The rout in the Australian banking sector continued today with the ANZ bank’s shares plunging more than 13% this morning, after the bank forecast a 20%-25% drop in cash earnings after lifting bad debt provisions.

The sharp rise in provisions are a major blow to the market’s confidence in the banking sector, challenging its assumption that Australian banks had escaped the US toxic debt crisis and had not been stuck with dodgy loans of the type that afflicted Centro, Allco, Octivar and other property and financial engineering firms.

The news of the ANZ write down battered the sector after the NAB delivered its own savage blow to confidence on Friday with a shock $830 million in extra provisions against failing collateralised debt obligations on US housing loans.

The NAB was placed on credit watch negative Friday evening by Standard & Poor’s rating agency and it’s likely the ANZ will join it after its shock this morning.

In early trade, ANZ shares were down as much as 13.2%, or down $2.35 to $15.40. The stock recovered slightly to be around $15.86, a level not seen from around 2001-02. That was a fall of $1.85 or more than 10.6%.

The overall market was off 1% at 11am. Friday saw the market lose around 3% in the biggest plunge since January 22. Nab shares were sold down another 61 cents to $25.95, the CBA, 5% to $41.11 and Westpac 5% also to $20.98.

The ANZ’s problems seem to be an extension of the ones flagged earlier in the year: a couple of poor local loans, an involvement with a faltering US monoline insurer which had insured some of ANZ’s corporate bonds, Centro (and when is the Commonwealth bank going to write its Centro loans down?), rising provisions here and in New Zealand for consumer problem loans, and the failed Bill Express business … as well as ANZ’s entanglements with various margin lenders.

The bank said that cash earnings per share, which excludes income from derivatives trading, is expected to drop by between 20% and 25% in the 12 months to September, compared with the 2007 figures.

Provisions for bad debts in the current half are likely to be about $1.2 billion, compared with $980 million in the first half. That would take the total provision to well over $2.1 billion for the full year, three to four times what they were in 2007.

The ANZ reported a 7% drop in first-half profit because of the higher provisions, so the second half will be poor. The bank says the annual dividend of $1.36 a share won’t be affected. That will absorb around $2.5 billion.

The bank forecast that underlying profit before the provisions will be about $3 billion for the year to September, but that is cold comfort to the shareholders and market.

The bank’s 2007 cash profit rose 9% to $3.92 billion.

The ANZ said it had reset its collective provision above 1% of credit risk weighted assets, which it said was a prudent response to the deteriorating credit environment.

The second half collective provision charge is expected to be $375 million, ($376 million in the first half) while for individual provisions, ANZ said known credit issues had deteriorated including ”certain commercial property clients, securities lending and Bill Express”.

As a result half individual provisions are expected to be around $850 million, up from $604 million in the first half.

The bank said its institutional division’s after-tax profit will be weighed by ”substantially higher credit provisions and valuation adjustments.” The institutional division’s annual profit is expected to be about half 2007’s result of $1.44 billion.

The ANZ ’s news means the long reign of former CEO, John McFarlane and chairman Charles Goode take a second knock, after the first one with the surprise write-downs earlier in the year; just as the reputation of the NAB’s current CEO, John Stewart, was damaged by Friday’s announcement.