The City today gave a cautious response to news the Government could set up a bad bank to buy toxic assets from High Street lenders.

Alistair Darling admitted he has “certainly not closed the door on a bad bank” and said “a range of options” was needed to help ease the credit crunch and kick-start lending.

Critics said it represented a very expensive U-turn from the Chancellor, who two weeks ago appeared to rule out such a move when he instead launched plans to insure banks against heavy losses. But others argued it was vital to end the freeze in the credit markets and get banks lending again.

Peter Hahn, a fellow in finance at Cass Business School and former Citigroup banker, said: “We have to have a bad bank. I don't think we can get to the end of this problem until we have one. Banks have to go forward but at the moment they are overwhelmingly focused on the past.”

He said there was “no way” of telling how much it would cost the taxpayer to buy up toxic assets from British banks, but added: “The sooner it is set up, the less it will cost.”

Manoj Ladwa, a senior trader at ETX Capital, said: “I think it's unfortunate but necessary, as these so-called toxic assets need to be removed from the balance sheets of banks in order to free up lending. But, although the borrowing public would benefit, which is the majority of us, it's the same individuals who are paying for these assets. The other key problem is, how do you value these assets when there is no market for them?

“What would be preferred is a combination of the insurance policy that has been mentioned, for the banks in a better financial position. For the others, the bad bank option is the only way if they are not to go under or be nationalised.”

Others were less enthusiastic. One City fund manager said it was “a very bad idea” and an “unnecessary burden for the taxpayer” as it could cost hundreds of billions of pounds.