By David Milliken and Laura Noonan
LONDON (Reuters) - British banks need to act now to bolster their defenses against financial shocks, as many have underestimated the cost of loans going sour and future fines for misconduct, the Bank of England said on Thursday.
Underlining a growing sense of urgency about capital defenses, BoE Governor Mervyn King said that while the problem was "manageable", he wanted the banks' regulator to report back by March on what steps banks were taking, and warned that he did not want them to cut lending.
"(Our) primary concern has been to ensure that UK banks have sufficient capital ... so that they are on a solid footing to support economic growth," King told a news conference.
"The problem is manageable, and is already understood at least in part by markets. But it does warrant immediate action," he added.
The BoE has been taking an increasingly tough line on the amount of capital banks hold and the government has chosen Mark Carney, a leader of the global push for stronger banking regulation, to succeed King as governor in July. Carney is currently Canada's central bank chief.
Whether the BoE's deputy governor for financial stability, Paul Tucker, will stay long at the central bank is now in doubt. After losing out to Carney in the race to succeed King, he declined to confirm in the news conference whether he would see out his five-year term, which ends in 2014.
Bank shares pared gains on King's presentation of the half-yearly report by the BoE's Financial Policy Committee, which from next year will take charge of British bank regulation.
One dealer said the share price falls were due to uncertainty about how much capital banks would have to raise. But declines were limited, with equity analysts pointing out that the BoE was giving banks choices on how to raise funds beyond the costly option of issuing new shares.
"What they don't want is banks to say: 'You want more capital? We'll deleverage'," said Gary Greenwood, a banking analyst at Shore Capital.
"Initially you can look at this and read it very negatively and say it's bad for banks. But (the BoE) are saying a lot of it is in the price already ... and seem willing to give banks favorable conditions to enable them to get there."
King said that the government would not need to put extra money into Royal Bank of Scotland
Instead, he said banks could raise funds by issuing contingent debt that converts into equity in a crisis, or by restructuring actions - often a euphemism for asset sales.
INVESTOR CONFIDENCE LOW
The BoE said that British banks' true capital position was probably worse than relatively healthy official numbers imply, and this was already hurting investors.
"Progress by banks in raising capital has slowed and investor confidence remains low," the BoE said in its half-yearly Financial Stability Report. "Market concerns are likely to reflect in part uncertainty about bank capital adequacy."
The BoE has repeatedly urged British banks to raise capital levels, and November's report marks a stepping up of these recommendations, despite a slight reduction in the risks facing the financial system due to an easing in euro zone tensions.
"UK banks' capital buffers, available to cushion losses and maintain the supply of credit following realization of a stress scenario, are not as great as headline regulatory capital ratios imply," it said.
King also confirmed the new effort would apply to international banks with British subsidiaries which are regulated by the Financial Services Authority.
The BoE identified three main areas where banks were over-optimistic about how much capital they had.
First, information from supervisors suggested some British banks would suffer bigger losses on loans than they had made provision for, according to the report.
Second, it said banks had also persistently underestimated the scale of fines they would face for past misconduct, adding that external analysts had suggested further costs of 4 billion to 10 billion pounds ($6.4 billion to $16 billion) for missold payment protection insurance and the LIBOR rate-rigging scandal.
Finally, the BoE criticized the "complex and opaque" system banks use to calculate the riskiness of its assets, with the amount of capital that banks estimated they needed sometimes varying threefold between banks for the same type of assets.
FSA analysis suggested this could lead to an overstatement of the largest four banks' true capital by anything up to 35 billion pounds, though one BoE official, Andy Haldane, cautioned against taking the figures too literally.
The report also revealed muted results from the BoE's June effort to get banks to boost lending, by paving the way for up to 500 billion pounds of liquidity reserves held by the banks to be run down.
But Thursday's report noted that just 31 billion pounds had been released and that it was mostly used to repay debt rather than provide direct support to credit growth. The BoE cautioned that it was "too early" to judge the impact of the initiative.
($1 = 0.6257 British pounds)
(Additional reporting by Estelle Shirbon, Steve Slater and Alessandra Prentice)