The eurozone's debt crisis poses the biggest single threat to UK financial stability, the Bank of England's new financial watchdog has warned.
Despite the limited direct exposure of UK banks to debt in beleaguered countries such as Greece, the impact on nations such as Germany and France would have a knock-on effect and lead to a tightening of bank funding conditions.
The minutes of the first meeting of the interim Financial Policy Committee set out a number of risks to the stability of the UK financial system, saying: "Sovereign and banking sector strains in some vulnerable euro-area economies were the most material and immediate threat to UK financial stability."
Among recommendations, banks will be told to retain more of their profits as they face threats from the eurozone debt crisis and the possibility that homeowners may not be able to repay their mortgages. It said in the medium-term banks face a potential problem from the number of businesses and homeowners that are struggling to repay their loans or mortgages and warned that banks may have made inadequate provision for bad debts.
The committee, which has been set up to oversee the country's financial stability in the wake of the credit crunch, advised banks to hoard more money during the good times to prepare them for any shocks ahead. Members discussed possible measures to limit dividends paid to shareholders or to rule that they are paid in newly created shares rather than cash to help banks build their capital reserves.
If the banks do not start to follow its advice by later this year, it will reconsider the issue, it said. There was also a medium-term threat from mortgage and business lending, it warned, and that banks could have taken an "overly sanguine" view of the ability of borrowers to repay their debts. It could not be ruled out that inadequate provisioning for bad debts may have masked underlying credit risks, it added.
It said the number of residential mortgages in some kind of forbearance - where banks had shown leniency to struggling borrowers - in the year to March 2010 was four times higher than those that had been repossessed or were six months or more in arrears.
Bank of England governor Sir Mervyn King refused to liken the eurozone debt crisis to the collapse of Lehman Brothers, which triggered the financial crash, saying the only thing it has in common is that "it's a mess".
He said the current crisis, which centres on Greece as it struggles to implement tough austerity measures, will only be resolved when countries get to the heart of their debt problem by tackling their deficits.
He added: "Right from the start of this crisis, people wanted to believe it was a crisis of liquidity and we need to accept it's a crisis based on the build-up of large amounts of debt. The belief that we lend a bit more will never be an answer but it can buy more time to put in place a fundamental solution."