By Marcus Leach

The Bank of England's Financial Policy Committee (FPC) has warned banks to cut staff bonuses and shareholder dividends in order to save cash.

This stark warning comes amidst the Bank's fears that UK banks might suffer losses if eurozone governments default on their huge debts.

The Committee recognised that dealing with the problems facing the international financial system as a whole would require long-term reforms to tackle unsustainable debt positions and the cumulative and persistent loss of competitiveness in a number of euro-area countries.

But given the scale of current risks, the Committee also discussed the need for shorter-term measures to reduce the risk of a significant disruption to financial stability, and so to the supply of credit to UK households and firms, which could feed back through the economy to increase the pressure on the financial system.

UK banks had made progress over the past two years in building up their capital and liquidity, which had placed them in a somewhat stronger position to withstand adverse developments whilst maintaining the supply of credit to the economy.

The Committee had advised UK banks in June that, if their earnings were strong, they should seek to build capital levels further, given the risks to the economic and financial environment. But events had lowered the likelihood that banks would be able to strengthen their balance sheets in this way over the short term.

The Committee therefore recommended that banks should take any opportunity they had to strengthen their levels of capital and liquidity so as to increase their capacity to absorb flexibly any future shocks, without constraining lending to the wider economy. This could include raising long-term funding whenever possible and ensuring that discretionary distributions reflected any reduction in profits.

The Committee also advised the Financial Services Authority (FSA) to encourage banks, via its supervisory dialogue, to manage their balance sheets in such a way that would not exacerbate market or economic fragility. For example, at the present time, some actions taken to raise capital or liquidity ratios could potentially worsen the feedback loop between the financial sector and the wider economy and so should be avoided.

Moreover, the Committee recognised that, in the event that severe risks crystallised, it would be natural for banks’ capital and liquidity ratios to be run down to ensure that lending to the non-financial economy was not impaired.

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