Banks need to maintain lending to the real economy, but should cut dividends and bonuses — and possibly even issue new shares — to build these capital levels further, the Bank's interim Financial Policy Committee said.
And in a sign that the FPC does not trust how banks report how indebted they are, it recommends that they be ordered to publish leverage ratios from the start of 2013, two years earlier than international Basel III rules require.
The interim FPC is chaired by Bank Governor Mervyn King, and issued its first recommendations in June. Currently it only has an advisory role, but new laws are expected to make it Britain's top financial regulation body from the start of 2013.
The FPC said the euro zone debt crisis remained the top threat to Britain's banking system, and stepped up its calls for banks to raise more capital from its last set of recommendations in September.
"Given the current exceptionally threatening environment, the Committee recommends that, if earnings are insufficient to build capital levels further, banks should limit distributions and give serious consideration to raising external capital in the coming months," the FPC said.
Tier 1 capital ratios for UK banks, a key measure of stability, were well above 12 percent in the first half of 2011, among the highest in the world, and far above pre-crisis levels.
British banks are unlikely to react warmly to the FPC's calls. The chief executive of Royal Bank of Scotland — which was rescued by taxpayers at the height of the financial crisis — said recently that onerous regulation meant investors believed UK banks were a "dumb" place to invest, and that it limited their ability to lend.
King, in testimony to MPs on Monday, denied that tighter capital rules would constrain bank lending, though he did concede that there was more room for argument about liquidity rules.
The FPC said major UK banks are already very close to meeting their funding targets for 2011 and have 140 billion pounds of funding due to mature next year, most of it in the first half.
Lenders across Europe are reining in loans and selling off assets in a bid to reduce their capital requirements, raising fears of a squeeze for businesses and the broader economy.
Banks should "improve the resilience of their balance sheets without exacerbating market fragility or reducing lending to the real economy," the FPC said.
The report appears to cast doubt on the effectiveness of the central plank of the world's regulatory response to the crisis — tougher capital and liquidity rules.
The failure of Belgian bank Dexia in October — which had high capital levels — signalled the importance of looking at broader indicators of a bank's health, in particular a leverage ratio, the FPC said.
"Opaque and overly complex regulatory risk-weight calculations and inconsistent and incomplete disclosure have increased uncertainty about bank resilience," it said.
"Market intelligence suggest that investors are now questioning the reliability of ... the calculation of risk-weighted assets," it added.
