City regulators will be able to veto the pay deals of bank executives under new proposals set out today by Alistair Darling.

Addressing MPs in the House of Commons, the Chancellor said that the Financial Services Authority (FSA) will monitor the structure of bankers' remuneration packages and produce a report on them every year.

Should the City watchdog find that an executive's pay encourages the financier to take risky investment decisions, it can order the lender to put aside more capital in reserve. Any such requirement would reduce a bank's profitability and, the Treasury believes, act as an effective veto.

"We need a change of culture in the banks and their boardrooms, with pay practices that are focused on long-term stability and not short-term profit," Mr Darling said.

In a long-awaited White Paper on banking regulation, Mr Darling rebuffed calls to force large banks to carve themselves up. Such measures would have been designed to limit the impact of the collapse of a large bank on the rest of the financial system.

In September last year, politicians, regulators and bankers were stunned when the collapse of Lehman Brothers, the Wall Street bank, triggered a domino effect, bringing down other lenders and insurers.

Today, Mr Darling argued that any attempt to limit bank size was "simplistic" and that small banks, such as Bradford & Bingley, can pose an equal threat to financial stability.

Both Mervyn King, the Governor of the Bank of England, and George Osborne, the Shadow Chancellor, have made it clear that they favour forcing large banking empires to carve themselves up into smaller units.

Mr Darling also refused to return the scrutiny of Britain's banks to the Bank of England, instead choosing to increase the powers of the FSA.

Under Gordon Brown's chancellorship, the responsibility for regulating lenders was transferred from the Bank of England to the FSA, a body which has been attacked for failing to avert the near-collapse of Britain's financial system.

Setting out the causes of the crisis, Mr Darling said: "Financial institutions in many countries simply took on too much risk. They became over-reliant on wholesale funding, too exposed to particular products and irresponsible pay practices made banks take unnecessary risks.

"It’s also clear that some financial institutions had little appreciation of what was going on inside their businesses."

Ruling out a separation of banks’ investment and commercial arms, as implemented by the US Glass-Steagall Act in the 1930s, he added: "I believe that this is a simplistic solution and fails to take into account the complexity of today’s financial systems. It is not only large banks but small ones too that can threaten financial stability, as in the case of Northern Rock."

Mr Darling said that as a result of the turmoil in the sector there was less competition in the UK financial services market than before. He wanted to see greater competition, with a bigger role for mutuals and building societies and the possibility of non-banking institutions entering the market.

The part-nationalised banks will be returned to the public sector "in a way that brings best value to the taxpayer, promotes competition and maintains stability". Proceeds of the sale of the taxpayers’ stake would be used to cut Government debt, he said.

"We are empowering consumers, supporting better corporate governance and we are strengthening regulation so our financial sector can continue to be an engine of prosperity," he said.

For the Tories, Mr Osborne said that the proposals in the new White Paper were a "totally inadequate response to what has happened ion the last two years" and the document seemed to contain no acknowledgement of government failings.

He said: "The only admission of any kind of responsibility for what has happened is the sentence that says, ’The crisis has shown that aspects of prudential and macro-prudential supervision were insufficient’.

"That is the understatement of the century when you have nationalised half of the British banking system."

He also said it "ducks every difficult question" for the future, including how to replace the tripartite system, stop excessive debt levels, and put in place a banking system which offers families and businesses the services they need without the British taxpayer footing the bill.

Mr Osborne said: "None of these difficult questions are properly addressed today. Every single one is basically left to the next Government to deal with. It means we have more of a white flag than a white paper, a complete surrender of this Government’s responsibility to fix the system of regulating the City it created and which so spectacularly failed."

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