Investors in HBOS endured another grim session yesterday as the UK stock market lurched still lower and interbank lending markets seized up, and international agencies Standard & Poor's and Fitch added to the Edinburgh-based bank's woes by cutting its credit ratings.

The UK's FTSE-100 index of leading shares plummeted another 178.6 points to 5025.6 yesterday, its lowest close since June 9, 2005. It fell below 5000 points during the session, dropping as far as 4961.2 points. Fears that the collapse of venerable Wall Street institution Lehman Brothers and the financial woes of giant US insurer American International Group will trigger a fresh multi-billion-pound wave of asset writedowns by the big banks, and necessitate further capital-raising in this sector, hung like a dark cloud over proceedings.

Philip Milburn, investment manager at Edinburgh-based Aegon Asset Management, warned any failure of AIG would have much greater fall-out than Lehman's collapse.

Noting AIG was a huge player in credit default swap (CDS) insurance, cover which underpins banks' valuations of their assets, Milburn said: "If AIG goes, all these people who thought they had protection don't."

He pointed out AIG had assets of more than $1 trillion, and believed roughly half of these could end up on the market if AIG were allowed to fail. Noting Lehman had assets of more than $600bn, Milburn added: "We have potentially $1 trillion of assets going to hit the street."

The US stock market rallied last night on hopes the American authorities would pull together a loan package for AIG, which has been thrown a $20bn lifeline by the New York State.

Shares in Bank of Scotland and Halifax parent HBOS tumbled a further 50.5p or nearly 22% to 182p, wiping another £2.7bn off its stock market worth.

HBOS shares, which dropped by 18% on Monday, were down a further 41% at one stage during yesterday's session. Their intra-day low yesterday of 137.4p was less than half of the 275p-a- share price of HBOS's £4bn summer rights issue.

In the first quarter of 2007, HBOS was hitting highs close to 1200p.

HBOS was hit hard again yesterday because of its reliance on wholesale credit markets to raise a substantial portion of the funds which it lends on to its customers.

Interbank lending rates leapt yesterday.

The British Bankers' Association's London Interbank Offered Rate for overnight sterling rocketed from 5.49375% on Monday to 6.79375% yesterday - the highest since April 2001 and thus exceeding anything seen when UK mortgage bank Northern Rock was failing. This is in spite of the fact that UK base rates have been cut by three-quarters of a point, to 5%, since the revelation last September that Northern Rock had got into trouble.

Three-month sterling LIBOR jumped from 5.715% to 5.79125%. The LIBOR rate for overnight dollars meanwhile more than doubled from 3.10625% to 6.4375% - more than three times the US Federal Reserve's benchmark 2% Fed funds rate.

Milburn said of the interbank lending market: "If you want money, you are going to have to pay for it because people are scared. People are terrified."

In a statement to the stock market at 3.08pm yesterday, HBOS said: "HBOS notes the current volatility in bank share prices following developments in the United States. HBOS has a strong capital base and continues to fund very satisfactorily."

The FSA took the unusual step of adding its reassurance.

An FSA spokeswoman told The Herald: "We can confirm that, as HBOS has already stated, it has a strong capital base and continues to fund satisfactorily."

Standard & Poor's yesterday cut its long-term counterparty credit rating on HBOS from AA- to A+.

S&P credit analyst Nigel Greenwood said: "The rating action reflects Standard & Poor's opinion that HBOS's financial profile is less well positioned to manage the deteriorating operating environment than AA' rated global peers "The main differentiating factor in our view is credit risk. This reflects the sizeable role for both specialist and high loan-to-value mortgages in HBOS's UK mortgage book and its weaker-profile corporate book. We also note that earnings may be constrained by higher funding costs given that HBOS is less well-positioned."

S&P said: "HBOS's ratio of total loans to customer deposits, 178% at June 30, 2008, is higher than many similar-rated peers. Earnings will also be affected by weaknesses in its corporate investment portfolio, and further credit market-related write-downs, which cannot be ruled out, add to this pressure."

Fitch downgraded HBOS's long-term issuer default ratings from AA+ to AA, and said the outlook remained negative.

Fitch said: "The downgrade reflects heightened concerns over the outlook for core parts of HBOS's retail banking (eg mortgage portfolios) and corporate banking (eg property-related exposures) divisions as the UK economy and property markets weaken."

An HBOS spokesman said of the downgrades: "It is a fact of life in the current very difficult market conditions. We continue to have an exceptionally strong credit rating."

Royal Bank of Scotland was hit hard yesterday, although again it fell less sharply than HBOS.

Shares in Royal shed 21.4p or 10.1% to 189.1p. Barclays ended down another 2.5% at 208p, although Lloyds TSB bucked the trend with a 6p or 2% rise to 279.75p on rumours of stakebuilding by a Chinese bank.

Diane Wilde, fund manager at Barclays Wealth in Glasgow, was surprised the UK banking sector fell only 4% in the quarter to August given the wider UK All-Share Index dropped 6%.

Wilde, who remains negative on banking stocks, said of the financial sector shake-out: "It feels very messy and yet no-one thought it would be this messy. Everyone kept trying to discount the story and say everything is okay. There will be a couple of crimson-faced fund managers around."