King warned robust reforms were needed to prevent a repeat of the 2007 rescue of Northern Rock, when the Bank was forced to step in.

He told peers and MPs that future banking regulators should have the power to order banks to improve the transparency of their operations, even if they were following the letter of the law.

Appearing before the joint parliamentary committee, he said the credit crunch had seen banks buying and selling financial products that were “riskier than they were led to believe”.

He said the rigid, “rules-based” approach of the past had allowed the financial sector to take on huge liabilities, with regulators largely unaware of their activities.

His demands come in response to the government’s plan to break up the FSA and turn the Bank into a super regulator. A new subsidiary, the Prudential Regulatory Authority, will be given responsibility for financial stability.

Sir Mervyn said the new authority should be able to tell banks: “Look, frankly, we don’t understand why your organisation needs to be so complex. We can’t work out what you are doing, so you’re going to have to change it. You haven’t broken a rule, but too bad, you’ve got to change it.”

Sir Mervyn said that Britain was finally moving towards a system in which a badly run financial institution could be allowed to fail without endangering the banking system as a whole.

“If they screw up, we just let them go, go bust,” he said. He supports the Vickers report recommendations that banks separate their high street and investment operations and hold more capital in case of a crisis.