The Bank of England’s Financial Policy Committee (FPC) has said that UK banks had a £25 billion shortfall in their capital requirements at the end of 2012, as stricter capital requirements impacted balance sheets.

The committee, which monitors the financial system and the broader economy, said the immediate objective for banks should be to hold at least seven per cent in common equity against their risk-weighted assets by the end of the year, after making three key adjustments for potential loan losses, higher risk weights and the costs of past misconduct.

The FPC said the Financial Services Authority (FSA) has identified a potential £50 billion capital hole at the UK's major lenders. It said this is made up of a potential £30 billion in potential loan losses from UK commercial real estate and assets in weakened euro zone countries; around £10 billion in additional charges for past misconduct such as the cost of reimbursing customers for faulty payment protection insurance; and around £12 billion to cover higher capital charges for raising risk weights applied to banks' assets.

"Taken together, the effect of these three adjustments would be equivalent to around a £50 billion reduction in the regulatory capital of the major UK banks and building societies," the FPC said in a statement.

The FPC said the Prudential Regulation Authority (PRA), which takes over from the FSA on April 1st, should consider requiring higher capital ratio requirements for any major lender with "concentrated exposures to vulnerable assets, where there are uncertainties about assets not covered in the FSA's assessment of future expected losses or risk weights analysis, or where banks are highly leveraged relating to trading activities."

It said: "The PRA should ensure major UK banks and building societies meet the requirements... by issuing new capital or restructuring balance sheets in a way that does not hinder lending to the economy.

"Any newly-issued capital, including contingent capital, would need to be clearly capable of absorbing losses in a going concern to enable firms to continue lending."

The FSA released its findings of the review of banks’ capital pressures yesterday, stating that banks need to plug the hole as soon as possible. It indicated that annual stress tests should be carried out on banks and it has ordered them to make a more “honest” assessment of hidden losses on their balance sheets.

The banks, and some building societies, with shortfalls were not specifically identified in the review but have until the end of the year to plug the gap by winding down businesses or retaining more profits.

The FPC, set up to prevent a fresh crisis in the financial system, found that banks were overestimating their capital by around £50 billion after the FSA conducted an analysis of the amount capital banks were holding.

The FSA release yesterday stated: “Some firms, even after the adjustments described above, have capital ratios in excess of FPC’s recommended seven per cent of risk-weighted assets under Basel III definitions; for those that do not, the aggregate capital shortfall at end 2012 was around £25 billion.”

The body also noted that after 2013, further increases in capital ratios will be required. It added: “In particular, banks will need to transition to full Basel III compliance and meet the surcharge on systemically important banks and the new trading book capital regime.”

The FPC added: “In parallel, they will need to meet the requirements imposed by the Government’s implementation of the Independent Commission on Banking (ICB) recommendations.”

Banks will no doubt find it hard to expand lending to the wider economy while strengthening balance sheets, but one positive is the scale of the so-called black hole in their finances.

A £25 billion funding shortfall will be easier for banks to tackle than the £60 billion which was suggested at the end of last year.