The battle for Northern Rock has been whittled down two bidders, after Cerberus, the American private equity firm, dropped out of the running for the troubled bank.

Sources close to the bank said that only two bids were being seriously considered by the Northern Rock board and its advisers. Virgin Group remains the preferred bidder, but shareholders favour a proposal from a consortium led by Luqman Arnold, the former Abbey National chief executive.

Northern Rock is expected to update the market within days on the effect on itgs finances of the credit crunch. The bank promised in September that it would issue a pre-close statement in “early December”.

Sir Callum McCarthy, chairman of the Financial Services Authority, emphasised how narrow the race to buy the bank had become when he testified yesterday at a hearing of the Treasury Select Committee.

The watchdog’s chairman dismissed a suggestion by the committee that nationalisation was the best way to deal with the bank, which owes the Bank of England an estimated £29 billion after it was unable to obtain funding in the inter-bank market.

Sir Callum said: “We’ve got at the moment two proposals that don’t require nationalisation. It’s important that these two proposals are investigated and pushed through without resorting to legisation”. He added that the FSA was “working very hard to discharge our duties” on the bids.

The bank is also continuing to work on the legal details of an extraordinary general meeting called by its two largest shareholders, the hedge fund managers SRM and RAB Capital. The funds want Northern Rock to be forced to seek shareholder approval before disposing of more than 5 per cent of the bank’s assets.

Sir Callum and Hector Sants, the FSA chief executive, yesterday made their second appearance in front of the Select Committee as part of the committee’s investigation into the credit crunch. The pair were asked whether the Government should have waved through a takeover of the Rock by Lloyds TSB. The high-street bank approached Northern Rock during the early weeks of its funding crisis, but wanted a loan of up to £30 billion from the Government to finance the deal.

The Chancellor and the Bank of England refused to permit the loan because of fears of contravening competition rules, but later said that the unlimited credit line given to Northern Rock would be extended to potential buyers of the bank. They were subsequently criticised for scuppering a bid, only to result in the more difficult auction that has since occurred.

Sir Callum said yesterday: “It’s very difficult to form a judgment \ because it wasn’t as cut and dried as it’s been made out, as if there was a complete proposal on the table.”

Mr Sants contradicted the claims of Matt Ridley, the former Northern Rock chairman, to an earlier committee hearing that the bank had alerted the regulator to its financial difficulties. “My understanding is that we contacted them first,” Mr Sants said.

“We always knew the funding model of Northern Rock and from the moment we set up our special process \ on August 10, we were interacting with firms that we saw as having issues”. The regulator was accused by Michael Fallon, the Conservative MP for Sevenoaks, of failing to discharge its responsibilities in regard to Northern Rock. “We’ve had the worst banking crisis in 100 years. Someone failed,” Mr Fallon said.

Mr Sants said: “We’re in no way not acknowledging the fact that our supervisory engagement with Northern Rock up to July should have looked into these scenarios and, on reading the files, it didn’t.”

The FSA will issue a discussion paper on the liquidity crunch by the end of the year. It will release a forensic review of its regulation of Northern Rock in March next year.

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