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.
The Bank urged lenders to take action to bolster their balance sheets.
It also wants them to reveal the full extent of losses on bad debts, as well as expected compensation bills, in particular for mis-sold payment protection insurance.
UK 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 of England said the UK's economic recovery was in danger of being hampered unless banks took action now.
Bank Governor 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.
Mr King 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 together these factors were likely to have a "material" impact on banks' capital buffers. "The danger to be avoided is inadequate capital holding back the recovery,'' he cautioned.
