Bank of England governor Mervyn King yesterday warned banks that the tax- payer would not pick up the cost of their losses on investments in the mortgage market and said they could face having to hold higher amounts of capital to cover losses in future.

Addressing MPs, he said Threadneedle Street was in discussions with banks about long-term solutions to the current credit crisis which has seen financial institutions shying away from lending to each other and to individuals and companies.

But he said the taxpayer would not foot the bill for any losses they made by buying or selling mortgage assets, many of which have plummeted in value after problems with rising defaults from American sub-prime borrowers became apparent in the summer.

King argued they had reaped the benefits of securitisation without acknowledging the potential costs of that approach.

"First, the risk of losses on their lending should remain with banks' shareholders. Second, a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets. One of the lessons of this financial crisis is that providers of mortgage finance had underestimated the risks, and hence the true cost of the securitisation process."

King told the Treasury Select Committee that much mortgage lending in the last couple of years had been "underpriced" as banks reaped the benefits of selling on their loans.

"There are very many lessons to be learned and the conclusions inevitably turn in the direction of saying that the financial institutions will have to hold more capital in the longer run and these activities will have to be monitored much more carefully."

He added: "There is a lot of hubris that expansion of financial services was good in itself. It was not, it is a means to an end."

King made it clear that he thought problems in financial markets were getting worse, even using the now popular term "credit crunch" to describe events.

He said: "In the last couple of months there has been a further deterioration of credit conditions."

King said this was reflected both in the rates banks were charging and the quantities of credit they were making available to each other.

Yesterday London interbank rates for three-month sterling funds edged up for the twelfth session in a row to 6%, their highest since late December, up from 5.995% on Tuesday.

King dismissed suggestions that the Bank should be doing more to support the financial sector, arguing that its approach mirrored that of the European Central Bank and that it had not followed the US in a series of large rate cuts was due to differences in their respective economies.

King illustrated the dilemmas being faced by the rate-setting Monetary Policy Committee he chairs by saying that while tightening credit conditions could curb the growth of spending and therefore inflation, this had remained strong throughout January and February.

"This is not an economy that has completely ground to a halt but looking ahead we would expect some slowing."

He also suggested that past rate cuts, including a quarter-point cut in February, had only served to ensure mortgage rates offered by banks remained at the level they would have been without the credit crunch. But he stressed that the MPC was focused on the risk of heightened inflation expectations feeding into wage demands: "We can't afford to go back to the 1970s or early 1980s."

His comments still prompted speculation that the MPC could be about to cut interest rates again.

Howard Archer, chief UK and European economist at Global Insight, brought forward his estimate that rates would be cut by a further 25 basis points to 5% in April rather than May as he had previously expected.

It is likely that impetus from a rate cut will continue to come from King's colleague on the MPC, David Blanchflower, who took a more bearish view on the UK economy, suggesting it resembled that of the US several months ago before it took a sharp downturn.

He told the committee: "I am concerned that some of the soft survey data, particularly consumer confidence data and the labour market, have shown some similarities to the US some months ago."

King also indicated that a falling pound was an inevitable part of a rebalancing of the economy towards greater exports and falling consumer spending at home, and that it is merely back to the levels it was at before a massive surge in 2006.

He also took a cautious view on house prices. "I would be surprised in a few years if house prices are markedly higher than they are now. House prices should be more in line with average earnings."