Northern Rock, the state-owned mortgage lender, said trading conditions had continued to improve ahead of its split into a "good bank" and "bad bank" before the end of the year.

The lender, which was nationalised after it was forced to seek £26 billion in emergency funding from the Bank of England in September 2007, said that in the three months to the end of September, its net income had increased, costs had remained under control and there were lower losses from bad loans being written off.

Gary Hoffman, chief executive of Northern Rock, said: "Financial performance in the second half of the year is expected to show a significant improvement on the first six months. I am encouraged by the improving financial performance of the company. Today's results demonstrate that we are continuing to make good progress."

However, he warned that he bank would still be loss-making for the whole of the year because "conditions in the mortgage and housing market remain subdued and the company remains cautious as to the medium-term outlook, given rising levels of unemployment and weakness in the wider economy."

The European Commission's approval of state aid from the Government will release a further £445 million loan to Northern Rock further reducing its full-year losses.

The bank said fewer of its mortgage customers were now falling into arrears.

Although the numbers more than three months behind on their payments rose from 3.92 per cent to 4.11 per cent in the quarter, the rate of increase was smaller than previous quarters. Its stock of unsold repossessed homes halved from a peak of 4,201 in September last year to 2,193 at the end of September this year.

Mortgage lending during the quarter accelerated to £1 billion compared with £1.3 billion lent over the first six months of the year. It said the quality of loans remained high with the average loan-to-value ratio of new loans at a safe 55 per cent. The newly separated Northern Rock plc will increase total mortgage lending next year towards a target of £9 billion.

Its customer deposits rose in the quarter from July to the end of September from £18.4 billion to £19 billion, helped partly by the Government guarantee that protects customer deposits should Northern Rock go bust.

The Treasury and the Financial Services Authority, the City watchdog, will review whether to keep this guarantee in place once the split is complete. Customer deposits will go into the "good bank", or Northern Rock plc, which will be sold before the election and it has pledged to keep its total customer savings under £20 billion until 2011 as part of an EC agreement over its state support.

The bank still owes the Government £10.9 billion and Mr Hoffman said last month that it would take a decade before the money could be paid back.

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