By Marcus Leach

Banks are being warned by the Bank of England's financial policy committee that they must raise capital in order to counter the current economic downturn.

With the eurozone slipping into deeper trouble, and the fear of knock-on effects hitting the British economy, Mervyn King has said banks need to build up their capital buffers further to protect against an "exceptionally threatening" environment.

"Faced with a crisis of the euro-area system, we are seeing at first hand the costs of financial instability," King said.

"The symptoms of the crisis have been widely reported. Many European governments are seeing the price of their bonds fall, undermining banks’ balance sheets. In response, banks, especially in the euro area, are selling assets and deleveraging.

"An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. That, in turn, will weaken banks’ balance sheets further. This spiral is characteristic of a systemic crisis.

"Following its recommendation from September, and given the current exceptionally threatening environment, the Committee recommends that, if earnings are insufficient to build capital levels further, banks should limit distributions and give serious consideration to raising external capital in the coming months.

"This recommendation does not reflect a view on the Committee that the current level of capital in individual UK banks is insufficient. Indeed, UK banks are better capitalised than many of their Continental peers. Rather, it reflects a judgement that it is sensible and desirable to raise capital buffers further in order to improve resilience in light of the continuing threats to UK financial stability, while at the same time enhancing the capacity of banks to provide credit to the wider economy. That is why the recommendation is framed in terms of levels of capital and not capital ratios."

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