* SNB says Swiss capital requirements should be stricter
* Says UBS, Credit Suisse profit potential declined
* Says leverage still elevated, no room for errors
* Says bank sector's situation improved but risks stay high
(Adds quotes from SNB's Jordan, UBS, CS comment)
By Sven Egenter and Katie Reid
ZURICH/GENEVA, June 17 (Reuters) - Switzerland's global banks, UBS and Credit Suisse, must hold more and better capital to absorb losses in the case of another crisis and to limit the risk of a failure that could drag the economy down, the central bank said.
The situation of the two banks along with the whole industry had improved since the crisis year 2008, the Swiss National Bank said in its financial stability report published on Thursday, but risks remained high.
UBS and Credit Suisse together still hold more than four times the country's gross domestic product (GDP) in assets on their balance sheets and had a share of around one third in key domestic markets, making them too big to fail, the SNB said.
"A further strengthening of the capital situation and a further realignment of the business model in order to achieve sustainable profitability, are still central challenges facing the big banks," SNB Vice-Chairman Thomas Jordan said at a media conference following the SNB's interest rate decision.
In the report, the SNB called for capital requirements that went beyond the strict measures adopted in 2008.
"It is essential that capital requirements be significantly increased and that they rise in line with the degree of systemic importance of a bank," Jordan said.
Switzerland led the global push for tighter bank rules after the government's bailout of UBS in autumn 2008, introducing higher capital requirements, a leverage ratio, a stricter liquidity regime and new rules for bankers' pay.
A government commission has made further proposals, including changes to the banks' structure to allow a break-up in the case of insolvency and the introduction of progressive capital requirements depending on a bank's size.
"UBS has been stabilised and delivered a net profit in the last two quarters, the balance sheet has been reduced and we are committed to further strengthen our capital base via retained earnings," UBS said in an e-mailed statement.
Credit Suisse declined to comment on the SNB stability report, but it reiterated that it had strong capital and liquidity positions.
NO MARGIN FOR ERRORS
Under the rules adopted in 2008, UBS and Credit Suisse must hold twice the international minimum standard in regulatory capital in good times and meet a leverage ratio of at least 3 percent, rising to 5 percent in good times.
Both banks already meet the capital requirements with a tier 1 capital ratio of above 16 percent, making them two of the best capitalised banks in the world according to current standards.
Bank regulator FINMA has already said that new international rules, discussed by the Basel Committee for Banking Supervision, may lead to adjustments.
The banks' leverage was still very high, the SNB said, especially when excluding hybrid instruments and deferred taxes from regulatory capital, something the Basel committee is calling for.
"The margin for error that the big banks can afford remains narrow, and any misjudgment of the risks could have serious consequences," the SNB said.
In addition, the banks' ability to absorb losses was limited by the fact that their profit potential had declined as the global crackdown on banking secrecy ate into margins in the highly lucrative wealth management business.
Especially in the case of UBS, a full recovery of profitability did not appear very likely, the SNB said.
The SNB said that the situation of Switzerland's banking system had improved overall as banks with a domestic focus, such as the state-owned cantonal banks, held up well throughout the crisis and the big banks recovered.
But risks remained high, the SNB warned, because banks faced losses from foreign loans even under the main scenario of a gradual recovery of the global economy and first signs of risks on the Swiss mortgage market also appeared.
For the SNB's full report click on: www.snb.ch/
(Additional reporting by Catherine Bosley; Editing by Ron Askew)