The City regulator has warned UK banks over denying accounts for sex workers, after hearing that a lack of access to business banking could lead to “significant harm” for individuals.

The Financial Conduct Authority (FCA) said that while banks said they were able to provide accounts for the adult entertainment industry in theory, they were often denying or shutting down business accounts in practice.

Lenders often closed accounts on the basis of financial crime or reputational grounds, the watchdog said. That is despite sex work being legal in the UK apart from Northern Ireland, where it is illegal to pay for sex.

A recent FCA roundtable meeting revealed serious concerns about a lack of access to financial services for individuals across the adult entertainment industry, which covers stripping, pornography, escort and dominatrix work and “full sexual service”, more commonly referred to as prostitution.

“As adult entertainment industry representatives explained to us, these account denials or terminations could lead to significant harm for individuals running those businesses, particularly if they then had to rely on cash or personal bank accounts for their work, with the latter revealing their name to their clients and therefore exposing them to blackmail,” the FCA said in a report released on Wednesday.

The regulator also heard that the family members of adult entertainment workers were also having their accounts shut. Sex workers have long complained that they are treated unfairly by lenders.

Some financial firms told the FCA they had found it difficult to balance financial crime regulations with financial inclusion, but said those controls may need to be “‘recalibrated” to reduce the risk of “inadvertently excluding consumers from the adult entertainment industry” who met their “account opening criteria”.

The FCA is now calling on lenders to issue a “clear and properly considered definition” of reputational risk to govern decisions around account closures.

Dr Raven Bowen, the chief executive of National Ugly Mugs, which provides support to sex workers, said it welcomed the regulator’s intervention.

It is the first time that the FCA has given such detailed guidance regarding the way banks handle the adult entertainment industry. UK Finance, a trade association for the banking and financial services sector, does not provide guidance for its members on the issue, and has previously said each bank would take a view depending on their commercial and risk appetite.

“We recognise some sectors experience greater challenges in accessing banking services,” said a spokesperson for UK Finance. “We are continuing to work with regulators, our members and relevant trade bodies to facilitate improved access to banking.

“If an account is closed, or an application refused, this only happens after extensive review and investigation. The main reason for this happening is dealing with financial crime concerns and banks have to follow strict regulations in this area.”

Banking the proceeds of sex work is not a criminal offence and does not constitute money laundering under UK law. However, the parameters are narrow, given that many related activities, such as soliciting in a public place, operating brothels, pimping and kerb crawling are unlawful.

There are no specific regulators for sex workers or for the pornography and adult entertainment industries. This means there are no officials to certify that work is being done within the rules, which in turn can make it harder for private companies such as banks to assess potential customers.