Britain's financial regulators sent banks mixed messages on Wednesday, saying they should trim surplus reserves to help the struggling economy although they need more capital as the worst may yet be to come.
British banks have been forced to build up large capital defences since the 2007-09 financial crisis, when some like Royal Bank of Scotland and Lloyds had to be rescued by taxpayers - something the public does not want repeated.
Banks now hold greater reserves than the minimum international standards known as Basel III being phased in from January.
The Bank of England's Financial Policy Committee, which monitors risks in the financial system, said in September that banks could trim reserves if they lent the freed-up money to businesses but that banks should also build up core defences, by cutting bonuses if need be.
Two FPC members speaking at the British Bankers' Association's annual conference in London repeated this apparently conflicting guidance on Wednesday.
"We are in very difficult circumstances at the moment in the sense that huge risks are behind us. There is still a tangible probability - not a high probability - that the worst may still be ahead," Bank of England Deputy Governor Paul Tucker said.
Even the new Basel rules designed after the financial crisis were not enough to ensure banks had adequate defences, he said.
"Basel I, II, III, IV and V are not calibrated for the kind of end of the world risks that lie within the realms of the possible at the moment," he said.
"If we get a tidal wave, we may all be grateful that there are a few billion more in capital here and there in the banking industry, keeping banks in the private sector rather than the dead hand of state ownership," he continued.
But Andrew Bailey, head of banking supervision at the Financial Services Authority said the FPC was grappling with trying to get a clear message to banks on how big their capital defences should be to remain resilient.
Bailey said there was a need to fill in "what for me is the big gap at present, namely how we explain and calibrate the resilience objective in terms of capital".
The FPC will focus on this at its next meeting and monitor how any trimming of capital defences has worked.
"We will be prepared to amend our judgements in the light of experience," Bailey said.
Bankers said privately that the mixed "good cop, bad cop" message from regulators was partly due to the FPC's added remit of helping economic growth as well as maintaining financial stability, two objectives that can contradict each other.
The FPC is one of a new breed of watchdog practising that seeks to cool asset bubbles before they destabilise the economy or cut some slack for banks in tough economic conditions.
"It shows that supervision is an art and not a science," said Paul Chisnall, executive director of the BBA.
"The process of supervision is evolving. There is a new dynamic between the overall level of capital in the financial system and the ability to adapt this to give some assistance to help the economy," Chisnall said.
Bailey conceded that FPC members were trying to flesh out a clearer line on capital and what type was needed.
"This danger of creating uncertainty exists because we are finding our way in a new and difficult area of policy," Bailey said.
Rolls Royce Finance Director Mark Morris also urged regulators to find the right trade off between regulation and financial stability.
"The balance between stability and growth is a fine judgement, which we feel … is being overlooked more in favour of regulation rather than growth. If the patient is on the operating table, our view is, don't kill him, resuscitate him and try and keep him alive," Morris told the BBA conference.
Bailey said the FSA is still requiring banks to build up their core Tier 1 ratios - a benchmark of a bank's health - in line with new global Basel III minimum capital requirements from January.
Where banks are being given latitude is in scaling back on capital they hold above the regulatory minimum, know as Pillar 2, and set at the discretion of supervisors, Bailey said.
Since 2008, this type of capital that sits on top of the regulatory minimum has risen from just under 20 billion pounds to 150 billion pounds.
(Reporting by Huw Jones; Editing by Dan Grebler)