The Governor of the Bank of England paved the way yesterday for it to take more radical steps to ease mounting financial stresses on British banks as he admitted that the credit squeeze had entered “a new and difficult phase”.

Mervyn King signalled to MPs that ground-breaking action to buy up or swap the illiquid mortgage-backed securities blamed for the near-seizure of credit markets could be taken, in a decisive attempt by the Bank to quell resurgent financial strains.

The Governor said that present conditions were “the sorts of circumstances in which central bank action is necessary to prevent a major shock to the system as a whole. We are discussing with the banks how a longer-term resolution of the problem might be reached,” he told the Commons Treasury Committee.

Mr King highlighted his concern over deteriorating financial conditions when he conceded for the first time that the economy faced a full-blown credit crunch. Until now, he had avoided using that term, but yesterday he emphasised that “across the world, confidence in financial markets is fragile”.

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His comments came as renewed strains in Britain’s money markets were confirmed when sterling Libor interest rates for three-month loans between banks rose to 6 per cent, the highest since December 28.

The Governor also boosted City speculation that interest rates could be cut again as soon as next month. Asked whether market upheavals meant that the Bank was more predisposed to cut interest rates, Mr King replied bluntly: “Yes.”

His clear hint that the Bank was contemplating unprecedented measures to restore financial calm in its talks with commercial banks came as he pinned the blame for the funding drought in inter-bank lending firmly on largely untradeable assets, such as mortgage-backed securities.

“The heart of the problem stems from an overhang on banks’ balance sheets of assets in which markets have closed,” he said. “These assets cannot now be sold or used to secure funding in the market; they are difficult to finance.

That has created uncertainty about the strength of banks’ financial positions.”

The Governor made clear that the Bank would continue to lend against asset-backed securities. However, in a signal that he sees a sound case for stronger measures, he added: “Such lending can only be a temporary measure, but it can be a useful bridge to a longer-term solution.”

While he did not detail any specific measures, he underlined the case for more far-reaching action. “It is unrealistic to assume that markets for many asset-backed securities are likely to reopen speedily, or, when they do, to their previous levels of activity.”

While Mr King’s comments were seen as pointing to potential Bank moves that would remove asset-backed securities from banks’ balance sheets, he also emphasised to MPs that any action would come with two key conditions.

He said it was essential that the risk of losses on banks’ lending “remain with banks’ shareholders”, while any public funds should not simply subsidise new commercial lending by banking groups. The Governor could impose conditions on any new Bank of England support to ensure the first condition, but guaranteeing the latter could be much harder to achieve.

Mr King mounted a strong defence of the Bank’s handling of the credit crisis, rebuffing challenges from MPs who suggested it had been less proactive than the US Federal Reserve.

He also repeated his prediction that house prices were unlikely to rise over the next few years, while a sharp squeeze on household spending power was likely to continue for another year. Despite that, he dampened hopes of steep cuts in interest rates, pointing again to the difficult balancing act between pressures from rising inflation and weaker growth.

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