Plans to free up billions of pounds of cash held by banks were announced today to help kickstart lending in the latest attempt to ward off a tightening credit squeeze.
The Bank of England said City regulators should tell banks they can tap into large amounts of cash held on their balance sheets if needed in the face of a worsening eurozone crisis.
The Bank hopes the move will offer a substantial amount of cash to lenders, estimating total liquidity held across Britain's banking system at around £500 billion.
On unveiling the Bank's latest Financial Stability report, Governor Sir Mervyn King said: "Our challenge remains making sure the banks are in the best possible shape to weather the storms they are facing and those that lie ahead so they can support lending to the real economy."
He added: "Banks have built up significant assets in recent years. They are in a strong position to withstand a period of market stress.
"But it's very important that they are willing to use them in times of stress to support lending to the real economy."
It is the next plank in the Bank's strategy to help Britain's economy recover from its double-dip recession, following the announcement earlier this month of a £100 billion-plus scheme to boost bank lending.
The Bank is working on a new "funding for lending" scheme, while last week it held its first £5 billion monthly auction under a six-month loan facility programme.
Sir Mervyn confirmed that UK banks were suffering from higher funding costs as money markets tighten due to the deepening woes in Europe.
They have already been passing on half of these increases to borrowers through loan rates, but the Bank warned that credit availability will tighten further if the rises are passed on in full.
The Bank believes today's recommendation to allow banks to make greater use of liquidity cash piles will help ease conditions for borrowers.
But the Bank stressed that it was still vital for banks to build up longer-term capital reserves that protect them in the event of further financial crisis.
Sir Mervyn reiterated calls on banks to rein in bonuses and investor dividends to boost their capital cushions.
He said four out of five of the UK's biggest banks had already reined in their cash bonuses, but more needed to be done.
Efforts to build capital reserves have slowed in recent months and the Bank is recommending the Financial Services Authority (FSA) takes action with banks to strengthen their buffers.
Sir Mervyn said: "It's vital that our banks are sufficiently well capitalised to be able to continue to provide the services on which we all rely. More capital and more lending go together."
This comes amid fears over bank exposure to troubled European countries.
UK bank exposure to governments and banks in vulnerable eurozone regions stands at around £42 billion, but total exposure - including to borrowers - is around £169 billion, according to the Bank.
The Bank said in its report: "Major UK banks' exposures to the most vulnerable economies' sovereigns and banks are low.
"But their exposures to non-bank private sector borrowers in many of these countries are significantly larger.
"Banks in other EU countries are also exposed to vulnerable euro-area countries. If contagion spread, significant disruption would be likely."
It is also hoped today's moves to relax liquidity buffers will allow banks to make better use of the cash boost offered under the Bank of England's £325 billion Quantitative Easing (QE) programme.
The Bank is widely predicted to extend QE in the coming months and minutes of the June rates meeting revealed four of the nine-strong committee - including Sir Mervyn - were narrowly outvoted on more QE.
But fears remain that there are no guarantees the Bank's raft of measures will persuade banks to lend or recession-hit companies to borrow.
Simon Hayes, economist at Barclays, said the Bank's Financial Policy Committee gave no clear indication of how its latest move would directly result in higher lending.
"The Committee was unable to put figures on how much liquidity would be freed up and the implications that might have for lending. As such, the macroeconomic effects of the policy guidance remain unclear," he said.
Today's report was published by the Bank's Financial Policy Committee after its meeting last week.
The Committee was set up to spot risks in the financial system, such as asset bubbles, in the wake of the credit crisis.