UK bank profitability is set to stay under pressure through to 2013 as margins erode and regulatory costs rise, while an uncertain domestic economy keeps the outlook for the UK banking system negative, ratings agency Moody's said.

In its latest UK Banking System Outlook, Moody's on Tuesday said losses from bad loans should fall in the next 12-18 months, but may rise due to banks' heavy exposure to the UK commercial real estate market and retail and corporate loan exposures in peripheral euro zone countries.

"The continued negative outlook for the UK banking sector is driven by the UK's uncertain economic prospects, pressure on profitability and downside risks for asset quality," said Elisabeth Rudman at Moody's.

The ratings firm predicted UK banks have enough capital to absorb potential losses under its base case and adverse stress scenarios.

Profitability is likely to remain under pressure over 2012-13 due to weak net interest margins, a tough growth environment, higher regulatory and compliance costs and subdued capital market activity, Moody's said.

Their operating environment is likely to stay challenging over the next 12-18 months due to weak economic growth prospects, with economic growth expected to be "marginally positive", Moody's said.

It said cost-cutting should allow banks to counter some of the challenges they face, and other positives include strengthened capital ratios, business franchises capable of strong underlying earnings and progress in improving liquidity.

(Reporting by Steve Slater; Editing by Hugh Lawson)