Lloyds downgraded its economic forecasts to reflect a worsening outlook, and is now predicting the economy will shrink 1% next year and that house prices will fall 8%.

The country's biggest mortgage lender posted pre-tax profit of 1.5 billion pounds ($1.74 billion) for July-September, compared with 2 billion pounds a year earlier and below analyst forecasts.

The fall was largely down to setting aside an additional 688 million pounds to cover potentially soured loans as customer budgets come under pressure.

Lloyds shares fell 4% in early trading and were last down 2%, against a broadly flat benchmark FTSE index (.FTSE).

The mixed update from Lloyds, with profits sliding and bad loans charges rising while the bank nonetheless increased its guidance for several key performance metrics, showed the unusual environment Britain's banks are now in.

Rising central bank interest rates aimed at combating inflation also boost banks' income, but those same pressures of inflation and higher rates on mortgages are squeezing household budgets, risking defaults on loans later down the line.

Rivals including Barclays and HSBC reported robust results this week, but investors are wary the rising cost of living will bite long term.

Analysts have argued Lloyds could be particularly vulnerable to any increase in loan defaults because of its huge mortgage book and significant share of the credit card market.

"To a large extent, Lloyds can't control the external forces that govern its customers' behaviour, but its particular exposure to traditional lending, especially mortgages, puts it in the firing line when conditions sour," said Sophie Lund-Yates, equity analyst at Hargreaves Lansdown.

HOUSING CRUNCH

Britain's new prime minister Rishi Sunak has said the country faces a "profound economic crisis" as he seeks to fix the mistakes made by his predecessor Liz Truss.

Market turmoil sparked by Truss' tax-cutting plans pushed up the country's borrowing costs and led lenders to ratchet up mortgage rates, piling further pressure on households.

"Our one request would be for a period of stability," Lloyds' finance chief William Chalmers told reporters when asked about what he wanted to see from government. "That, in turn, will help us to support customers."

Chalmers said there was likely to be a slowdown in mortgage lending over the next 12 months as a result of higher rates and affordability pressure.

Banks are also concerned Sunak's new government could slap additional taxes on the industry, with a surcharge on bank profits under review by finance minister Jeremy Hunt.

Chalmers said further bank taxes were a decision for politicians, but added: "Our longer term request is for a competitive tax regime for the banking sector in the UK."

Despite its lower profit, Lloyds said the strength of its underlying performance meant it could raise its forecast on several performance metrics for the year.

Net interest margin, which measures how much the bank makes on the spread between what it pays savers and charges borrowers, will be 290 basis points rather than 280, it said, and the bank will generate more capital.

However, Lloyds said asset quality - measuring potential loan defaults - was expected to be slightly worse this year. Actual loan defaults remained low for the time being, it added.

($1 = 0.8604 pounds)