The Bank of England stepped up pressure on commercial banks to shore up their capital on Thursday, days after the government chose a leader of the global push for tighter banking regulation to head the central bank.
The BoE's Financial Policy Committee (FPC), which from next year will take charge of British bank regulation, urged the current regulator to reassess whether banks' capital properly reflects the risk of loans going sour and future fines for misconduct.
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British banks may take an over-optimistic assessment of the risks facing them, it said.
Banks' true capital position was probably worse than relatively healthy official numbers imply, and this is hurting investor confidence, the BoE said.
"Progress by banks in raising capital has slowed and investor confidence remains low," the BoE said in its half-yearly Financial Stability Report. "Market concerns are likely to reflect in part uncertainty about bank capital adequacy."
The FPC has repeatedly urged British banks to raise capital levels, and November's report marks a stepping up of these recommendations, despite a slight reduction in the risks facing the financial system due to an easing in euro zone tensions.
"UK banks' capital buffers, available to cushion losses and maintain the supply of credit following realization of a stress scenario, are not as great as headline regulatory capital ratios imply," it said.
British bank shares trimmed gains after the Bank of England's call, saying banks may not have enough in reserve to protect against problems ahead.
At a press conference to explain the report, BoE Governor Mervyn King said the problem should be kept in perspective.
"The problem is manageable, and is already understood at least in part by markets. But it does warrant immediate attention," King said.
Information from supervisors suggested some British banks would suffer bigger losses on loans than they had made provision for, according to the report.
Banks had also persistently underestimated the scale of fines they would face for past misconduct.
"In 2012, the number of identified conduct issues has grown and it seems likely banks could face additional sizeable costs," it said, adding that external analysts had suggested further costs of 4-10 billion pounds for mis-sold payment protection insurance and the LIBOR rate-rigging scandal.
The system of risk weighting that banks use to judge how likely they were to face losses was also "complex and opaque" and probably undermined investor confidence, the BoE said.
The BoE is also concerned that banks continue to lend to British businesses and households at a time when it blames a lack of bank credit as part of the reason for the country's very sluggish growth.
Inadequate capital buffers are not an excuse for reining back on lending, the central bank said.
"The Financial Services Authority should ensure that firms either raise capital or take steps to restructure their business and balance sheets in ways that do not hinder lending to the real economy," it said.
In September, the FPC urged British banks to boost capital by tapping external investors, strengthening earlier guidance which had focused more on curbing bonuses and keeping back profits.
The 11-member FPC held its first meeting in June last year. It issues guidelines to tackle broad threats to the stability of the British financial system, rather than problems specific to one firm.
In June it recommended that the FSA - which conducts day-to-day regulation of banks - consider relaxing rules on how much banks need to hold as cash buffers to reflect the emergency liquidity insurance available through the BoE's Extended Collateral Term Repo scheme.
Generally though, King, who chairs the FPC, has taken a tough line on bank regulation, and favors a complete separation of investment banking from retail bank activities.
Legislation going through Britain's parliament stops short of this, and envisages a 'ring-fence' to protect key retail banking activities from investment bank losses.
The BoE has also tried to provide incentives for banks to lend more with its Funding for Lending Scheme, which started several months ago and offers banks cheap credit if they lend in turn to businesses and households. The first detailed data about the scheme's take-up is due on Monday.
"At present, a range of policy measures including the Funding for Lending scheme, have given banks a breathing space in which to reinforce their bank sheets. It's important that they take advantage of that breathing space," said King.
(Editing by Estelle Shirbon/Ruth Pitchford)