Barclays was forced to bail out its conduits this year. The summer turmoil in financial markets created the toughest climate in years for the UK banking sector, taking the gloss off record profits for the "big five".

It all seemed so different back in March when the quintet lined up to reveal jaw-dropping combined profits of £37.3 billion for 2006 in a triumphant procession of corporate earnings.

But by the end of a year in which phrases such as "sub-prime mortgages" entered the lexicon, investors were nervously poring over trading updates from the likes of Barclays and HSBC to assess the fall-out from their high-risk investments.

The financial manoeuvres at the heart of the crisis may seem arcane to the man in the street, but the impact is likely to be felt in more expensive mortgages as banks recoup losses and take a less risky approach to lending.

Until the Bank of England and four other central banks around the world launched their latest attempt to tackle a global liquidity crisis by pumping billions into frozen money markets just before Christmas, inter-bank borrowing rates had soared because banks fearing exposure to bonds based on US mortgages were refusing to lend to each other.

But the trouble all looks set to spill over well into the early months of the new year, and perhaps longer.

The initial foreshadowing of the dangers ahead came in February, with HSBC's shock warning that it had set aside almost £900 million more than expected on bad debt charges for its US sub-prime mortgages business.

It was bad news for HSBC, but the implications were to stretch far wider for the rest of the banking sector trading complex bonds based on bundles of mortgage debt, called collateralised debt obligations, dreamed up by financial whizzkids.

US interest rates had risen from a low of one per cent in 2003, leading to spiralling mortgage defaults among homeowners with poor credit histories - some of whom were arguably never in a position to repay in the first place. Talk of socalled "ninja" loans - to borrowers with no income, no job and no assets - was rife in the market.

Investors left holding the bits of paper based on these increasingly dubious-looking mortgage debts considered the dire US situation and panicked. And the crisis of confidence hit a key short-term method of funding used by the banks, intensifying the liquidity problems.

The banks raised short-term cash by selling asset-backed commercial paper (ABCP) based on securities held in complex off-balance sheet "conduit" companies. These securities include the mortgage-backed bonds feared by investors - and if the market becomes more suspicious of the assets, it will not buy the paper and the value of the conduit's assets shrink.

The assets, which were funded by the sale of the paper, have to be funded from the bank's own balance sheets. Banks including HSBC and Barclays have been forced to bail out their conduits this year by taking them back onto their books.

In November and early December the current toll of the credit crunch became clear. Barclays wrote off £1.3 billion -albeit less than feared - while Royal Bank of Scotland was hit for £1.5 billion. HSBC unveiled another £700 million in sub-prime related write-downs.

The numbers were large, but dwarfed by the damage done to the major US investment banks. Charles "Chuck" Prince, the chief executive of the world's biggest bank, Citigroup, resigned in November as the company admitted extra write-downs potentially running to $11 billion (£5.5 billion).

Merrill Lynch meanwhile wrote off $7.9 billion (£3.86 billion) due to its exposure to bad mortgage related debt and its chief executive Stan O'Neal paid the price in October.

The UK players saw first-half profits reach £21 billion although the scale of the financial turmoil will not be felt until next month when the second-half damage is revealed in full-year results.

Other headwinds faced by the sector include refunded overdraft charges, which shaved £399 million from the profits of the big five over the first half - almost double the £200 million predicted by some City analysts.

Claims have now been frozen until the outcome of a case being brought against eight banks by the Office of Fair Trading after complaints from thousands of customers.

The outlook for next year is uncertain. After years of steady profits growth, fearful investors are now beginning to bail out of the sector - as made painfully clear in the share price falls of the big five in the past six months. Barclays is off 33 per cent, Halifax Bank of Scotland 29 per cent, Lloyds TSB 20 per cent and HSBC 10 per cent.

RBS has tumbled furthest - down 34 per cent - and faces the added challenge of integrating Dutch bank ABN Amro after a long-running fight with Barclays. Given the current woes of the banking sector, ABN's £49 billion price tag - struck before the summer's turmoil - now looks expensive with brokers at Morgan Stanley saying RBS had been hit by the "winner's curse".

Morgan Stanley added to the gloom over banking stocks after warning in a pessimistic note a few weeks ago that 2007 could mark the peak for earnings in the sector.

Its gloomy predictions highlighted the problems of a slowing UK and US economy, a turn in the credit cycle and a pricking of the residential and commercial property bubbles.

Morgan Stanley also flagged concerns about the exposure of HSBC and Royal Bank of Scotland to the "more perilous situation" surrounding the US economy.

Bank of England Governor Mervyn King is confident that the UK's banks have strong enough balance sheets to see their way through the current crisis, but warned of a "painful adjustment" for the sector as losses are revealed.

With forecasts of a slowing economy this year, the pain is likely to be felt by all as banks lick their wounds after a turbulent 2007. ..SUPL: