Top City law firms are preparing themselves for an unprecedented surge in litigation between banking giants as a result of the credit crunch, in what looks set to be the biggest client dilemma to hit the UK's commercial legal industry in years.

The issue has caused litigation leader Herbert Smith to create cross-departmental consultation groups in preparation for a big dispute arising and the firm has already raised the potential issue with a number of its banking clients. Meanwhile, City firm SJ Berwin has already accepted an instruction to act against a bank.

Partners across the City are anticipating a rise in major disputes, which have the potential to jeopardise the numerous banking relationships held by the UK's biggest firms, all of which attempt to steer away from litigating against banking clients.

Herbert Smith litigation partner Tim Parkes said: "It is a very tough call. We are used to banks being the claimant or defendant against non-banking entities. People will have to decide: if a bank is being sued by another client, do you just say 'no' or weigh up the strength of the relationships?"

One in-house lawyer at a major financial institution told Legal Week that the bank is reviewing commitments entered into before the market dropped off this summer on the back of the sub-prime mortgage crisis in the US.

Each of the UK's largest firms – Clifford Chance, Linklaters, Freshfields Bruckhaus Deringer and Allen & Overy – have relationships with most of the world's largest banks. The majority of magic circle partners contacted by Legal Week said that unless they were bound by panel restrictions they would review each situation on a case-by-case basis.

The consequences of acting against a bank are well documented. Slaughter and May was not instructed by Merrill Lynch for two years after acting against it on behalf of Unilever's pension fund in 2001 and Freshfields was blacklisted by Citi after acting on behalf of Prince Jefri Bolkiah and the Brunei Investment Authority in a dispute over assets in 1999.

Barlow Lyde & Gilbert has traditionally been the only top UK litigation firm to openly state its willingness to sue banks.

SJ Berwin litigation partner Hilton Mervis added: "The fact that banks are so large means that even if there is strictly no legal conflict, there can be a commercial conflict because other partners have a relationship."

Additional reporting by Claire Ruckin.

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