Banks have characterised this year�s trading conditions as the most difficult they have faced for decades.

Tim Gibbens

Banks have characterised this year's trading conditions as the most difficult they have faced for decades. In the United States, the bankruptcy of Lehman Brothers, the fourth-largest investment bank, the $85bn bail-out of global insurance giant AIG, Bank of America's $50bn bid for Merrill Lynch and yet more Fed action to supply liquidity to the market to ward off systemic risk, highlighted just how tough things still are.

In particular, the fact the US authorities were prepared to allow Lehmans to go under, after engineering the rescue of Bear Stearns by JP Morgan Chase in March, has sent further shockwaves across markets. By early September, the sharp downturn in the US housing market and the resulting credit crunch had already triggered more than $500bn (around £280bn) of write-offs for financial sector companies worldwide.

Despite UK banks collectively raising over £20bn in fresh funds so far, their capital ratios still appear low compared with those of their European, North American and Asian peers.

The banks that seem best positioned in this environment are those with strong capital and liquidity positions such as HSBC. In contrast, banks with high ratios of loans to deposits are relatively dependent on expensive wholesale funding. The nationalisation of Northern Rock, the agreed offer for HBOS from Lloyds TSB, and the takeover of Alliance & Leicester by Banco Santander show the pressure this has exerted on the mortgage banks in particular. Alternative means of repairing balance sheets could include slower loan growth, selective disposals, reduced share buybacks or dividend cuts.

More than ever, there is uncertainty over the extent of banks' future write-downs and whether they will need to raise further capital. To bolster margins, banks have raised the price of loans and this has restrained loan growth, particularly in the residential mortgage market. The resultant macro slowdown is already leading to credit quality deterioration, but the question is: how bad will things get?

While the Bank of England has also taken various measures to increase liquidity in the markets, further interest rate cuts could be slow in coming as long as inflation remains at elevated levels.

Besides, it is debatable how effective such rate cuts actually are as they fail to deal with the underlying problem, namely the banks' basic reluctance or inability to extend credit.

While several banks are highly exposed to the slowing UK economy, HSBC and Standard Chartered have a strong presence in Asia, a region relatively unaffected by the credit crunch thus far. However, if the US slowdown were particularly severe, Asia would certainly not be immune because of its reliance on exports to the US.

The key to an improvement in current conditions is undoubtedly a stabilisation of the US housing market. The dramatic move that effectively nationalised Fannie Mae and Freddie Mac should help in this regard. These GSEs, or Government Sponsored Enterprises, together own or guarantee about half of the US mortgage market, so the government's bail-out should lower their funding costs, in turn feeding through to lower mortgage rates. However, due to a deep-rooted imbalance between demand and supply, the US housing market is still not likely to stabilise until some time in 2009.

While credit quality will continue to deteriorate in the UK, defaults are not expected to rise to the levels of the early 90s because of a relatively high level of employment and low, stable interest rates.

The business areas of most risk would appear to be specialist mortgage markets such as buy-to-let and corporate loans (particularly commercial property, where several banks have increased their exposure, but where prices continue to fall).

Although the crisis has not yet ended, valuations among the UK banks are now attractive, especially on a long-term basis. Most banks are trading on single-digit P/E multiples and at, or near, book value. Returns on equity are expected to be lower going forward because of continued deleveraging, although this fall in returns is arguably already discounted in valuations.

Although banks' dividend yields are at historic highs, in some cases, this may simply reflect market expectations of future dividend cuts.

When conditions eventually do stabilise, banking stocks are likely to experience a sharp bounce, but it may be short-lived.

Tough fundamentals such as a mature UK economy, increased competition and still-stretched capital positions will soon reassert themselves.

Tim Gibbens, Alliance Trust Global Financials analyst