BRITISH BANKS should stop paying large cash bonuses and dividends in order to increase their ability to resist the threat of a wider and deeper euro zone crisis, said the Bank of England (BoE) in its latest Financial Stability Report.

Officials worry that although banks have improved their ability to absorb losses, the interconnectedness of the European banking system will amplify losses from peripheral economies.

“UK banks have claims of almost £300 billion (€354 billion) on France and Germany, whose banking systems are more heavily exposed to the most affected economies,” said the BoE.

It added that although UK lenders have limited direct exposure to peripheral European debt, renewed stresses in those regions could undermine growth and create large losses in banks’ much larger portfolios of loans to households and companies. To guard against this, the BoE insists buffers of capital should be gradually built up, by banks retaining profits rather than paying cash to shareholders and employees.

“It is in banks’ collective interest to build resilience gradually through retention of earnings, which would be boosted if banks restrain distribution of profits to equity holders and staff,” the report argues. The Bank is not proposing new sanctions, but as it will become the supervisor of UK banks, its words have more strength than usual.

– (Copyright The Financial Times Limited 2010)