Banks face legal action if they refuse to resume lending amid dire warnings of a mortgage drought that will bring further misery to homeowners.

The Times has learnt that legal curbs will be imposed on banks if they fail to abide by a new code of practice on lending. They will also be compelled to open their books to the Government so that their lending can be monitored. The move is being considered to alleviate a squeeze on lending that is starving businesses and consumers of credit.

Sir James Crosby, a former chief executive of HBOS, told ministers that for the first time since records began, banks and building societies are likely to take in more in mortgage repayments next year than they give out in new loans. Such negative net lending could push house prices into a new “self-feeding” downward phase, he said.

Amid growing impatience at the failure of the banks to provide sufficient lending Mervyn King, the Governor of the Bank of England, told MPs on the Treasury Select Committee that getting normal credit levels restored was the most important issue in recovering from the slump. Britain would go into a “steep recession” if there was no thaw in lending, both to individuals and businesses.

“I am in no doubt that the single most pressing challenge to domestic economic policy is to get the banking system to get lending in any normal sense. That is more important than anything else at present,” Mr King said.

Like Downing Street last week, Mr King also held the threat of wholesale nationalisation over the banks, although no plans are under active consideration at the moment.

A new lending panel chaired by Alistair Darling, the Chancellor, and Lord Mandelson, the Business Secretary, has been established to monitor lending to business and households so that the Government can judge the apparent contradiction in claims from banking chiefs that normal lending is beginning to resume, and experience at branch level, where companies are being hit with new charges.

The Financial Services Authority has also told the banks that it is prepared to be flexible about the tough lending limits set out when they were recapitalised – a point reinforced by Mr King.

Lord Mandelson is to insist on the banks signing up to a new code of good lending practice. The current plan is for it to be voluntary but The Times has been told that if the banks do not improve their performance it could become a legal regulation to be policed by the FSA.

Asked to rule out the possibility that the Government might be forced to resort to wholesale nationalisation of the banking system, Mr King refused to do so. “It would be a very serious error to rule out measures that may ultimately prove necessary,” he said.

Mr King admitted that despite the £37 billion recapitalisation of the banking system already put in place by the Government, yet more taxpayers’ money may have to be injected into the banks to strengthen their finances and allow them to resume more normal lending. “We may not have come to the end of the recapitalisation process,” the Governor said.

“The banks may need more capital, in which case it should be considered. We have seen that happen in the United States. If we need to inject more capital we will take further measures. We must not shy away from that.”

Sir James’s warning came amid new figures showing that mortgage lending remained becalmed. In October mortgage approvals for home purchases more than halved compared with a year earlier, falling to within a whisker of the record low posted in August, according to the British Bankers’ Association.

House prices have fallen by 15 per cent from their peak in October 2007, according to Nationwide Building Society, with little if any sign of a bottoming-out.

Sir James said: “The real risk . . . is that the shortage in mortgage finance feeds on itself and causes the housing market to overshoot on the down-side.” That would have serious consequences across the housing market and across all dependent industries.

The comments came in Sir James’s report on improving mortgage finance, in which he recommended that the Government guarantee £100 billion of future mortgage-backed securities issued by lenders as the best way of kick-starting the mortgage market.

Sir James said that housebuilders in particular were being severely hit, with capacity already shrunk by 40 to 50 per cent. Shares in Taylor Wimpey, a leading housebuilder, collapsed further yesterday on growing fears that it might struggle to negotiate fresh financing.

Under the Crosby proposals, government guarantees would be auctioned to the highest bank bidder. Banks would use the guarantees to gold-plate their issues of mortgage-backed securities, making them much more attractive to investors. Demand for these securities has evaporated, turning off key funding for banks.

Mr King was sceptical about the Crosby plan. “I am all in favour of finding ways of encouraging a sustainable rate of mortgage lending but I am not entirely clear that the best way to do this [boost lending] is to resurrect an instrument that for very good reaons has fallen out of favour,” he said.

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