THE Government is not going to put any more taxpayers' money into Royal Bank of Scotland and Lloyds Banking Group, despite a demand from the Bank of England that institutions raise capital or restructure to cover hidden losses.
The Bank's Financial Policy Committee (FPC) warned banks are making an over-optimistic assessment of the level of bad debts and the penalties they face for mis-selling payment protection insurance (PPI) and manipulating key interest rates.
Bank Governor Sir Mervyn King said: "The danger to be avoided is that of inadequately capitalised banks holding back our recovery."
The FPC has asked the Financial Services Authority (FSA) to ensure banks' capital reflects a proper valuation of their assets.
Sir Mervyn also revealed the Treasury has said it is not prepared to put more money into Lloyds Bank Group and Royal Bank of Scotland, which received capital injections of £66 billion from the taxpayer four years ago. This raises the prospect of them selling more assets to reduce their need for capital and some experts have warned they might cut lending.
The FPC believes banks have a "window of opportunity" to deal with their balance sheet problems while they have access to cheap state funding. But Sir Mervyn said: "We are not saying 'tomorrow morning, be out there with collecting tins'."
He refused to provide an estimate of how much more capital the UK banking system needs, although scenarios described in the Bank's Financial Stability Report, published yesterday, suggested that banks could need tens of billions of pounds of capital unless they scale down their balance sheets.
The FPC is concerned that, in part driven by accounting conventions, expected loan losses are greater than the provisions banks have made for them.
It also highlighted that banks have underestimated redress costs for PPI, mis-selling interest rate swaps to small firms and manipulating the London Interbank Offered Rate.
These have so far cost UK banks more than £13bn, but the FPC warned of "additional sizeable costs", of up to £10bn.
Meanwhile, the committee cast doubt on risk calculations that banks use to determine the capital they need to absorb potential future losses. Sir Mervyn wants banks to make an "honest and open statement" of what they have on their balance sheets.
The Bank is particularly concerned about property loans, which make up just under half of banks' lending. It said a third of these loans have been to subject to forbearance where banks have relaxed conditions.
There was little movement in banks' share prices. RBS closed up 4.4p or 1.5% at 299p and Lloyds at 46.64p, up 0.7p or 1.5%.
The City largely dismissed the chances of dilutive capital raisings. Ian Gordon, analyst at Investec, said he expected the FSA to be "pragmatic".
He said: "Despite the uncertainty, we see the risk of equity issuance as low."
Robert Webb, senior lecturer at Glasgow Caledonian University said there was little investor appetite for banking paper.
He said: "Who is gong to give money to an ailing banking sector to give to ailing small and medium-sized enterprises who are ailing because the economy is flat-lining?"
Mr Webb said he expected banks to rejig their balance sheets. He warned this could see lending to smaller firms cut.
But the Bank of England claimed historical experience suggests rapid progress in tackling balance sheet problems will improve funding conditions and allow banks to extend more loans to households and businesses.
The British Bankers' Association said: "The banks are raising money, they are raising capital. They are doing what the Bank of England asked."
The FPC also called for further reforms to executive pay.