The FTSE 100 index of Britain's leading shares ended down 1.1 percent on Tuesday as banking stocks fell after a downbeat Morgan Stanley note. The blue chip index was 71.4 points lower at 6,315.2 points, as traders looked ahead to a key interest rate decision from the Bank of England (BoE) later in the week.
A Reuters poll suggested last week that the BoE would likely keep interest rates steady on Thursday but gave a roughly one-in-three chance the bank could cut rates.
"The (UK) market still remains nervous ahead of the interest rate decision," said Barclays strategist Henk Potts. "The reality is that investors have become more and more reliant on the central bank's ability to cut interest rate - the problem is that inflation is continuing to be a problem."
"Everyone knows that the BoE is going to cut rates, the question is when. We would suggest that (Thursday) is going to be a little bit too early and may have to wait until February," he added.
Banks were the worst performers in the FTSE 100 after Morgan Stanley started Royal Bank of Scotland and Lloyds with an "underweight" rating and cut its price target on HSBC. Analysts at Morgan Stanley said the credit crunch would depress earnings at British banks after this year, threatening dividends at RBS and Lloyds TSB.
Shares in these banks fell between 1.9 and 5.3 percent. Mortgage lender HBOS shed 3.5 percent and Barclays was down 4 percent. RBS is also due to issue its pre-close final trading update on Thursday. "Our view is that banking stocks have been indiscriminately oversold," said Barclays' Potts. "We would suggest that the earnings downgrades look too extreme, there is money to be made in terms of the banking sector but clearly sentiment is against them at the moment until we get full transparency."
The negative sentiment was little-helped by US markets, which fell for a second session in a row as J.P. Morgan Chase cut its earnings estimates on several banks, citing writedowns, slowdowns in mergers and acquisitions and reduced opportunities for other fees.
On Monday, US Federal Reserve policymakers also gave a sober assessment of the US economy, reinforcing the view that the US central bank will again cut short-term interest rates next week.
Key to all markets will be whether the US jobs data on Friday will reinforce the case for an expected interest rate cut by the Fed next week. A weak number would suggest the trouble in the housing and credit markets is spreading to a driver of the world's largest economy.
Mitchells & Butlers fell to its lowest point in over a year, down 5.2 percent after Citigroup cut the stock's price target. Traders also said the stock was being hit by talk that activist shareholder Robert Tchenguiz is to reduce his stake in the British pub and restaurant group.
Housebuilders also dipped, as credit fears and US housing worries heightened, with Taylor Wimpey down 7.1 percent and Barratt Developments 5.9 percent lower.
Britain's biggest retailer Tesco dipped 0.7 percent even as it met forecasts with a 4.1 percent rise in underlying third-quarter UK sales and said its new US stores had been "very well received" by customers. Among rare gainers, Royal Dutch Shell was 0.9 percent higher even as oil prices slipped to near $88 a barrel.
Rio Tinto climbed 1.3 percent after China's top steelmaker, Baosteel, told a Chinese newspaper that it might bid at least $200 billion for the miner, topping a take-over proposal by BHP Billiton. BHP shares were 0.9 percent lower.
The world's fourth-biggest cigarette firm, Imperial Tobacco tacked on 1.2 percent after ABN Amro raised its price target to 2,750 pence from 2,400 pence with a "buy" rating.