BRITAIN’S banks could be “misleading“ investors by failing to face up to their bad debts and not putting enough cash aside to cover mis-selling scandals, the Bank of England warned yesterday.

It urged lenders to take action to bolster their balance sheets and reveal the full extent of losses on bad debts, as well as expected compensation bills, in particular for mis-sold payment protection insurance.

Taxpayers would not need to be asked to stump up cash to strengthen bank capital buffers and the Bank added the capital crisis was “perfectly manageable“.

But in its Financial Stability Report, the Bank said the economic recovery was in danger of being hampered unless banks took action now.

Bank Governor Sir Mervyn King said there were currently “good reasons“ to believe banks are not accurately reporting the level of capital buffers they hold.

“This uncertainty is responsible for low investor confidence,” he added.

Sir Mervyn said expected future losses were “understated”, banks had underestimated costs for customer compensation and added the assessment of risks faced by banks were “optimistic”.

The Governor warned that these factors were likely to have a “material” impact on banks’ capital buffers.

He added: “The danger to be avoided is inadequate capital holding back the recovery.”

The UK’s four biggest banks – HSBC, Lloyds Banking Group, Barclays and Royal Bank of Scotland – could need to increase their capital reserves by as much as £35bn between them, according to the Bank.

And the industry needs to reflect an accurate picture of financial health with “honest balance sheets”, deputy governor Paul Tucker said.

The Financial Services Authority is expected to now ask banks to increase their capital buffers, which act as a cushion against shocks in the financial system and future crises.

But the Bank said it was vital this was done in a way that would not impact lending to businesses and households. Sir Mervyn said there was a “window of opportunity” for banks to build up capital reserves while they are able to use the £80bn Funding for Lending scheme, which offers cheap cash for lending on condition they pass it on.

He said: “The choice we face is to tackle the situation head on, which will be difficult and in some quarters unpopular, or to suffer a prolonged period of adjustment in which an inadequately capitalised banking system holds back recovery in the wider economy.” Deputy Governor Paul Tucker faced awkward questions after losing out on the top job to Mark Carney, who was named as Sir Mervyn’s successor earlier this week.

Amid speculation he will quit the Bank, Mr Tucker said: “I’m deputy governor for financial stability, there’s a job of work to be done, I’m doing it.”

While today’s report makes for grim reading by the banks, it suggested some of the risks facing the economy had started to ease.

Sir Mervyn said market sentiment had improved “a little“, although the Bank remains concerned by weak global economic conditions and the ongoing debt-crisis in Europe.

The report added there were signs of improvements in lending and lower rates for borrowers in the wake of the Funding for Lending scheme.