Shares of London Scottish Bank (LSB) plunged almost 20 per cent in early morning trading after the small finance house and debt collector issued a profit and dividend warning. By mid-morning, the shares were down 17.86 per cent at 62.98p

The group said it was in discussions with the Financial Services Authority over its capital base, that it would falll into loss this year and may be unable to pay the final dividend.

It said some low-income customers had been unable to repay loans and it would have to add a further £22 million to cover bad debts in the year ending October 31.

Discussions with the FSA will begin this week on how to address the shortfall of regulatory capital, which will stand at £13 million as of January 1.

The customer arrears means the lender is no longer holding the required amount of regulatory capital under new international banking rules due to come into effect in the new year.

LSB now expects a pre-tax loss of about £4 million to £5 million for the year. Analysts were looking for underlying profits of about £17 million. That loss could swell to over £17 million if an interim one-off charge, relating to the company's broking arm, is also taken into account.

In a statement, LSB said it believed the bank continued to have strong balance sheet and was in compliance with all the convenants in its banking agreements.

The group said: "However until the company has remedied the shortfall....it may have to restrict new lending volumes and may be unable to pay a final dividend in respect of the year ended 31 October 2007."

LSB said it had been told by the City watchdog, the FSA, to adopt an interim Individual Capital Guidance (ICG) from January 1 2008, which will require it to hold more regulatory capital than needed under new Basel II laws until the FSA has set a formal limit.

The business offers loans to customers in the C, D and E socio-economic bands, which is equivalent to the sub-prime lending market in America whose failure to repay mortgages led to this summer's financial crisis.

LSB's troubles are one of the first indicators of potentially much deeper problems in Britain's own sub-prime sector, as low income customers get hit by rising interest rates and utility bills.

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