Miscalculating the amount banks needed to pay out because of bad behaviour is one of the reasons their balance sheets fall short (Reuters)

Bank balance sheets are giving a misleading impression of their capital adequacy meaning their capital buffers are weaker than they should be to protect them, their investors and their customers against collapse in any unforeseen future financial disasters, according to the Bank of England's Financial Policy Committee (FPC).

The FPC's latest financial stability report said that understated potential future loan losses, a shortfall in provision for payouts relating to bad behaviour such as PPI mis-selling, and over-emphasis on the impact of risk weights all raise doubts about the integrity of bank balance sheet valuations.

"In combination, these factors would imply that UK banks' capital buffers, available to cushion losses and maintain the supply of credit following realisation of a stress scenario, are not as great as headline regulatory capital ratios imply," said the report.

Its recommendation is that the Financial Service Authority (FSA), which regulates the banking industry, ensures that the capital of UK banks and building societies "reflects a proper valuation of their assets".

If a bank is deemed to need strengthening of its capital buffer, which is a regulatory requirement, the FSA must make it restructure its business or raise more cash to shore itself up.

Sir Mervyn King, Bank of England governor, was asked in a press conference if this meant more bank bailouts were coming should any big event shake the financial sector in the coming months.

"I don't think the problem is on the scale where it should concern taxpayers," said King.

When asked if banks were essentially lying to the markets about the state of their balance sheets, King said that it is "not a case of not being honest" and that "they are constrained by accounting conventions".

In June the FPC warned that significant bank losses stemming from their exposure to the crisis-stricken eurozone still loomed on the horizon.

Now the FPC says the picture has improved, with market fears over the eurozone easing as the European Central Bank takes action, though there is still a risk from the single currency area.

"While UK banks have significantly reduced their direct exposures to sovereigns and banks in vulnerable euro-area economies, exposures to non-bank private sectors in these countries are likely to remain significant for some time, unless they sell loans or businesses," said the FPC report.

"Historical experience suggests that more rapid progress in tackling balance sheet problems would support improved funding conditions and the ability of banks to extend new loans to households and businesses.

"The FPC's recommendation is aimed at achieving such an outcome."