Banks told to cut dividends and bonuses to build financial buffers

Banks should make preparations to withstand the "extraordinarily serious and threatening" economic situation in Europe, the governor of the Bank of England said yesterday.

Sir Mervyn King said the Bank itself was making "contingency plans" in case of a eurozone collapse, with its financial policy committee confirming that the crisis was the biggest threat to the UK's banking system.

He also said British banks must cut bonuses and use the money they would save to protect themselves from the eurozone debt crisis and help businesses and households.

Speaking at the launch of the Bank's twice yearly Financial Stability Report, Sir Mervyn said UK banks need to raise their levels of capital to survive the "exceptionally threatening" sovereign debt crisis sweeping Europe. The Governor also warned banks not to withdraw credit from UK firms and borrowers in the process.

"If earnings are insufficient to build capital levels further, banks should limit distributions," said the Governor. "Distributions" refers to banks' payments of dividends to shareholders and bonuses to employees.

He also stressed that banks should not respond to the threats of financial contagion from the eurozone crisis by cutting the flow of lending to UK households and businesses.

"It is crucially important that we avoid causing individual banks to seek to strengthen their balance sheets in such a way that... may cause harm to the wider economy," he said.

The Bank has repeatedly warned that viable, small firms are being unfairly squeezed by lenders. And Bank figures show that the levels of new mortgage credit extended to the public have fallen almost to zero. The Bank's stability report yesterday said there were ominous signs that borrowers were being penalised still further by banks as their own borrowing costs have crept up in recent months.

It said: "There are early indications from market contacts that some banks may be starting to pass on higher funding costs to household and corporate customers through higher prices." The report also warned that if banks cut off lending to the UK economy, they could end up undermining their own solvency by crimping UK growth rates.

The Bank of England has argued in the past that private banks should build up their capital buffers by cutting dividend payments to shareholders as well as pay awards for staff.