Banks protest as FSA demands more capital

Watchdog to treble the amount lenders must hold in gilts to prevent crises

In a further twist of the regulatory screws, the Financial Services Authority said yesterday that banks operating in the UK would be required hold approaching £1bn in government securities – three times their current levels – to ensure that they have enough liquidity in times of financial stress. Government bills and bonds are readily convertible into cash.

The FSA will set individual liquidity requirements for institutions, require them to report weekly, and will "stress test" them. Taken together with other rules now being prepared or implemented on capital adequacy, bonuses and "off-balance sheet" banking, the moves promise to reduce permanently profitability in the banking sector

Paul Sharma, the FSA's director of prudential policy, said: "The FSA is the first major regulator to introduce tighter liquidity requirements for firms. In the current crisis, some firms weathered the storm better than others. These firms tended to be those that had policies that were similar to those that we are introducing today – including holding assets that were truly liquid, such as government bonds."

Fears that banks will be encouraged to "hoard" cash rather than lend it to hard-pressed small businesses and homeowners were allayed by the FSA. The FSA said that it could take "several years" for them to be implemented completely, because "all firms at present are experiencing a market-wide stress".

Nonetheless, the banks gave the proposals a hostile reaction. Simon Hills, executive director of the British Bankers' Association, said: "These proposals would oblige banks to hold high amounts of government bonds, rather than allowing them to diversify their assets. Self-evidently any money held in these 'liquidity buffers' is money that banks cannot lend to individuals and businesses. No other regulator has yet created such a far-reaching liquidity regime, yet we are constantly assured at global meetings of the G20 that effective change needs international consensus. We cannot put at risk the attractiveness of the UK as a centre for international finance without also risking our chances of economic recovery."

Pat Newberry, chairman of UK financial services at PricewaterhouseCoopers, added: "Banks now face a major increase in costs which could impact profitability."

Having identified a lack of liquidity as a factor in the crisis, the FSA has decided that even highly rated corporate bonds, commercial paper or asset-backed securities will no longer qualify as "liquid" under their new regime.

The restriction of the definition of liquidity to government bonds and bills will force the banks to treble the amount they hold in such form to £900m.

It is the latest move to turn talk of reform into action. Last week the Treasury agreed with the largest banks a new rule on bonuses. Tighter rules on capital adequacy are also expected. "Living wills" will be required to make closing banks smoother.

Much of the banks' funding from wholesale sources and the securitisation of mortgage and loan books has been replaced by official schemes. Since the spring some banks have raised funds, but a capital gap remains for many. A research note from JP Morgan yesterday indicated that it expected the world's banks to have to raise $78bn (£49bn) in new capital to meet the revised prudential rules and repay governments. The banks most exposed are Commerzbank ($10bn); Allied Irish Banks ($10bn), Bank of Ireland ($7bn) and Société Générale ($6bn).

Banks will be required to have a "contingency funding plan" by December. Foreign banks with subsidiaries in the UK will be covered, to prevent a repetition of the collapse of UK arms of the Icelandic banks and Lehman Brothers' "sweep" of $8bn of London money to the US on its last day of solvency.