BRITAIN'S supermarket giants are gearing up for a loyalty scheme price war over the new Individual Savings Accounts, a leading banker warned yesterday.

Mervyn Pedelty, chief executive of the fast-growing Co-operative Bank, said the assault on the financial services market by the leading food retailers was already unprofitable and would lose them even more money when competition to sell the first ISAs began in earnest.

''The Government has made it very clear that it is launching ISAs in order to encourage ordinary people to save more,'' Pedelty told bank executives.

''What better way to do this than to link a tax-free savings element to a supermarket loyalty card scheme?

''However, as people will be limited to one ISA per person this could lead to intense competition among the retailers, with each wanting their own loyalty card to be the ISA-linked one.''

Pedelty warned that this would further erode the profitability of the retailers' ventures into loyalty schemes and financial products, leading to lower returns for savers once they were ''captive'' in a scheme.

The Co-operative Wholesale Society, the biggest chunk of the co-operative movement, is to follow the supermarkets into financial services this summer with the launch of its own savings account.

The CWS recently reported a fall in profits in its core retailing division from #37m to #32m - after paying out #7m on its own loyalty scheme, the Dividend card.

Pedelty was speaking as the Co-operative Union, the holding company for the Co-op empire, reaffirmed its position as one of the UK's biggest retailers, reporting that sales had broken through the #8000m barrier for the first time.

The figures come as the Co-op defends itself against the onslaught from the supermarket giants on one front and the out-of-town retail parks on another.

They also follow speculation about the Co-op movement's future in the wake of last year's vigorous defence against a possible takeover bid by City financiers led by Andrew Regan.

But while sales increased, annual results for 1997 showed that profits fell as the Co-op faced intense competition.

National Co-op sales rose to #8200m last year, an increase of less than 3% against the previous year's #7900m. But trading profits fell from #135m to #118m .

Although the Co-op's sales are dwarfed by the likes of Tesco and Sainsbury, it can still boast it is the country's biggest retailer, with 4500 outlets, from hypermarkets and department stores down to small neighbourhood convenience shops.

It is also the UK's biggest undertaker, a major petrol retailer, and runs a chain of chemists and travel agents.

In addition to the two largest societies, the CWS and CRS, it takes in 46 independent regional and local societies.

Co-op Union chief executive Lloyd Wilkinson said: ''The Co-op is going through a period of major change and is on target to emerge as a more sharply focused business in retailing in financial services.''

Selling groceries remains its main business, but its share of the food market dipped from 6.8% to 6.4% in the face of supermarket competition and a decision to build on its reputation as a neighbourhood retailer by switching from large out-of-town stores to smaller convenience stores.

The Co-op's key role in the British way of death was reflected by an 8% growth in funeral business, taking its market share to 25%.

Richard Hyman, analyst at retail consultants Verdict, said: ''I think there is a future for the Co-op in the short to medium term because of its sheer size.

''It still represents a large chunk of consumer spending, but it is a diminishing slice and it is very difficult to see it stop diminishing.

''But two surprising things happened last year. First, someone tried to buy the group and second, it put up a dynamic defence to repel the suitor. What if they could bring that force and dynamism to their daily operations?''

CRS earlier this month reported a #22.3m operating loss on #1500m of sales. It invested #155m in modernising the business but also admitted to management mistakes and inefficiencies.

The CWS last month reported retail sales slightly lower at #1600m, the third successive year of falling sales when the average growth rate in the retailing industry is more than 3%. The group's position was largely rescued by the Co-operative Bank, which turned in record profits of #55m, up from #44.3m last year.