Bank of England Governor Mervyn King has warned banks not to rely on its cash for long-term funding and raised the prospect of another series of capital raising by beleaguered financial institutions.

Bank of England Governor Mervyn King has warned banks not to rely on its cash for long-term funding and raised the prospect of another series of capital raising by beleaguered financial institutions.

As he prepares to unveil a replacement for the Bank's current emergency funding scheme next week, King hinted he is prepared to continue accepting mortgage debt in return for government bills in a new permanent facility but only as new problems arise and only in short-term arrangements.

He said: "Liquidity insurance is there to help banks face a short-term problem. What such a scheme is not, and cannot be, is a source of long-term funding to finance investment."

King told MPs on the influential Treasury Committee yesterday that take-up of the current scheme had been "significant". He added: "The Special Liquidity Scheme was designed as a one-off scheme to provide exceptionally generous and long-term insurance."

The facility allows banks to swap mortgage debt, which they are currently struggling to sell into the market, for more popular government paper for up to three years but is due to close on October 21.

King's comments yesterday were interpreted by many in the banking sector to mean the future scheme would be limited to three-month funding.

King also indicated his scepticism about government intervention in the mortgage market, the subject of an ongoing inquiry by former HBOS chief Sir James Crosby.

"The idea that there is structural failing in the mortgage market does not ring true," he said.

He added that banks' options were "more capital" or a "different business model".

His Monetary Policy Committee (MPC) colleague Paul Tucker added: "Their balance sheets would not contract if they were to raise further capital and that may be something to come to view in the next 18 months or so."

King warned that if the government decides to provide guarantees for mortgages, taxpayers could end up footing the bill for bad debts.

"If you are going to be providing the funding you are inevitably going to be taking on the credit risk."

He added: "The banks did not ask the taxpayer to take the credit risk. They do not want themselves undermined by having competitors sub-sidised by the government."

King noted that US government support for ostensibly independent mortgage funding providers Fannie Mae and Freddie Mac eventually led to their effective nationalisation this week.

As figures published by the Bank yesterday revealed that Britons think inflation is currently at 5.4%, up from 4.6% in May, King struck a particularly cautious tone on the state of the UK economy.

He said he expects inflation, which in July hit a high of 4.4%, will remain well above the MPC's target of 2%.

"In the UK we face a difficult but temporary period during which inflation will remain high for a while and output growth at best weak. I would be most surprised if, next week, I were not required to write a further open letter to the Chancellor explaining why inflation is more than a percentage point away from target."

More controversially, King took it upon himself to warn the government of the need to rethink its finances in the wake of slowing economic growth.

He said: "There has been a change in the world since last summer and that will require some adaptation in the outlook for fiscal policy."

He added: "The long-term risk is a fiscal framework that is not perceived by financial markets to be credible but does put up pressure on inflation expectations because it undermines the market's belief in the credibility of both the monetary and the fiscal framework and that will make our life more difficult if inflation expectations were to remain higher than we would wish."

This prompted a hostile reaction from Labour MP George Mudie, who accused him of giving Chancellor of the Exchequer Alistair Darling "lectures on economic policy".

King's MPC colleague David Blanchflower, a long-term backer of rate cuts, also warned that unemployment in the UK could rise faster and further than many expect.