The British banking sector was thrown into fresh uncertainty yesterday as underwriters to the huge HBOS rights issue were faced with the prospect of being lumbered with £4 billion of unwanted shares.

Shares in Royal Bank of Scotland, Barclays and Alliance & Leicester, as well as HBOS, sank to levels not plumbed in at least eight years as London faced the possibility of the biggest equity capital flop since the BP fiasco of 1987.

The fresh alarm was triggered when HBOS shares dropped below the 275p price at which it plans to issue £4 billion worth of new stock in five weeks, closing at 258p, down 12 per cent.

Unless the share price recovers, the underwriters, Morgan Stanley and Dresdner Kleinwort, and sub-underwriters, will be forced to buy all the shares, leaving them with 29 per cent of the enlarged bank.

As the 275p price level was breached, HBOS issued a statement that the rights issue would go ahead on the present terms and insisted the underwriting agreement was bullet-proof.

Shane O'Riordain, the HBOS communications director, said: “This bank is not for turning. The reasons for the rights issue are as valid now as when we made the original announcement.”

Short-selling by hedge funds was blamed for some of the share price slide. The sub-underwriters, fearing a loss, may too have resorted to short-selling as a hedge, analysts said.

The collapse in housebuilder valuations may also have damaged sentiment.

HBOS has been an enthusiastic buyer of housebuilders, with stakes in Crest Nicholson, McCarthy & Stone, Cala, Keepmoat, Apollo, Miller and Tulloch and has loans outstanding to some of them.

HBOS added in a statement yesterday that current trading in general, and mortgage arrears in particular, were in line with its expectations, but declined to comment specifically on its housebuilder exposure.

Housebuilders blamed short-selling hedge funds for another day of plunging share prices.

Mark Clare, the chief executive of Barratt Developments, blamed short-sellers for forcing down his share price by as much as 42 per cent yesterday, after a 24 per cent decline on Tuesday.

Mr Clare said: “Nothing has changed since our last interim management statement [in May]. The only thing that has changed is that there are people out there for whom it may be in their interest to see share price falls. That attaches to short sellers.”

Fears that the current round of capital-raisings by UK banks will not be enough further hit their share prices.

Robin Geffen, the founder of Neptune Investment Management, said that banks had still owned up to only half of the $2 trillion of losses they have sustained.

“So the banks are on the first of at least two rights issues.”

Shares in RBS, which successfully raised £12 billion last Friday at 200p, sank 9 per cent to 212.25p yesterday, falling lower than at any time during its fund-raising period.

Sir Fred Goodwin, the chief executive, said it was “a great relief” the capital-raising was completed successfully, conceding there had been some nervous moments.

Barclays and Alliance & Leicester, which have so far announced no equity capital raisings, sank by 5 per cent and 8 per cent respectively.

One source close to HBOS said: “HBOS would rather be in the queue for capital than sweating on the sidelines.”

The Financial Services Authority, which is responsible for bank supervision, is understood to be monitoring closely the HBOS capital raising, which is designed to strengthen the bank's balance sheet.

HBOS is due to publish a prospectus and accompanying trading statement next week.

Shareholders, who include two million small investors, have until July 18 to put in applications.

The last time underwriters were faced with a multi-billion equity flop was 1987 when the stock market crash sent BP shares below the planned privatisation price, though the issue was resolved when the Kuwait Investment Office came in to mop up the unwanted stock.

Short-sellers, often hedge funds or proprietary traders in bank dealing rooms, aim to make money by betting on a particular company’s share price falling. There are four steps:

1. They borrow shares from other shareholders, usually for a very small fee, and sell them in the market (the proportion of company stock on loan gives a clue as to how heavily it is being targeted).

2. They wait, hoping that the share price will fall. Sometimes the wait is minutes, sometimes weeks, or very occasionally, years.

3. Then they buy the same number of shares in the market at the lower price and return them to the original lending shareholder.

4. They pocket as profit the difference between the proceeds from the shares they sold and the cost of the shares they bought later. If they guess wrong and the share price rises, they make a loss.

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