Dire warning banks would fail if hit by new financial shock 10 years after Northern Rock's near-collapse

It comes as the think tank produced research suggesting that the current Bank of England stress tests – launched in 2013 to determine how banks might cope with troublesome economic scenarios – are “worse than useless”.

Professor Kevin Dowd of Durham University, senior fellow of the ASI who compiled the report, said: “The stress tests are about as useful as a cancer test that cannot detect cancer.

“They seek to demonstrate a financial resilience on the part of the UK banks that simply isn’t there.

“It is disturbing that 10 years on from Northern Rock, the best measure of leverage – those based on market values – indicate that UK banks are even more leveraged than they were then.

“The biggest risk facing the UK banking system now is the Bank of England’s own complacency.”

The research says the Bank’s tests give false comfort by overstating the resilience of the financial sector.

It said major UK banks remain over-borrowed and would likely fail the stress test if it was based on market value of bank capital rather than book value.

The highly critical report comes as the banking industry marks 10 years since the collapse of Northern Rock, which acted as a precursor to the global financial crisis.

The report insists that a failure to control borrowing helped fan the flames of the financial crisis, while market valuations of UK lenders indicate that some experienced hidden losses.

Asked whether efforts to root out poor practice within the financial system have worked since the collapse of Northern Rock, Mr Dowd said: “The reform of corporate governance has been pretty menial.

“The problem is that senior bankers don’t have enough incentive to avoid excessive risks.

“There has to be strict liability of bank directors so they have serious skin in the game.”

The annual stress test examines the resilience of seven UK lending giants: Barclays, HSBC, Lloyds Banking Group, Nationwide, Royal Bank of Scotland, Santander UK and Standard Chartered.

Under the “very severe” central bank tests, lenders have to show they would be able to cope with a house price crash in the UK and the impact of a potential global recession.

According to the Adam Smith Institute, another shock on the scale of the 2007 crash is a possibility but UK banks and the Bank of England are not adequately prepared to absorb it.

Ben Southwood, head of research at the Adam Smith Institute, added: “The Bank of England, understandably, wants to prepare for bad eventualities. But its definitions of risk are nonsensical.

“That means that the stress tests are yet another incentive for banks to put all their eggs in one basket. Even if the Bank were right about risks, this would make crises less frequent, but when they did arrive, much, much worse.”

Neither banking umbrella body UK Finance nor the Bank of England would comment directly on the Adam Smith Institute report.

But the Bank of England released a letter from Governor Mark Carney to an Oxford academic last December which addressed the issues raised in the latest research.

Mr Carney said: “We are therefore of the view that current low price to books ratios reflect investors’ concerns about long-term profitability of UK banks – with return on equity of UK banks averaging just two per cent in 2015.

“Various headwinds continue to dampen bank profitability, including misconduct costs and weak investment banking returns.

“This analysis suggests that low price to book ratios do not necessarily imply that banks’ capital positions are mismeasured or threatened by imminent large losses.

“We find that our baseline projection for the four largest UK banks equates to a price to book ratio of between 0.7 and 0.8, consistent with the actual price to book ratio at the time the stress tests were published.

“This is not a coincidence – we look at the prevailing price to book ratios as one cross-check of our base line forecasts for bank profits.”