Bank of England: cut bonuses and dividends, not lending

British banks have been advised to cut their dividends and bonuses in order to strengthen their balance sheets by the financial sector's new super-regulator.

The Bank of England's Financial Policy Committee (FPC), which is due to take over the powers of the Financial Services Authority, released a statement yesterday warning about rising risks of disruption to financial stability in the UK as a result of the eurozone crisis.

In the minutes from its second quarterly meeting, the FPC recommended that banks "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." It added that these efforts should include "ensuring that discretionary distributions reflected any reduction in profits". Such "discretionary distributions" are understood to include dividend payments to shareholders and bonuses to employees.

After its first meeting in June, the FPC had urged British lenders to seek to bolster their capital buffers without delay. But it admitted yesterday that recent stresses in the global financial system had "lowered the likelihood" that banks would be able to do this.

The FPC instead advised that, in the event of an overseas financial shock, banks should allow their capital ratios to run down, rather than attempt to preserve their buffers by cutting lending to the British economy. This went down well with some parts of the financial sector. The Japanese bank Nomura said in a note to clients: "We welcome this flexibility as something that is essential to damping down the credit cycle. Ultimately, buffers are there to be used."

There are, however, still signs that the squeeze on domestic UK borrowers is continuing in any case.

The Bank of England's quarterly Credit Conditions Survey, also published yesterday, said the supply of secured credit to households increased slightly in the three months to September, but lending to businesses remained flat.

It also warned that "adverse wholesale funding conditions" might constrain future lending to the British economy. The UK's banks are heavily reliant on borrowing in the wholesale money markets to finance their operations. These markets are prone to seizing up in times of financial stress.

The FPC further suggested in its statement that it needs some powerful regulatory tools in order to perform its job of ensuring financial stability properly. These include powers to set maximum leverage ratios for banks, the authority to dictate maximum loan-to-value ratios on mortgage lending and the ability to force complex financial trading on to transparent exchanges.

It also urged the Treasury to ensure that European legislation does not hinder its ability to perform its domestic regulatory duties.

The FPC, which is chaired by the Bank of England's Governor, Sir Mervyn King, is an advisory body at the moment but it will gain formal powers once legislation, presently before Parliament, is passed.

The regulator is expected to be up and running by early 2013.