The minutes of the FPC's September 14 meeting add urgency to its existing call for banks to raise capital, saying banks should tap outside investors for capital instead of simply relying on curbing bonuses and keeping back profits.

"Recent improvements in market conditions should help in that respect, with the options including debt conversion and the issuance of suitable contingent capital instruments as well as conventional equity," it continued.

Britain's relatively well-capitalized banking sector is confident of meeting targets under the Basel III rules brought in since the 2008 financial crisis, but they also face risks ranging from legal cases around the Libor interest rate fixing scandal to a wobbling domestic economy and property sector.

Analysts said investors were still leery of banks, noting the difficulties some European banks had in tapping markets. There has also been mixed investor appetite for Royal Bank of Scotland's (RBS.L) forced sale of insurance unit Direct Line.

"The senior management of banks are also not incentivized to raise new equity capital. It would impinge on the wealth prospects of senior management due to dilution, and the new equity would probably be raised at a significant discount," said Vivek Raja, a banks analyst at Oriel Securities.

The British Bankers' Association had no immediate comment.

The committee said banks had made only "limited progress" in building up their capital cushions, partly because profits were being hit by the weak economy, payouts for mis-selling and other conduct issues.

HSBC (HSBA.L), Lloyds (LLOY.L), Barclays (BARC.L), Royal Bank of Scotland (RBS.L) and Santander's (SAN.MC) UK arm will end up paying the bulk of an estimated 10 billion pounds ($16.15 billion)in compensation for mis-selling loan insurance.

"The committee judged that these factors were likely to provide a continuing drag on banks' earnings, diminishing their ability to build capital internally," the FPC said.

The FPC said it would consider giving banks more precise individual guidance on how much capital to raise at its next meeting.

EURO ZONE EXPOSURE

British banks still had exposures to the most vulnerable euro zone countries that totaled 70 percent of their core regulatory risk buffer, and should use calmer market conditions to sell this type of risky asset, the FPC said.

The FPC met just after the European Central Bank had appeared to agree to purchase debt from embattled euro zone countries such as Italy and Spain, helping to bring down high interest rates.

But since then the reluctance of Spain's government to formally ask for a bailout has put the project on hold, causing euro zone peripheral bond yields to climb back up above critical levels.

The 11-member FPC held its first meeting in June last year, and issues guidelines to tackle broad threats to the stability of the British financial system, rather than problems specific to one firm. From next year, it will have statutory powers and sit at the top of Britain's financial regulatory structure.

However, the BoE is keen to balance a safe banking system against the need to ensure that it lends to businesses and households, as it says a lack of lending is one thing that has held back Britain's recovery from the 2008-09 financial crisis.

The minutes of September's FPC meeting said policymakers had a "range of views" about the existence and strength of any trade-off between tighter regulation and greater UK lending.

One FPC member, former banker Robert Jenkins, blasted banks this week for spreading "myths" such as that tougher rules make it harder for lenders to supply credit to businesses.

The FPC recommended last year that banks publish their leverage ratios - a benchmark of how stretched their balance sheets are - from 2013, two years earlier than under the Basel III global accord.

In its minutes, the policymakers emphasized that earlier disclosure did not mean that UK banks also have to comply early with the actual leverage ratio cap set out in Basel III as well. ($1 = 0.6193 British pounds)

(Reporting by Huw Jones and David Milliken, editing by ....)

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