Speculation that HBOS is on the verge of major funding problems saw its shares dip to a record low yesterday, prompting regulators to warn they would not tolerate the spreading of unfounded rumours.

HBOS shares were down 17% at one point to a record low of 398p although later recovered to close down 7% as investors fretted that the bank was struggling to raise cash in the money markets, a problem that hit Newcastle's Northern Rock in the summer, leading to its eventual nationalisation last month.

The Edinburgh-based institution dismissed the speculation, claiming it had an "extremely strong balance sheet" and continued to access wholesale funding.

Chief executive Andy Hornby told the Herald: "It is really sad that people can put rumours out into jittery markets like these and especially when the rumours are so firmly completely unfounded and scurrilous. "We believe we are in a really good state."

HBOS's woes dragged down the FTSE-100 index which, despite having started positively, shed 1% over the course of the day, closing 60.2 points down at 5545.6.

Such was the concern about the sell-off of HBOS shares that the Financial Services Authority, which regulates financial markets, announced an investigation into whether the rumours were put about by traders betting on it going down.

Sally Dewar, managing director of wholesale and institutional markets said: "There has been a series of completely unfounded rumours about UK financial institutions in the London market over the last few days, sometimes accompanied by short-selling.

"We will not tolerate market participants taking advantage of the current market conditions to commit abuse and by spreading false rumours and dealing on the back of them."

The Bank of England also sought to restore calm by reassuring investors not bank had sought its help.

"No meetings have taken place or been scheduled to discuss problems with any institution in the UK, a spokesman said.

However there will be plenty to talk about at a scheduled meeting on financial stability today. The heads of Britain's top five lenders, including Hornby, and the governor of the Bank of England are expected to attend.

Despite yesterday's reassurances there are still worries about HBOS's general health. Collins Stewart analyst Alex Potter said that HBOS's exposure to risky assets such as US mortgage-backed securities and collateralised debt obligations, another form of investment that can be backed by mortgage debt, is second only to Barclays when the relative size of the companies was taken into consideration. He added that Barclays staff were better equipped to manage them.

This is denied by HBOS which says such assets represent just 0.1% of its balance sheet.

But even Potter conceded that any future write-downs on the value of the HBOS's assets are unlikely to be so bad as falls in its share price, down 39% this year compared to 15% for the wider banking sector, represents.

HBOS was not the only bank under scrutiny yesterday.

Another big faller was Bradford & Bingley which closed down almost 6%. After markets closed last night ratings service Moody's downgraded its debt because it fears it could be forced to make further writedowns on assets linked to the US sub-prime mortgage crisis and is being heavily hit by rising costs of raising money in the wholesale market.

Such was the air of nervousness that Bank of England deputy governor Sir John Gieve, who is responsible for financial stability cancelled an lunch engagement in eastern England scheduled for today so he could keep his eye on market developments. Gieve took the brunt of MPs' wrath at a hearing of the Treasury Select Committee last year on problems at Northern Rock where chairman John McFall accused him of "having a sleep in the back shop while a mugging was taking place in the front".

US markets were also nervous yesterday. The Dow Jones Industrial average shed 293 points, or 2.4% to 12,099.66. The S&P 500 index fell 32.32 points, or 2.4% at 1298.42. But the fall was blamed, not on specific worries about the financial sector but general worries that the country could be in or heading for recession.

The bleak mood was reflected in polling of fund managers published by investment bank Merrill Lynch yesterday, but conducted before the collapse of US investment bank Bear Stearns at the weekend darkened sentiment further, which revealed that most are stockpiling cash and that 64% think the world economy is likely to head into recession in the next 12 months. One in five, up from one in six last month, think it is already there.