The European debt crisis is a "key risk" to the UK's banking sector and banks should build up their cash reserves in response, the Bank of England has warned.

In its latest financial stability report, the central bank welcomed recent measures taken by the EU to stem the crisis.

But it said UK banks' exposure to other European lenders made them vulnerable.

Investors remain concerned that some eurozone countries risk defaulting.

Market expectations of a default by Greece hit an all-time high on Thursday, as the cost of insuring against the country rose sharply.

Sovereign debt concerns have raised doubts about the strength of some European banks, the Bank of England said, which could have a knock-on effect on the UK financial sector.

UK banks have relatively little direct exposure to Greece and other crisis-hit European governments.

However, the Bank of England indicated that indirect exposures were substantial. For example:

UK banks have major "counterparty" exposure to its fellow European banks, and a default by Greece and other sovereign borrowers could lead to the collapse of these European banks.
The European debt crisis could scare markets, making them less willing to lend to anyone they consider risky, including to UK banks.
Greater market fear could also lead to falling prices for risky assets like corporate bonds, forcing UK banks to write down the value of their loans and other assets, causing them heavy losses.
The report also warned of the potential risks posed to banks by the UK economy.

A weaker-than-expected economy or a rise in interest rates could see large numbers of mortgage holders default on their loans, it said.