British banks must strengthen their balance sheets against potential future crises without damaging the wider economy, the Government's new financial watchdog warned today.
Eurozone debt fears have made it harder for banks to hoard cash to prepare for the shocks ahead without choking off lending to households and firms, the Financial Policy Committee (FPC) said.
In its first meeting in June, the FPC said banks should build up cash levels when earnings are strong - but today admitted this may not always be possible given increasing risks to the economy.
The latest quarterly update from the FPC, set up to oversee the country's financial stability in the wake of the credit crunch, comes after the International Monetary Fund (IMF) warned the eurozone debt crisis had added €300 billion (£260 billion) to the risk exposure of EU banks.
The FPC, an official committee of the Bank of England, chaired by the Bank's governor Sir Mervyn King, currently meets on an interim basis before it is given full legislative powers next year.
The committee in June urged banks to withhold dividends and retain profits to deal with the impact of the eurozone debt crisis - which it singled out as the biggest threat to UK financial stability.
But the FPC today acknowledged that "severe strains" to financial markets had weakened the outlook for bank earnings, which will hit their ability to strengthen balance sheets.
In minutes from its September meeting, the committee said: "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 went on: "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."
The FPC said this could be achieved by banks securing long-term funding and linking payouts to profits.
It also advised the Financial Services Authority (FSA), which the FPC is set to supersede, to encourage banks to manage their balance sheets in a way which would not worsen the economic climate.
Elsewhere, the committee said it will continue to debate which tools it will need to promote financial stability once its powers are finally established.
The meeting was held as eurozone and IMF officials met Greek leaders to discuss the debt-ridden nation's progress on cutting its deficit - a requirement of receiving the next €8 billion (£7 billion) tranche of bailout funds.