The financial policy committee, set up to ensure the system functions smoothly, urged banks to bolster their capital cushions after telling them they had been too slow to respond to the crisis.
The FPC, chaired by the Bank of England governor, Sir Mervyn King, said banks needed to either conduct cash calls on shareholders or issue new types of instruments that can convert into equity in times of stress, rather than just restricting bonuses to staff.
It said the cost of compensating customers for mis-selling financial products, such as payment protection insurance, was also preventing banks from using profits to bolster their capital. To be able to raise new capital, they might need to come clean about the size of their bad debts, the FPC said while acknowledging the difficulties associated with raising more capital and trying to lend to businesses and householders.
"Members agreed that the challenge of boosting both resilience and credit availability was particularly complicated in the current conjuncture," the committee said at its latest meeting on 14 September, published on Thursday. "The committee believed that banks should supplement internal capital generation by seeking opportunities to raise capital externally. Recent improvements in market conditions should help in that respect, with the options including debt conversion and the issuance of suitable contingent capital instruments as well as conventional equity."
The FPC indicated that it might give more detail about the timescale given to banks to raise capital, and how much they should raise, after its next quarterly meeting in November.
Earlier this week, the committee admitted it had not altered its outlook on financial stability since its previous meeting in June, when banks were allowed to eat into their cash holdings to stimulate lending. But it has been urging banks to preserve capital since its first meeting in June last year.
While banks had reduced their exposure to the eurozone, the FPC noted that "exposures remained large, at an average of about 70% of major UK banks' core tier one capital."
It added: "Progress by UK banks in building capital against current threats had been slow. There had been no material issuance of external capital, and earnings had continued to be constrained by a number of factors, including the impact of weak economic activity and redress for mis-selling financial products and other conduct issues. The committee judged that these factors were likely to provide a continuing drag on banks' earnings, diminishing their ability to build capital internally."
The FPC said the Financial Services Authority was working with banks on valuations about their loans. "The FSA was continuing to encourage banks to improve provisioning practices and to mark assets on their balance sheets more prudently, working within the constraints of existing accounting standards. It agreed to provide an update on this work at the committee's next round of meetings."
As a result of the weak economic backdrop – data released on Thursday showed the economy contracted by 0.4% in the second quarter – the FPC has in the past discussed whether banks should be allowed to eat into the capital buffers to make it easier to lend. However, the committee has concluded that banks do not yet have enough capital to do this. Instead, the FSA has made changes to the rules, outlining how much capital banks might set aside to cover loans by avoiding the need for banks to hold capital for their additional lending.
"The precise amount of this offset will be determined in the context of discussions with firms on their capital adequacy and forward looking capital plans, and will be consistent with FPC recommendations relating to capital," the FSA said. The FPC is also keeping track of whether US investors are going to be prepared to lend money to UK banks, as they have in the past, and made clear that it wants banks to publish their leverage ratios – which measure how risky their businesses are – from next year.
guardian.co.uk © Guardian News and Media Limited 2010