The Governor of the Bank of England put himself on a collision course with the Government and the City again last night by laying out radical plans for clamping down on banks.

Mervyn King said that he wanted a restriction on the size of banks and that investment banks might have to be split from retail banks. In his annual speech at Mansion House before an audience of bankers and other City grandees, he said that banks should not be allowed to grow so large that they were deemed too big to fail.

Mr King sought to apply pressure on the Government to award the Bank stronger powers to police lenders that had in the past regularly ignored his warnings. But he admitted that he did not know in what form the Bank would discharge such a responsibility. But such a move would belittle the Financial Services Authority, the official banking regulator, which has been accused of allowing lenders to behave recklessly while on its watch.

The Governor reinforced a suggestion he had made before that retail banks should be split from investment banks and added that there should be a plan for potential winding down of the largest institutions so that there could be an orderly process if they failed.

Mr King’s proposals on how to prevent another banking crisis go much further than those of Alistair Darling, the Chancellor, and Lord Turner of Ecchinswell, chairman of the Financial Services Authority. Mr King said that a lot of work still needed to be done on the future shape of regulation, but he signalled that he wanted to use his enhanced authority to impose stringent conditions on banks.

In February the Bank was given greater power for financial stability by the Banking Act. Lord Turner has played down the possibility of a new Glass-Steagall Act, America’s Depression-era legislation that imposed a separation of retail and investment banking. But Mr King said that a split should be considered. “It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure,” he said.

The State could limit providing a guarantee for depositors to high street banks that offered straightforward services. Alternatively, riskier banks should have to hold much more capital. Finally, banks may have to provide their own plan for how they could be wound down in the event of failure. “Making a will should be as much a part of good housekeeping for banks as it is for the rest of us,” Mr King said.

Mr King said there must be profound change to financial regulation. But he was not sure how the Bank would use its enhanced authority because its new tools were limited to giving warnings that were likely to be ignored: “The Bank finds itself in a position like that of a church whose congregation attends weddings and burials but ignores the sermons in between.”

Mr King, who agreed only reluctantly to bail out Northern Rock with taxpayers’ money and has often given warning of the perils of the “moral hazard” involved in saving banks, blamed the financial sector for “wreaking havoc on businesses and families”.

The Treasury is preparing a White Paper on improving financial regulation but Mr King said that regulators and politicians still had work to do to understand the causes of the crisis. “We need to reflect more deeply on the nature of the failures before designing a regulatory response,” he said.

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