Alliance & Leicester warned that higher funding costs will significantly hurt its margins next year as it reported a 30 percent drop in annual profits after a big writedown, hitting its shares.

A&L, the country's seventh-biggest listed bank, suffered a 185 million pound writedown on its exposure to risky assets and also reported higher funding costs of 23 million pounds in the fourth quarter.

The bank said that depressed its net interest margin to 0.93 percent and warned the margin would be about 1 percent this year, down from 1.16 percent in 2007 and 1.3 percent in 2006.

"The outlook is for earnings materially below our expectations largely due to narrower net interest margin," Cazenove said in a research note. "Our initial reaction is to reduce EPS (earnings per share) for 2008 by 26 percent to 64p."

A&L stock dropped 14 percent to 455 pence by 8:08 a.m.. HBOS fell 4.4 percent to 630p on read-across fears.

A&L reported a 2007 pretax profit of 399 million pounds on Wednesday, down from 569 million pounds in 2006 and below an average forecast of 416 million from 12 analysts polled by Reuters Estimates.

The bank said underlying core operating profit rose 3 percent from 2006 to 602 million pounds.

It raised its full-year dividend by 2.2 percent to 55.3 pence per share, below an average forecast of 56.2p, and said it expected the payout in 2008 to be maintained at the 2007 level.

A&L warned three weeks ago that its writedown on holdings of structured investment vehicles (SIVs) and other products tarnished by the U.S. subprime housing crisis had more than tripled from a previous estimate to 185 million pounds. Profit was also knocked by a 10 million pound loss on ineffective hedges and 8 million pounds of redundancy costs, it said.

"The previous guidance (for 2008 margins) was around 110 basis points and they are now talking about 1 percent. That's 10 basis points and you could say that doesn't sound very big... but that drops straight through to the bottom line," Pali International analyst Bruce Packard said.

The shares have more than halved since May, hit by a relatively high exposure to risky assets, given its size, by a sharp rise in funding costs and modest growth prospects as the housing market and economy cool.

A&L calmed worries about funding problems in November by saying it had agreed medium-term financing facilities, and on Wednesday is said it had funding to see it through to the first quarter of 2009.