Panic as investment banks face pounds 1bn loss

City fall-out looms from obscure Budget measure Sterling remains buoyant Utilities recover

An obscure tax measure in the Budget could cost the City of London well over pounds 1bn, experts warned yesterday.

The potential losses facing some individual investment banks could reach hundreds of millions of pounds, although the exact figures will not be known until full details of the measures are published with next week's Finance Bill. The full extent of the blow emerged as the FTSE 100 index leapt to a new record yesterday. It ended more than 80 points higher at 4,831.7.

BZW is one of the banks thought to be especially vulnerable to big losses from the Chancellor's unexpected decision to close a tax loophole.

A BZW spokesman said: "We do not believe the Budget will have a material impact on Barclays or BZW's first-half earnings. However, based on our understanding of the situation, we do foresee some potential loss of future earnings.

"It is too early to evaluate the financial impact of the changes but the numbers being suggested, amounting to hundreds of millions of pounds, are unfounded and ridiculous."

BZW refused to comment on whether its losses were material or on rumours that it was poised to abandon its market-making altogether as a result of the hit from the Budget change.

"This would affect all the big banks. It could have a huge impact," said one leading analyst yesterday.

Other institutions said yesterday their losses as a result of the move would not be large, but the City was awash with rumours that one large market-maker was in serious financial trouble. The extent of the panic in the stock market was such that there were even unsubstantiated rumours of Bank of England involvement.

UBS denied it was one of the biggest victims. A spokesman said: "A final assessment cannot be made until we have seen the detailed provisions of the Finance Bill. But we do not expect it to have a material impact."

However, industry sources said UBS could still be very exposed. It is understood to be the biggest player in the market for the contracts backing guaranteed bonds issued by insurance companies, but most of the major banks are exposed to these.

"If the income from dividends falls by just 1 per cent it can have a devastating effect. Most of the contracts last for 10 years, so a bank's income could fall by at least 10 per cent. That could cost them hundreds of millions of pounds if not more," said one source yesterday.

The guaranteed bonds alone could cost the banking sector as a whole more than pounds 500m, according to the source.

The contracts with a host of building societies and insurance companies to provide guaranteed income bonds for their customers mean the banks have to create an income stream by investing in complicated futures and options.

The reduction in dividend income as a result of losing tax-exempt status will sharply cut the return the banks can expect to achieve. Many are exposed to potential losses on the derivatives trades.

Equities derivatives contracts are calculated on the old tax-free dividend basis. The income stream according to which they were originally priced has been sharply reduced by the end of the tax exemption.

The direct effect of the tax change will cost securities traders pounds 500m over four years, the Inland Revenue estimated yesterday. It said the move was designed to clamp down on a tax incentive for big investment banks to opt for dividends rather than trading profits.

Even without taking into account the huge indirect effects, it could lead to some institutions withdrawing from market-making. A Stock Exchange analysis last autumn showed the business was generally unprofitable.

John Whiting, a partner at Price Waterhouse, said: "This new move is flagged as blocking a loophole but the net effect is penal. Market-making is not very profitable, and this will make it even less so."

The Inland Revenue was contacted by several concerned banks yesterday, all seeking further clarification of the "tax leakage" measure.

The unexpected move, contained in a press notice issued after Gordon Brown's Budget on Wednesday, ends the tax exemption on dividends on shares held by dealers. From Budget day, dividends will be treated for tax purposes as part of their trading profits, and liable to tax.

This will yield pounds 500m directly by April 2001. However, indirect losses due to the Budget could be much greater.

"This could cost the banks up to pounds 1bn," Paul Wopshott, another partner with Price Waterhouse, one of the biggest accountancy firms in the UK, said yesterday.

Some traders will have contracts based on underlying dividend flows on shares they do not hold. Some analysts suggested this helped explain the surge in the stock market yesterday, as some banks rushed to buy the underlying shares, hedging this liability.

Anthony Rush, a senior manager at accountancy firm Coopers & Lybrand, said: "The measures introduced by the Chancellor fundamentally change the manner in which UK dividends in the hands of securities traders are treated."

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