Credit markets point to election risk for British bank share rally

* UK bank 5-year CDS spreads: http://link.reuters.com/gur64w

* UK bank share price performance: http://link.reuters.com/kur64w

By Alistair Smout

LONDON, May 1 (Reuters) - The resilience of shares in UK-listed banks to uncertainty over the consequences of next week's election could be short-lived, with credit markets signalling that stock prices are overdue a correction.

Among the policies being proclaimed by the main parties ahead of the May 7 vote, set to be the most unpredictable for decades and unlikely to produce a working majority for either main party, are increased regulation and a possible referendum on Britain's EU membership.

Despite this, FTSE 350 banks have risen 5.5 percent so far this year, with the head of Lloyds playing down potential disruption from the election after posting higher profit on Friday.

Yet Europe's biggest bank, HSBC, has rallied strongly over the past week after saying it was considering moving its headquarters away from Britain to minimise the potential disruption from politics.

Investors in banks' credit default swaps appear to share some of HSBC's concerns.

Spreads have widened, meaning that investors are pricing in a greater chance of default among UK banks. The widening is not evident in continental European lenders, and analysts attributed it to concern about the consequences of the election.

HSBC's 5-year CDS spreads have widened by 40 percent since February, with Barclays (LSE: BARC.L - news) , Lloyds and RBS (LSE: RBS.L - news) spreads up 10-25 percent.

By contrast, Deutsche Bank (Xetra: 514000 - news) has not seen spreads widen, despite receiving a bill of $2.5 billion from regulators in April. France's BNP Paribas (Xetra: 887771 - news) and Italy's UniCredit (Milan: UCG.MI - news) have seen spreads tighten by 3 and 15 percent respectively.

CDS spreads for UK utilities, also seen as vulnerable to increased regulation depending on who wins the election, have also widened. But unlike banks, their shares have fallen.

Chris Parkinson, head of research at Christopher Street Capital (Other OTC: CGHC - news) , said the widening CDS spread did not reflect a serious chance that banks will default, but that it did suggest, on past form, that equity prices would correct.

"The UK lenders have CDS spreads at the wider end of the spectrum after spiking higher ahead of the election. We have seen an increased risk outlook in the UK banks," Parkinson said.

"We see more downside for the UK banks than continental European counterparts."

Veronika Pechlaner, fund manager at Ashburton, said: "I'd be wary of chasing the rally. We know there are more taxes to come, from both parties, and they will only get higher for the entire industry.

"It's hard to get any visibility on future returns in UK banks."

Saxo Bank recommends buying "put" options on the blue-chip FTSE 100 index to hedge against a win by the opposition Labour party, which could increase regulation of banks and energy stocks, knocking back the market as a whole.

Conversely, should Prime Minister David Cameron's Conservatives win, the bank recommends a purer play on financials, given their promise of an EU referendum, saying it would short Barclays, currently around 254.60 pence, with a target price of 240 pence. (Reporting by Alistair Smout, editing by Nigel Stephenson and Kevin Liffey)