Fears were growing in the West Midlands last night that the banking crisis generated by Northern Rock and the global credit crunch could begin to damage the region's economy.

Business leaders aired worries after the Governor of the Bank of England, Mervyn King, warned UK banks face a "painful adjustment" as losses from exposure to the bombed-out sub-prime mortgage market mount.

His gloomy forecast, which came as the Treasury extended guarantees to Northern Rock, put a dampener on pre-Christmas festivities. It reinforced findings of the Chartered Management Institute showing a big fall in confidence among West Midland executives.

Questioned about prospects in 2008, only 33 per cent said they were optimistic compared with 56 per cent last year. It was the first indication that confidence, until recently holding up well, is falling in local boardrooms.

Chris Clifford, regional director of the CBI, the country's biggest business lobby group, said after Mr King's statement to the Treasury Select Committee yesterday: "Nobody really knows how this might pan out."

Until now, the problems besetting banking since the summer have not spilled over into the 'real economy'.

But with rising oil, gas and food prices putting margins under pressure, any attempt by the banks to raise the cost of borrowing to claw back sub-prime losses and offset soaring wholesale money market rates would quickly hit the business world.

"It is difficult to predict at the moment how things will look in the first quarter of 2008," Mr Clifford said. "The situation looks reasonably OK, but looking forward it is obvious we are in a very unusual situation."

Peter O'Grady, a Birmingham spokesman for the EEF, the engineering employers' organisation, said 40 per cent of members are reporting no ill effects from the credit crunch.

Mr King's statement, however, was "one of a number of warning lights for the economy".

But Mr O'Grady stressed manufacturers in the region were showing "greater resilience" to economic pressures than previously and the sector is expected to grow in 2008, albeit it at a reduced rate.

Alan Durham, a director of the Coventry and Warwickshire Chamber of Commerce, said of Mr King's statement: "It is very worrying, especially against a backdrop already much less positive than for several years.

"It is absolutely vital the Government and central banks do all they can to ensure confidence is injected back into the economy."

Birmingham Chamber of Commerce and Industry spokesman John Lamb said he hoped the Government would take note of business worries.

Mr King told the Treasury Select Committee: "A painful adjustment faces the global banking sector over the next few months as losses are revealed and new capital is raised to repair balance sheets."

When quizzed over the possible nationalisation of Northern Rock - which has borrowed an estimated £25 billion - Mr King refused to rule it out.

He again called for changes to the law to improve the handling of any future crisis following the run on the Newcastle-based lender in September, as, under current rules, depositors could wait for up to a year for savings if a bank fell into administration. There was a "strong incentive" for customers to join a bank run and "credible" deposit insurance arrangements

were needed to reassure savers, the Governor said.

The Bank is also backing a drive from the Financial Services Authority watchdog to make sure banks have enough cash to cope with the severe credit conditions which struck Northern Rock in August and forced it to call on emergency funding.

Mr King said the company's borrowing operations were "fatally flawed".

Angela Knight, chief executive of the British Bankers' Association, said the crisis had dealt a blow to London's reputation as a centre of financial services. "We have to recognise that it has done us damage, and we have got a lot of work to do to restore the damage."