Bank of England policymakers are concerned that Britain's banks are sitting on hidden losses and should be forced to raise fresh capital to bolster their financial positions.
The Bank's half–yearly assessment of the risks to the financial system calls on the Financial Services Authority to conduct a "proper valuation of their assets" which assesses their ability to withstand future losses.
"Where such action reveals that capital buffers need to be strengthened to absorb losses and sustain credit availability in the event of stress, the FSA should ensure that firms either raise capital to take steps to restructure their business and balance sheets in a way that do not hinder lending to the real economy," the financial stability report said.
It raises concerns among investors that banks may not have enough capital to absorb losses being stored up on their balance sheets because of leniency banks are giving customers unable to pay back debts on time. This practice is called forbearance — a type of "extend and pretend" which allows customers to stay in their homes or keep operating their businesses.
"One factor which may make stated levels of capital misleading is underrecognition of expected future losses on loans," the FSA said.
The policymakers, led by Bank of England governor Sir Mervyn King, want banks to raise capital or take steps to restructure their business in such a way that lending to the economy is not reduced as credit growth has been weak. Annual household lending growth has averaged less than 1% for two years.
The report also raises concerns about future losses from mis-selling incidents, such as payment protection insurance which has already cost banks £12bn.
"In recent years UK banks have also underestimated and underprovisioned for costs and conduct redress, notably for payment protection insurance.
"In 2012 the number of identified conduct issues has grown and it seems likely that banks could face additional sizable costs," said the report.
The way banks are valuing their loans might explain why banks' shares are trading at lower levels than their assets. At the end of June the discrepancy was £90bn.
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