U.K. banks remain "vulnerable" to further writedowns on their assets because of a potential decline in investor appetite for risk, Bank of England said.

Derivatives and other financial instruments accounted for 40% of U.K. banks' total assets at the end of 2009, the central bank said in its semiannual financial stability report published in London on Friday. Globally, mark-to-market losses on assets rose to $7.8 trillion in June, from $4.5 trillion in March, it said.

"If sovereign risk concerns rise or risk appetite continues to diminish, asset prices could fall further," Bank of England said. "This would have a significant impact on the solvency positions of holders of these assets, including both U.K. and global banks."

Policymakers are seeking to strengthen their banking systems after lenders globally posted $1.78 trillion of writedowns since the start of the financial crisis. Banks may need to raise as much as $375 billion to increase capital and liquidity under Basel III rules, which may be introduced by the end of 2012, according to an estimate by UBS AG analysts.

Though U.K. banks are still vulnerable to a drop in asset prices, they have mitigated that risk by reducing their holdings of credit market instruments by 21%, to 207 billion pounds ($310 billion) last year, Bank of England said. Writedowns on such instruments at the four biggest U.K. banks fell to 9 billion pounds ($13 billion) in 2009, compared with losses of 20 billion pounds ($30 billion) in the previous year.

Bank of England said the sovereign debt crisis in Europe had increased the risk of instability in the U.K. financial system and banks need to raise more capital to guard against shocks.

"The speed with which Greece's problems were transmitted to other countries and markets highlighted persistent fault lines in the global financial system," the bank said in the report. "U.K. banks face a number of challenges and need to maintain resilience in a difficult environment."

British banks' direct holdings in Greece and other peripheral European economies that are facing funding pressures are modest relative to their counterparts in the rest of the region, Bank of England said.

U.K. banks are "particularly exposed" to the French and German banking systems, which account for about a quarter of their claims on banks globally, the central bank said.

"U.K. banks face increased counterparty credit risk on exposures to other European banks," the report said.

European Union officials were meeting in Brussels Friday to discuss whether Spanish savings banks and Germany's regional state-owned Landesbanken should be included in the current round of stress tests, according to two people with knowledge of the situation. The Spanish government is already stress-testing 45 savings banks, known as cajas.

In the United States, congressional lawmakers approved a ban on proprietary trading by banks and new oversight of the derivatives market in an overhaul of financial regulation. The bill is designed to protect consumers, reduce risks and give regulators emergency powers.

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