Lloyds Banking Group is to incur £4.3bn of losses on loans to Ireland, the bailed-out bank admitted , in the latest evidence that problems inside the eurozone could have a dramatic impact on Britain's banks.

As Ireland's woes knocked currencies, stocks and bonds, the unexpected trading statement by Lloyds raised fears that Royal Bank of Scotland could also be facing rising losses in the debt-laden country.

The announcement came just hours after the ratings agency Moody's issued a savage downgrade of Ireland by five notches to just three levels above "junk status", meaning it will be regarded as even more risky by international investors.

Dietmar Hornung, vice-president of Moody's, blamed "increased uncertainty" about the economic outlook for Ireland and the cost of its rescuing its banking sector, which is absorbing much of the €85bn (£72bn) of aid from the International Monetary Fund and European Union.

The downgrade forced Ireland's cost of borrowing back up to 8.6% and widened the gap between the rate that Ireland and Germany can borrow at. Portuguese and Spanish spreads also widened against Germany amid continued fears of contagion inside the eurozone.

Win Thin, analyst at Brown Brothers Harriman, said: "While the Moody's downgrade of Ireland isn't any surprise, the sheer magnitude of five notches warrants a mention. We haven't seen anything like this since the Asian crisis."

In a further sign of the stress facing Ireland, the Bank of England announced a £10bn swap deal with the European Central Bank to provide sterling to the markets. The last time such agreements were signed was during the 2008 banking crisis.

The euro slumped to a two-week low against the dollar of about $1.3130, while sterling fell more than 1% against the dollar to $1.5454, its weakest since mid-September, after Lloyds' admission that it faced deeper losses in Ireland.

Analysts were racing to downgrade their forecasts for Lloyds. Marc Smart at Citi estimated the market would expect Lloyds profits for 2010 to be £2.2bn, compared with previous estimates of £3.5bn. "Lloyds have just effectively announced a profit warning," Smart said.

The banks shares, 42% owned by the taxpayer, slumped 3.5% to 66.5p but RBS was hit even harder, falling 5.7% to 37.8p, as its loan book in Ireland is twice as large as Lloyds and has not taken such severe impairment charges.

Lloyds blamed a "further significant deterioration in market conditions in the Republic of Ireland" since its last trading update in November for the warning about the repayment prospects for its £26.7bn of Irish loans. They are the legacy of Bank of Scotland (Ireland) – which Lloyds inherited when it rescued HBOS at the height of the banking crisis in September 2008. It is now closing down the unit.

The extent of Lloyds' problems in Ireland were laid bare as it admitted 90% of the £5bn or so of loans it granted to property developers in Ireland were "impaired" – or unlikely to be repaid. Of the £6bn it lent for property investment, 54% is impaired. After this £11bn of commercial real estate loans, the rest of its £26.7bn of loans in Ireland are split evenly between corporate customers and retail customers. Much of that retail lending is likely to be mortgages, which could cause yet more problems in the future.

"We are concerned that any economic recovery in the Republic of Ireland may take longer to achieve and that asset prices will remain depressed for longer, than previously anticipated," the bank warned.

"While the board will continue to review the status of the Irish portfolio as the group prepares its year-end accounts, it believes that the recent significant deterioration in the Irish market will affect the timing and level of value realisation from this portfolio."

The bank did not give details to enable comparisons with a year ago but said that compared with June it expected another 10% of the £26.7bn Irish portfolio to be impaired at the 2010 year end. It released a full-year impairment charge for Ireland for the first time of £4.3bn, compared with £1.5bn in the first half and about £1bn more than expected.

At the half year, it said £11.7bn of loans were impaired and that it had taken provisions for £4.9bn – or 42% – of these loans. The latest announcement refers to the provisions rising to 54% of the impaired loans which implies £7.8bn of Irish provisions.

Lloyds will formally announce the figures in its financial results on 25 February and just days before António Horta-Osório replaces Eric Daniels as chief executive.

The Bank of England warned that one of the vulnerabilities of the UK's banks was increasing turmoil inside the eurozone because, even though the banks were not directly exposed to sovereign debt, they faced exposure to companies and households.

Former chancellor Alistair Darling has called for a fresh round of stress tests, following ones earlier this year that had given Ireland's banks a clean bill of health. Darling urged the European commission to "urgently re-do these stress tests and do them properly". The EU's Jean-Claude Juncker, prime minister of Luxembourg and head of the eurozone group of finance ministers, speaking at a Brussels summit said the last stress tests "were credible but did not cover all the dimensions they could have covered".

www.guardian.co.uk/business/2010/dec/17/lloyds-banking-group-ireland-loan-losses/print

Dec. 17, 2010