The European Banking Authority (EBA) has warned lenders against being so risk-averse as to prompt a credit crunch.
It also said regulators would not allow a cut in lending as a means to meeting regulatory capital targets.
Banks have changed their behaviour far more than the public has realised in the wake of the financial crisis, EBA head Andrea Enria told German magazine Der Spiegel in an interview.
At the moment, our concerns have gone to the other extreme: that we could now have the problem banks are too risk-averse, which could ultimately lead to a severe credit crunch, Enria said in the interview in the magazine's Monday edition.
Lenders around Europe will need to drum up about 115 billion euros (98.3 billion pounds) in extra capital by June 30 to meet a regulatory capital target set by the watchdog.
Banks can retain earnings, curb dividends and bonuses, sell off chunks of their businesses or reduce risky assets to meet the target, but Enria put them on guard if they were thinking of choking off loans.
If a bank reduces its lending to small and medium-sized enterprises, it won't be counted (toward meeting the target), he said. We will not allow credit supply to be cut.
Banks have until January 20 to present their roadmaps for meeting the regulatory capital target to banking supervisors.
Loan portfolios can be sold, even to hedge funds, to help bolster banks' equity capital cushions, Enria said.
The EBA wants banks to reach a core Tier 1 regulatory capital ratio of 9 percent by the mid-2012 deadline, which should help lenders withstand any market deterioration.
The watchdog's stress tests of banks, based on data from the third quarter, revealed six German lenders need 13.1 billion euros of extra capital to meet the deadline, nearly triple the amount estimated previously.
These sorts of high figures do not necessarily mean that banks are in bad shape, Enria said.
The most urgent problem is funding, and in that regard the German banks are doing better than others. However, the storm is also affecting them, and they, too, have to strengthen their capital.
Only a few large banks have been able to fund their businesses since July, and have had to pay very high interest rates to do so, Enria said.
If banks cannot get funds, they stop lending and that damages the economy, he said. We are stuck in a vicious circle and we have to try to break out of it.
($1 = 0.7482 euros)
(Reporting by Jonathan Gould; Editing by David Hulmes)