THE CITY watchdog will this week start to probe the financial strength of Britain’s building societies, in a move that could see some of the mutuals brought into the government’s banking-bailout scheme.

The extreme financial stress tests imposed upon Britain’s biggest banks last weekend by the Financial Services Authority (FSA) will be applied to the building societies and could force some of the 59 mutuals to raise more capital.

The government’s scheme allows for the state to invest in the societies through permanent interest-bearing shares and was designed with the help of Nationwide, Britain’s biggest building society.

Lloyds TSB, HBOS and Royal Bank of Scotland (RBS) are lobbying the government to soften some of the terms of the bailout – particularly a ban on paying dividends.

Although there is no fear that any society is in imminent danger of collapse, the sector’s financial strength is being probed in light of the recapitalisations of the banks.

The banks have all been forced to raise their Tier 1 capital ratios to more than 10% and their core Tier 1 ratios to more than 8%. The capital raisings were demanded by the FSA irrespective of whether the banks wanted to take advantage of the government’s assorted guarantees. The extent of the stress tests shocked the banks.

Some mutuals will fall short of those targets, though building societies may be judged on different criteria because of the nature of their capital structure. A handful of societies have been caught in Iceland’s banking crisis, to which the sector has a £200m exposure. The Chelsea said last week it had a £55m exposure to Iceland.

Building-society bosses contacted by The Sunday Times have been studying the government’s bailout documents. One said: “I have a Tier 1 capital ratio of 6%. I have stress-tested everything far more vigorously than the FSA ever will.”

The costs of the bailout scheme are still a source of tension between the government and Lloyds TSB, HBOS and RBS.

Britain’s bailout has proved far more expensive to the banking sector than any of the other schemes that have been announced around the world. The interest rates being demanded by the government and the charges being levied for guarantees are much higher than elsewhere.

The Treasury’s ban on banks paying dividends to shareholders for at least one year has proved particularly unpopular with the market, which says it discourages investors to support the attempted capital-raisings by the banks and could force the government to take up its full allocation of shares in all three banks.

On Friday night Germany indicated that it would cut the cost of guaranteeing wholesale funding on behalf of its banks. The 2-percentage-point charge is now expected to fall closer to the 0.75-percentage-point fee in America. The costs for UK banks are variable for each bank but are working out at about 1.5 percentage points.

The banks are attempting to use the German climbdown, coupled with the more favourable terms being offered elsewhere in the world, to force a u-turn on the dividend issue.

Industry sources believe that if the share prices of Lloyds TSB and HBOS come under more pressure before their merger can be completed the Treasury may be forced to soften its stance.

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