of the debt crisis. "Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term," he said.