IN BANKING circles it is known as "the stick", and it is beating to a pulp the institutions that backed HBOS's disastrous rights issue to shore up its capital reserves. The name is given to the agreement that requires the sub-underwriter - the last man standing in a cash call of this kind - to mop up any shares without a buyer. And in the case of HBOS, there are a lot of them. After the main underwriters take up their shares, the subs will be stuck with up to £2 billion worth.

The City has not seen anything like this for over 20 years, indeed not since a rights issue by mighty BP flopped in the stock market crash of 1987. And HBOS shares rose late last week as rumours of a takeover by Spain's BBVA emerged and the short-sellers bought back in to cover their positions. In less than a year, banks have gone from being the darlings of the stock market to the pariahs.

The big question arising from the HBOS debacle is, where has all the investment money gone? Though some have argued the rights issue was snubbed by investors worried they would be stung by shares falling below the issue price, they would all have known HBOS is cheap by historic standards and that 275p was a good medium-term bet. With less than 10% of shareholders taking up the allocation, the reality is most institutions don't have capital to invest right now.

This is because it is being hoarded by the banks, which are under pressure from the Bank of England to shore up their reserves to cope with the prospect of bad debts from the mortgage market, commercial lending and so on. Where once debts were packaged up and sold on subprime style, now the banks are sitting on funds and sucking in back-up from rights issues and sales of assets while they wait to see how painfully the bubbles burst.

As a result, the economy is in the midst of a credit squeeze, evidence of which is pouring in from every level. As if you didn't know it, Bank of England data notes that banks have sharply reduced lending as well as increasing spreads and fees in an all-out grab for cash.

The bank's Paul Tucker, executive director of markets and a man at the very heart of the illiquidity turmoil, sees this as a race against time. If banks take too long to shore up their balance sheets, there will be a shortage of credit to what he calls "the real economy" for some time to come.

Take RBS as an example. Although it was smart enough to get away with its own record-breaking £12bn cash call by tapping the market early, it is still desperate to claw back as much cash as possible. Thus it reversed a £199 million investment in a London hedge fund soon after its daring acquisition of ABN Amro - a decision that has landed it in a lawsuit. It is also (with difficulty) selling its insurance businesses and trying to offload the Australasian assets of ABN Amro.

It must have been galling for RBS chief executive Sir Fred Goodwin that National Australia Bank last week spurned the Australasian business, reputedly because RBS wanted too much money. NAB is run by another Scot, the famously prudent John Stewart, who is behind the recovery of Clydesdale and Yorkshire banks. RBS is reportedly talking with another possible suitor, Australian giant Commonwealth Bank, but nobody will count their chickens until a deal is done.

As long as the banks continue to withdraw money from the system instead of the other way around, the capital that has lubricated the commercial community for the past 10 years will dry up, with serious consequences. As economist Ed Menashy of Charles Stanley brokers said: "The banks play a crucial role in the economy but now they must concentrate on building up their reserves before they can lend again. They have made immense write-offs and their balance sheets are under enormous pressure. There will be a credit squeeze for the next two or three years."

The consensus of economists - one reflected by a torrent of hard data from the engine rooms of the economy - is that the wider commercial sector is already experiencing a hard ride. Conservative party leader David Cameron agrees. As he observed in a mid-July speech to the Confederation of British Industry: "The credit crunch has now spread - from the City and into every home and business in Britain."

But his listeners already knew that. According to Begbies Traynor, which specialises in restoring businesses from near-terminal states, there are now more than four times as many financial services companies experiencing "critical problems" than this time last year. Worse, the numbers are accelerating. In the second quarter there was a 36% increase.

While financial services companies are facing the biggest difficulties, Begbies Traynor notes the contagion is spreading into other sectors and most obviously those with a dangerous reliance on credit. For instance, Begbies Traynor reported last week a near-fourfold increase in construction companies with critical problems compared with last year, and an almost precisely matching increase in IT companies, whose income depends heavily on banks. Other gloomy sectors include retail, print and packaging, transport and communications, engineering (all up threefold) and automotive (twice the number in trouble than before).

Together, it doesn't make a cheerful picture. And we haven't even mentioned the heavily indebted property sector.

The common thread in these potential basket cases is a lack of liquidity. As Begbies Traynor says: "Credit lines have dried up and companies which might have been supported by extended credit up to a year ago are now at real risk."

It is important not to get too carried away, however. Although these sectors face problems of varying - and mounting - difficulty, Begbies says only 15% of those red-flagged will typically end up in administration. The rest will suffer mixed fortunes.

It is hardly surprising David Cameron is worried about fundamentally sound companies crashing into administration because their lenders have turned off the tap. Thus he startled the CBI by floating an idea to introduce "the best aspects" of America's Chapter 11 system that protects successfully trading but financially challenged enterprises from the clutches of the liquidators until such time as they can be restructured. "This change will ensure that fewer good companies end up in liquidation - and fewer people lose their jobs through no fault of their own," he told the CBI.

This says a lot about the credit squeeze. A year ago, any suggestion UK plc might need a home-grown version of Chapter 11 would have brought ridicule on the Conservative leader. Instead, Cameron's brainwave is receiving considered debate. The time may have come for a UK-style Chapter 11, even though it would entail rewriting or scrapping the Enterprise Act.

As legislation from an earlier and less complex era, the act does not provide a distressed company any breathing space to sort itself out under a company doctor or other mentor. It does not even deliver a workable mechanism for rescue financing. Under the act, a company rescue requires the backing of 75% of creditors, which is hard to get when their money is at stake.

The absence of more flexible laws could hurt businesses over the next few years. "More companies will fail and more jobs will be lost than in the prior wave of restructurings," predicts Antonio Alvarez III, senior partner in turnaround expert Alvarez & Marsal.

This may already be happening. According to big four accountancy firm Ernst & Young, "the outlook is troubling". In a May survey of insolvencies, the firm predicted it would increase "at a much faster pace in the latter part of 2008 and in 2009". And it clearly laid the blame on tighter credit conditions: "The full impact of this tightening is just feeding through as credit providers deliver sharp doses of reality to credit-addled individuals and businesses who are just finding out that they can't live in never-never' land."

There is probably not a single economist in Britain today who does not think the rate of economic growth will fall significantly, although by exactly how much is still being debated. Ernst & Young estimates a decline to about 1.5%; others predict a full-blown recession. "Life will be increasingly difficult for many companies in 2008, especially businesses with high levels of debt or with loans to refinance this year," summarises Ernst & Young.

There is water in the middle of this desert, however. Unlike the biggest banks, the balance sheets of Britain's manufacturers as a whole are robust and can in theory take on more debt, assuming the institutions are willing to lend it. As Menashy points out, manufacturing is the only sector not borrowed to the eyeballs.

And there are still believers in Britain's high street banks, notably Spain's Banco Santander. This prudently run institution has just swooped on Alliance & Leicester, and beleaguered shareholders are expected to accept its takeover offer sweetened by a 36% premium on the pre-bid price.

As Santander's chief financial officer José Antonio Alvarez explained, the bank's collapsing share price made it an institution in need of rescue. "Alliance & Leicester has been operating in a complex scenario because of writedowns of its treasury assets," he told investors. "Its big funding issues meant there was an obvious risk of the franchise deteriorating as a standalone business in such a high-risk environment." Thus A&L will join Abbey in Santander's UK stable, another victim of the reckless lending Santander has eschewed.

Whether by good luck or good management, the Spanish bank has no exposure to the toxic US subprime market. It has not had to make massive writedowns or scrounge around for cash. Virtually overnight, cash-rich Santander will pick up an extra 7% of Britain's business loans plus 300 branches.

Have the banks hit rock bottom? US-based private equity giants Blackstone and TPG are reportedly looking at buy-to-let specialist Paragon, whose shares plummeted 90% in a year. And vultures are circling HBOS, following last week's news that investment bank JP Morgan and Spain's BBVA have been considering making takeover bids. Industry watchers declare these as good signs.

And no doubt to the banks' relief, the short-sellers have been reined in by new Bank of England rules requiring them to reveal any position of more than a quarter of 1% of the share register. Among other factors, this has helped the share price of bank shares to rally. At this rate, HBOS's sub-underwriters may yet get rid of some of their £2bn in unwanted shares.

It will, however, be a long way back for the banks. The days of easy credit are clearly over, probably for years, as the banks revert to boring, commodity-like businesses shackled by tighter regulation.