The City regulator issued a warning to the high street banks yesterday that the "clouds were already darkening" and urged them to prepare for the impact of rising unemployment and the knock-on effect on bad debts.
The Financial Services Authority highlighted mortgages based on high multiples to income - as much as five times in some instances - and questioned whether sales of these products would be monitored properly.
Clive Briault, managing director of retail markets at the FSA, said: "While retail banks appear to have adequate financial resources today, the good times will not last forever - indeed, there is evidence that the clouds are already darkening and that banks need to prepare now for the potential storms ahead."
In a speech to the British Bankers' Association, he also urged them to conduct stress tests - essentially worse case planning scenarios - to assess the impact of a downturn in the housing market on the business. The regulator believes banks should consider the impact of a 40% fall in property prices and a 35% increase in the repossession rate on their business but stressed that it does not mean it expects such sharp movements to take place.
Mr Briault's comments came as banks were embroiled in a row over moves to end free banking. First Direct, the online and telephone bank owned by HSBC, is facing the prospect of a customer backlash after its decision to levy a £10 monthly fee on its current accounts. The controversial move affects about 200,000 customers who pay in less than £1,500 a month. To avoid the fee, these customers will either have to pay in more money or sign up for another First Direct product such as a credit card or mortgage.
Vince Cable, the Liberal Democrat Treasury spokesman, said it was "shocking" that the bank was targeting its charges at anyone who earned less than £24,000. He added: "This is an early sign that the banks are going to abandon free banking and impose charges for the use of a current account. This will create a further barrier to people on low incomes trying to use the banking system."
One theory is that HSBC is using First Direct to trial the fee-charging model. Other banks denied they were moving towards charging for current accounts, but the price comparison website uSwitch.com said it would not be surprised to see the changes made by First Direct becoming common practice across the industry.
Mr Briault warned banks of the risk to their reputations if large numbers of customers started to default on loans. Figures show increasing numbers of customers are applying for individual voluntary arrangements (IVAs) to control their debt repayments. "You will already be at least as familiar as I am with the levels of unsecured debt and the possibility that a relatively small change in economic circumstances could result in a large increase in the numbers facing significant difficulties in meeting their obligations," he told the bankers. "Even if this is not in itself a significant threat to banks' capital, it is a potential reputational risk to the industry."