King tells bankers: Cut your bonuses to help us all

Banks must cut bonuses and use the money they save to protect themselves from the eurozone debt crisis – and to help businesses and households, the Governor of the Bank of England warned yesterday.

Britain's lenders need to raise their levels of capital to survive the "exceptionally threatening" sovereign debt crisis sweeping Europe, Sir Mervyn King said. He also warned banks not to withdraw credit from British firms and borrowers in the process.

"If earnings are insufficient to build capital levels further, banks should limit distributions," the Governor said in a warning against bonus culture. "Distributions" refers to banks' payments of dividends to shareholders and bonuses to employees. The move is unlikely to be met with enthusiasm by bankers.

The warning comes as David Cameron and Nicolas Sarkozy begin talks today, after the French President last night backed the German-led plan for a new EU treaty which would force eurozone countries to balance their books.

Sir Mervyn also stressed that banks should not respond to the threats of financial contagion from the eurozone crisis by cutting the flow of lending to British households and businesses, saying this "may cause harm to the wider economy". The Bank of England (BofE) has repeatedly warned that viable small firms are being unfairly squeezed by high-street lenders, and its official figures show that levels of new mortgage credit extended to the public have fallen almost to zero.

He said the Bank itself was making "contingency plans" in case of a eurozone collapse, with its Financial Policy Committee confirming that the crisis was the biggest threat to the UK's banking system. He refused to go into details about such plans, however, because there was no "single well-defined event against which we have to make contingencies".

In its latest stability report, the Bank said there were ominous signs that borrowers were being penalised still further by lenders whose own borrowing costs had crept up in recent months. "There are early indications from market contacts that some banks may be starting to pass on higher funding costs to household and corporate customers through higher prices," it said.

The BofE has argued several times that private banks should build up their capital buffers by cutting dividend payments to shareholders and pay awards for staff. On Wednesday, six of the world's central banks, including the Bank of England, pledged to cut the price of their lending of dollars to stressed private banks, a move that was greeted with enthusiasm by stock market investors.

But Sir Mervyn warned that this liquidity support was not a lasting solution to the eurozone debt crisis, and it was up to EU leaders, who will meet in Brussels next Friday, to stabilise the situation. "The crisis in the euro area is one of solvency and not liquidity," he added. "Only the governments directly involved can find a way out of [it]."

The net exposure of British banks to the weakest part of the eurozone, which includes Ireland, Spain, Italy, Greece and Portugal, is £191.8bn – 83 per cent of their capital cushion, the BofE said.

Q&A: The new credit crunch

Q. How are central banks helping?

A. On Wednesday, the world's central banks said they would make it cheaper for private banks to borrow dollars. Private banks have creditors – often other banks – who they must pay back on a rolling basis.

But US investment funds from which private banks normally borrow short-term are refusing to lend, fearing the banks might go bust because of their exposure to European governments' debt. So, if private markets won't lend, private banks can borrow dollars from central banks. Short-term emergency borrowing comes at quite a tough interest rate – around 1 per cent – but the world's central banks have halved that to 0.5 per cent so distressed private banks can keep afloat.

Q. How does this affect the UK?

A. British banks have larger capital buffers than their counterparts in Europe – but they're heavily exposed to eurozone debts. They hold around $430bn (£273.86bn) worth of loans to European states, banks, corporations and households. This is equivalent to 19 per cent of our GDP. If a eurozone nation defaults, British banks have a lot to lose. And if a nation leaves the euro, all the loans made by UK banks to that country will plummet in value.

Q. What's causing the problem?

A. Investors have lost faith in the ability of a number of European governments to pay back what they've borrowed. That's why Greece, Portugal and Ireland had to be rescued by the European Union and the International Monetary Fund. Now Italy is under pressure – but there's only around €250bn (£214.53bn) in the European bailout fund, which is not enough to rescue Italy, which has a debt pile of €1.9trn.

The IMF, which has lending power of around €290bn, is also too small to do the job. The European Central Bank could print money to finance a rescue, but Germany argues this would only create larger problems in future. Unless something is done to convince markets that Italy and other states can pay their debts, there could be a sovereign debt default by a eurozone nation, triggering losses across the banking system and plunging Europe into a depression.