Mervyn King won himself breathing space yesterday in his fight to hang on as the Bank of England’s Governor after he fought back over its actions in the Northern Rock debacle.

But a key part of his defence — that he had been hamstrung in attempts to prop up the bank by an EU directive — was dealt a blow last night as sources in Brussels claimed that the law had been misconstrued.

During a bruising encounter with the members of the Treasury Select Committee, Mr King drew some of the sting from his accusers’ charges, partly by deflecting blame on to the Financial Services Authority (FSA).

But the chances of a chastened Mr King being reappointed as Governor when his present term expires next summer remained in the balance after both he and his deputy, Sir John Gieve, were savaged by one MP after another during the hearing by the Commons Treasury Committee.

Both men had to deny that the Bank failed to be sufficiently alert to the dangers in the financial system that all but destroyed Northern Rock, leading to the first run on a British bank for 140 years. They insisted that they had done all they could to stem the past week’s crisis.

After the two-hour grilling, the committee said that it would step up its investigation into the crisis. It will summon Sir Callum McCarthy, chairman of the FSA, and its chief executive, Hector Sants, to a hearing on October 9. The Chancellor and Northern Rock’s executives are also expected to be quizzed.

Several committee members said that Mr King had failed fully to satisfy several nagging question marks over the Bank’s conduct.

The Governor startled committee members when he claimed that the crisis of confidence might not have happened at all if the Bank had been able to act as it had hoped in discreetly shoring up Northern Rock. He said that his preference had been for the Bank to “act covertly” as lender of last resort, but he was “hemmed in” and prevented from doing so by four separate pieces of law.

Ideally, he said, “depositors of Northern Rock would have woken up on Monday to find themselves depositors in a larger, well capitalised bank”. But the law meant that neither a rescue takeover nor a covert lifeline from the Bank that would have avoided panic could be achieved.

“The interaction between four different pieces of unconnected legislation made it almost impossible for us to act as lender of last resort in the way that we would have preferred,” he said.

The Governor explained that the City Takeover Code meant an orchestrated takeover of Northern Rock would not have offered a solution, since the time to legally complete a deal might have left anough time for uncertainty to spark panic and a run on the lender in any case.

At the same time, he said that the EU Market Abuses Directive, which took effect in 2005, specifically barred the Bank from a covert refinancing of Northern Rock.

However, although Mr King said that the Bank had sought legal advice over this, his assertion was denied by the European Commission.

Mr King said the Bank had also feared that, once it had no alternative but to offer Northern Rock a public lifeline, the very limited guarantees in law for depositors’ savings would lead to a bank run, but he had had little choice. Damning the legal regime faced by the Bank as “not fit for purpose”, the Governor called for cross-party support for urgent reform, which he said was now “absolutely crucial”. George Osborne, the Shadow Chancellor, said later that the Conservatives would back such changes and called on the Government to act next month.

Last night Sir Callum McCarthy hinted at further upheaval in Britain’s system of financial regulation. He said that the so-called “tripartite” system of joint working by the Bank, FSA and Treasury in financial crises would “need re-examination”.

Both Mr King and Sir John rebuffed attacks from the committee’s members, led by the chairman, John McFall, who accused the Bank chiefs of being “asleep at the wheel”. Mr McFall said Sir John had been “asleep in the back shop”. “The answers given to us this morning [say] that you weren’t very much alert. It seems to me that you were pretty laid back about it.”

Sir John replied that he “was alert” and it was easy to be wise after the event. “In April we identified the vulnerabilities in the system but we didn’t see exactly the path that would lead back to Northern Rock. I don’t think anyone did.” Both Sir John and Mr King insisted it was not the Bank’s mandate to monitor individual institutions, which was a task for the FSA.

Mr King failed to satisfy some of the committee over his rejection of claims that he had staged a humiliating U-turn over the decision that the Bank would on Monday pump £10 billion into the market for three-month lending between banks. Despite his previous insistence that just such action would “sow the seeds of a future financial crisis”, Mr King said he had to strike a balance between such worries and concerns over more urgent strains in the banking system. “We have to make these judgments in real time and, given where we are today, I would still have done it yesterday,” he said.

After the hearing, some MPs said they still believed that Mr King was lent on to change strategy by ministers. Doubts were fuelled by a comment from Paul Tucker, the Bank’s markets director, who said that market conditions had improved in recent days.

The Treasury admitted earlier that its present guarantee for Northern Rock deposits could be whisked away within months. Unveiling the fine print of the guarantee rushed out by Alistair Darling on Monday, it said that it would act as Northern Rock’s backstop until the “current instability in the financial markets” subsided.

The Treasury said that it would protect cash retail and commercial accounts opened at Northern Rock by midnight on September 19, but not after. The guarantee covers future interest payments, the movement of money between existing accounts and new deposits into existing accounts.

The Treasury will also protect customers who re-opened accounts at Northern Rock they had shut between September 13 and September 19.

The sparring

"Not fit for purpose"
— Mervyn King on the existing regime for the Bank of England to act as lender of last resort

"Headlines come and headlines go...I don’t think people will look back in a year and say that there was lasting damage to the British banking system"
— John Gieve, Bank of England and Deputy Governor

"People were talking about Northern Rock. I think it is absurd that you should come here and say you didn’t know anything about it. You were the guy in charge of financial stability. . . The answers you have given us this morning [say] that you weren’t very much alert, in fact it seems to me you were pretty laid back about it"
— John McFall, chairman Commons Treasury Committee

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