Bank chief: 'We're facing longest period of financial turmoil in living memory'

Speaking at the British Bankers' Association's annual conference, Mr King said that the world "was passing through the most prolonged period of financial turmoil that most of us can remember" and the crisis was "not yet over".

He said: "After a decade or more of economic stability, we are now facing a period of rising inflation and falling economic growth."

He added that he would make financial stability the top priority for his second term.

Bank of England governor Mervyn King says financial stability is the top priority for his second five-year term

"During my second term as Governor I would like to see us establish a framework for financial stability that is on as sound a footing as the one we have successfully established for monetary stability", he said.

Mr King gave no comment on the UK economy or the possible trends for interest rates, but said forthcoming reforms to the UK banking system should discourage excessive risk-taking by financial institutions.

Mr King said policymakers were grappling with the problem of how to allow a badly-run bank to fail without undermining the stability of the system as a whole.

Because the central bank has acted as a lender of last resort - in cases such as the Northern Rock crisis - this could encourage others to indulge in riskier behaviour, he added.

"If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time the parties will become wilder and wilder," Mr King said.

"That might not matter were the consequences limited to the party-goers. But they are not. When the party ends, some innocent bystanders may lose their homes altogether."

Mr King - who has previously criticised the bonus culture of the City for encouraging financial risk-taking - said it was not easy for banks or authorities to solve the problem because of the incentives to continue in the same manner.

Although over-regulated banks could mean there were "no parties worth going to", requiring banks to hold more capital could act as a "shock absorber" and strike a balance between burdensome regulation and excessive risk-taking, the Governor added.

In April, the Bank introduced a £50billion special liquidity scheme to allow banks to borrow against riskier assets such as mortgage-backed investments which have been hit by the credit crunch.

Mr King said the aim was to put in place a liquidity framework for banks - which would work in normal conditions as well as times of market stress - where participants were not "stigmatised" but at the same time discouraged from excessive risks.

He also offered support for a special resolution regime to intervene in the case of failing banks, and a pre-funded deposit insurance scheme to prevent bank runs in the wake of Northern Rock.

"A degree of pre-funding is one of those ideas that is bound to be unpopular before the fund is called upon, but seems decidedly wise after the event as it lessens the burden on the banking system in a time of stress," he added.

Mr King was addressing around 350 delegates gathering in the City, along with bank luminaries including HSBC chairman Stephen Green.

Mr Green told the conference the banking industry needed to get "back to basics" - focusing on attracting retail deposits instead of excessive borrowing to fund business growth.

Lower interest rates in recent years saw some institutions take on more and more finance to make investments - particularly in the shape of mortgage-backed securities.

These saw mortgage loans to customers with poor credit histories parcelled up and sold on to a wider variety of investors, and the resultant widespread default of the underlying loans caused havoc for the industry and led to the existing crisis in confidence.

Mr Green said: "We are seeing a profound shift in banking models. The huge build-up of leverage in the system in the last five years ... which stretched balance sheets and with profits dependent on high and increased leverage ... that model has gone.

"It is not just the end of a bubble, it's the end of a business model."

He added: "This means that sustainable and profitable growth is going to have to come through strategies that get us back to the basic tenets of the banking profession."

These were growing retail deposits, developing relationships with small businesses and making the banks more efficient, he said.

Mr Green, who is also chairman of the BBA, also singled out the growth in the mortgage-backed securities business over recent years as one of the main problems.

He said: "We need to examine the problem whereby the distance between loan originators and those exposed to the possibility of their assets defaulting has widened, without vital information following suit."

Along with Britain's other major banking groups, HSBC has suffered multi-billion pound write-downs on its own mortgage-backed investments.