The government should set incentives for banks to boost lending to credit-strapped small and medium sized companies, Bank of England governor Mervyn King said on Tuesday, defending the bank's decision to focus its asset purchases on gilts.
Members of parliament's influential Treasury Select Committee pressed King on the central bank's decision to buy only gilts and not other assets as part of its 75 billion pound quantitative easing programme announced on October 6.
But King told the committee the Bank should not take the decision to lend to individual sectors or companies and that the government had to address the lack of lending to smaller firms.
"Measures that are directed particularly on finding incentives for banks to lend specifically to SMEs ... is something which is appropriate for the government to do, and they have instruments to do it, which we don't," King said.
"Fiscal incentives can persuade banks to lend to SMEs, or use of direct ownership of the biggest lenders," he said.
The government agreed a deal in February with the five largest banks to increase lending to SMEs, but "Project Merlin" has so far had little impact.
Chancellor George Osborne announced a plan to funnel loans to small and medium sized companies through "credit easing" earlier this month, although the Treasury has yet to provide details of such a scheme.
Among the ideas floated were government guarantees for banks' lending to SMEs and support for a market of bundled and securitised SME loans.
But King said bundling SME loans to sell them could run into the same problems that haunted the market for mortgage backed securities, where people could not accurately assess risk.
"Only the banks and people close to the individual SME know what the credit risk is," King said. "The bank is supposed to be the vehicle by which you assess the credit risk.
"If you want to do anything effective quickly, only the banking infrastructure itself is capable of assessing credit risk."
Banks are still under enormous market pressure to deleverage, which hurts SMEs particularly because of their unique dependence on bank financing.
The banks themselves have said that firms are not borrowing because of the dire economic outlook.
"Firms are continuing to build up cash reserves where possible, while concerns about the economy may be putting some investment intentions on hold," the British Bankers' Association said on Tuesday in a release showing a small increase in business lending.
The Bank governor acknowledged that the Bank's resumption of its asset buying programme will not automatically persuade commercial banks to increase lending, though it should help to ease the funding pressures faced by banks.
"I can't guarantee that it means that bank lending will rise, but what I do believe is that it won't fall as far as it might otherwise have done," King said. "It certainly doesn't guarantee that lending to the real economy is positive."
The economy has barely grown since last September, and Bank policymaker Martin Weale warned in a TV interview on Monday that GDP may even shrink in the final months of 2011.
King said in Tuesday's hearing that the Monetary Policy Committee had already been close to voting for more easing in September, but held back to see if markets would recover from their slump suffered over the summer.
When market volatility did not dampen down, the Bank launched quantitative easing despite the "uncomfortable" level of inflation, which hit a three-year high of 5.2 percent in September.
"We did it because we thought there were real risks of inflation looking ahead falling below the target and we wanted to offset that," King said.
However, King rejected claims that the Bank's failure to control inflation was the reason for the squeeze on Britons' living standards, saying inflation was only a symptom.
"The causes of that squeeze on living standards are real causes," he said, citing changes in real prices of energy and food as well as the consequences of higher value-added tax and the fall in the pound necessary to rebalance the economy.
King voiced strong doubts that European leaders would quickly fix the root causes of the euro zone debt crisis, which was one of the main reasons for the Bank to ease policy again.
He said measures the region's leaders aim to introduce over coming days to tackle the crisis would only buy time.
"The aim of the measures to be introduced over the next few days is to create a year or possibly two years' breathing space. The underlying problems still have to be resolved," he said.
(Editing by Catherine Evans)