Britain's banks may need to raise capital above and beyond the £50 billion of taxpayer-underwritten money already earmarked for them.

The Bank of England's report into financial stability today suggests that a recession as severe as that of the early 1990s would lead to credit losses of £130 billion for Britain's six biggest financial institutions and possibly wipe out the entire government-backed funding package.

The losses were predicted for the country's five biggest banks and the Nationwide Building Society if mortgage arrears and business failures rise as high as in the last recession.

In its twice-yearly Financial Stability Report, the Bank said that the stress-test was a severe but plausible scenario. It omitted to stress-test the banks in a more extreme downturn. However, the implication is that the banks would have to raise even more capital, possibly from the Government, in the event of a sharper downturn.

Yesterday the banks were the worst-performing sector in the FTSE100, losing more than 4 per cent as the blue-chip index fell to its lowest since April 2003. The FTSE 100 closed down 30.77 points, or 0.8 per cent, at 3852.59, after healthy trading in defensive stocks offset falls in bank shares.

Howard Wheeldon, senior strategist at BGC Partners, the spread-betting firm, said that investors were waiting for the bailout cash to be passed on to the banks and into the wider economy. “We're in a black hole of transition at the moment,” he said. “It's chronic uncertainty.”

The Bank of England concluded in its report that the initial response to the bailout was encouraging but gave warning to the market that risks to financial stability lingered. It flagged up hedge funds, insurance companies and emerging market economies as three areas of potential concern. Sir John Gieve, the Bank's deputy governor for financial stability, said: “The financial system remains under strain.”

Aviva was the steepest faller in the insurance sector as shareholders waited for reassurance from Britain's biggest insurer, which announces third-quarter figures today, on its capital buffer. Aviva has lost almost 45 per cent of its value since October14, closing at 245.25p yesterday, over fears of defaults in the insurer's £25.6 billion portfolio of corporate bonds could force it to raise more capital.

An analyst said: “Aviva's already told us that it's got surplus of £1.9 billion but they didn't give us the full details, such as its sensitivity to corporate defaults ... It's the unknown elements that people are worried about.”

The central bank and the Financial Services Authority (FSA) are known to be watching the insurance sector carefully for signs of difficulty. In its report yesterday the Bank said that insurers had lower leverage and longer-term liabilities than banks and hedge funds, making it easier for insurers to avoid problems with their liquidity. However, the Bank said that if insurers were downgraded by the ratings agencies, counterparties to their derivatives trades could hit the insurers with margin calls, forcing them to find much more ready cash.

At 5pm yesterday the pound was worth $1.5539, down by more than 3 cents from Friday, as forex traders continued to speculate that Britain would be among the worst hit in a global recession. Investors are also nervous about the UK's exposure to Hungary and Ukraine, which are being given emergency loans by the International Monetary Fund.

In its stress testing the Bank assumed that mortgage arrears would grow from 1.3 per cent to 4.4 per cent and company failures rise from 0.6 per cent to 1.7 per cent — a level of stress similar to the recession of the early Nineties.

The Bank also revealed that UK-supervised banks have suffered mark-to-market losses running at £10billion a month in the past six months. Since its last FSR, UK losses have ballooned from £62.7billion to £122.6billion, it said. Worldwide, losses had more than doubled to $2.8trillion, it said.

The instability of the past few weeks had been the most severe in living memory, Sir John said. “And with a global economic downturn under way, the financial system remains under strain.” But he added that the financial system was better placed as a result of the exceptional package of capital, guaranteed funding and liquidity support announced in the past weeks by world governments.

Addressing the longer-term credit crunch issues, the Bank said that banks would need to grow their deposit bases to make them less reliant on wholesale funding and would need to hold a larger buffer of liquid assets.

It also proposed Spanish-style “dynamic provisioning” — where banks set aside large pools of bad debt provisions in benign years that can be drawn down in the bad years. That might help to counteract the pro-cyclical nature of capitalism, which led banks to overexpand in the good times and retrench too sharply in bad times.

“Over time against the backdrop of an economic downturn, banks will need to adjust their balance sheets and funding models, weaning themselves off current high levels of official sector support,” the Bank said. “Lending growth is likely to remain slower than in recent years.”

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