British banks should look to increase their capital buffers to guard against the "exceptionally threatening" current market crisis, the governor of the Bank of England has said.
Mervyn King said that the rising cost of borrowing in peripheral eurozone economies, which has caused the European banking sector to cut back on lending amid falling confidence, asset prices and economic growth, has led to "a spiral that is characteristic of a systemic crisis".
Presenting the bank's financial stability report on Thursday, King warned that the crisis in the eurozone "is one of solvency, not liquidity" and said that the UK "must bolster the resilience of our financial system".
While British banks have higher capital ratios than most of their European peers, they should consider finding external sources to raise even more finance, as well as retaining capital from bonuses and profits, King said. While many have made progress in building up their reserves, market conditions have led to those efforts being held back.
King said that banks should go beyond the requirements set out in international regulations and build higher buffers, and said that the Financial Services Authority (FSA) should encourage them to report their leverage ratios as early as 2013 in a bid to improve their transparency.
The risks from the eurozone's sovereign debt crisis are "the most significant and immediate threat to UK and financial stability", and those risks have intensified since the last financial stability report in June, the report said. Current market prices imply a 40% probability of a default in Italy, according to the bank's analysis, an event that could be catastrophic for world markets.
Banks still have exposures to sovereign debt on the mainland, but are even more exposed to the European private sector and banks in the eurozone. A default would cause rolling losses, and possibly failures, across the banking system, and certainly would restrict credit in the UK markets.
Central banks around the world moved together to ease funding constraints in global markets on Wednesday, providing a brief confidence boost to investors, but King warned that such measures are not designed to solve the underlying problems in the eurozone.
"Merely providing a temporary solution" is not a solution at all, King said. Governments will need to resolve the solvency issues in their own countries and tackle the cause, and not the symptoms of the crisis.