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The margin may erode further in coming weeks. Credit ratings on $704 billion of bonds have been cut this year following the collapse of the U.S. housing market. Sheila Bair, chairman of the Federal Deposit Insurance Corp., said last week that the downgrades may compromise bank capital ratios enough that some of the largest institutions will no longer be considered well capitalized.

Falling below a regulatory benchmark that is intended to maintain a minimum level of capital to protect depositors against losses would subject banks to more scrutiny from regulators than they have ever experienced.

“This is a nightmare for the country,” said William Isaac, who was chairman of the FDIC from 1981 to 1985. Banks will “raise what capital they can, then they’ll slow down their growth and stop lending, and what should be a mild recession becomes a much more serious one.”

The biggest danger to the economy is that to preserve their ratios, banks will cut off the flow of credit, causing a decline in loans to companies and consumers. Banks have already raised $136 billion in capital, based on data compiled by Bloomberg, and cut dividends. More stock sales and payout reductions are likely to follow, says analyst Meredith Whitney at Oppenheimer & Co.

`Institutional Panic’

The credit crunch has already cost the world’s biggest financial companies about $232 billion and forced a government bailout of New York-based Bear Stearns Cos., the fifth-largest U.S. investment bank. The International Monetary Fund said last week that banks were in the worst financial crisis since the Great Depression.