King and Brown in rift over whether to split the banks

Bank of England Governor breaks ranks over Labour policy on financial regulation

Gordon Brown yesterday slapped down a call from the Governor of the Bank of England, Mervyn King, that the big banks should be broken up and state support for their investment banking activities – so-called "casino banking" – should be withdrawn.

Challenged on the issue at Prime Minister's Questions, Mr Brown said of Mr King: "He has got to remember that Northern Rock was effectively a retail bank and it collapsed. Lehman Brothers was effectively an investment bank without a retail bank and it collapsed. So the difference between having retail and an investment bank is not the cause of the problem. The cause of the problem is that banks have been insufficiently regulated at a global level, and we have got to set the standards for that for the future."

In a hard-hitting speech on Tuesday evening, Mr King had argued that only "narrow" or "utility" banking – taking deposits, running accounts and providing simple mortgages and loans – should qualify for state guarantees.

Mr King also received short shrift from the Chancellor, Alistair Darling, for his plea for the "too important to fail" question be reopened. Referring to the White Paper that rejected breaking up the banks, Mr Darling said: "We published proposals in July and I intend to push ahead with them."

Mr King had called for a "serious review of how the banking industry is structured and regulated". He dismissed as a "delusion" some of the approaches in the review of regulation by the chairman of the Financial Services Authority, Lord Turner, which were adopted in the White Paper.

Mr Darling again rejected Mr King's model of separating banking activities, saying: "I don't think you can decide that in one type of banking you will intervene and in one type you can't."

Although Bank of England governors and governments have clashed before, there has never been such a public row as now, and it leaves the Bank in danger of becoming politicised. In contrast to the scepticism shown by Mr Brown and Mr Darling, the shadow Chancellor, George Osborne, praised Mr King's speech as "powerful and persuasive". "His analysis of how the Government's system for regulating banks failed and how there has been 'little real reform' since is one I share," he said.

David Cameron has promised to give back to the Bank of England its old powers over lenders, and Mr Osborne has made little secret of his contempt for the FSA. This week, he appointed a team to advise him on breaking it up and relegating it to the role of consumer watchdog. Then again, there is Conservative talk of making Lord Turner a third deputy governor at the Bank, which may not go down well in Threadneedle Street.

For now, Labour appears more closely allied to Lord Turner and the FSA. Oversight of banks was transferred to the FSA in 1997 under the "tripartite arrangements" unveiled by Mr Brown when he became Chancellor. Despite much criticism, that basic architecture has been reaffirmed by the Government. On Tuesday, Mr King described the system as "inadequate". Before the Budget in March, Mr King effectively vetoed any further fiscal stimulus, again in public remarks.

Mr King may not relish interference from Mr Cameron, who told his conference: "Right now, the Government is simply printing [money]. Sometime soon that will have to stop because printing money leads to inflation."

* The Treasury minister Lord Myners last night called on banks to make bolstering their capital reserves their priority. "Prudent banks should be making provisions... rather than paying out capital in unjustified bonuses, only to have to recoup money from shareholders through equity issues," he said.