Watchdog orders banks to cut bonuses, not credit

The Bank of England's Financial Policy Committee (FPC) has called on banks to cut bonuses and dividends and raise capital where necessary in order to protect themselves against financial shocks.

The committee also cast doubt on banks' financial targets and the calculations they make to judge the riskiness of their lending.

The FPC's demands came as the Bank announced a new scheme to make funding available to banks if the market for short-term sterling liquidity dries up. Under the contingency plans, banks would be able to bid for funds by putting up top-quality assets as collateral.

The Bank's announcements demonstrate its fears that trouble is in store for Britain's banking system as the eurozone crisis and the weakening economy threaten a new wave of upheaval.

The FPC said in the minutes of its recent meeting that, faced with short-term risks, banks should step up efforts to strengthen themselves against losses. Instead of reducing loans on their balance sheets, which could starve the wider economy of credit, they should build up their capital reserves.

The demands reinforce calls made by the FPC's chairman, Sir Mervyn King, for banks to boost capital without cutting credit to the economy. The minutes also say the banks should publish "leverage ratios" by 2013 so investors get a clear picture of their risks.

The committee's demands pile further pressure on Britain's banks ahead of a fraught end-of-year bonus round. Grim economic conditions have cut profit estimates for the banks and big bonus payments will be seen in stark contrast to falling general living standards. The Association of British Insurers has demanded the banks cut bonuses instead of reducing dividends.

The 11-member committee will be responsible for maintaining financial stability once the Chancellor's regulatory shake-up takes full effect later on next year.