Lending by Britain's top five banks shrank every quarter last year, official figures revealed today, in an embarrassing blow to the Chancellor's Project Merlin agreement.

After taking loan repayments into account, the five - Lloyds Banking Group, Royal Bank of Scotland, Santander, Barclays and HSBC - saw combined net lending slide in 2011, the Bank of England said, including a 3% drop in the final quarter.

The figures also confirmed that the five banks missed gross lending targets for small businesses in 2011 by more than £1bn but beat the target for all businesses by £24.9bn.

Following publication, Shadow Business Secretary Chuka Umunna called the figures "insult to injury for firms struggling to get the finance". Criticising Project Merlin, Umunna said said the deal "lacked any teeth".

"Having been put in place without any mechanisms for enforcement or sanctions in the event that its targets were not met. Project Merlin lies in tatters and it is clear that its promises were not worth the paper they were written on.

“We need to see banks adopting better relationships with their small business customers, because while the banks seek to blame a lack of demand for finance, it is clear that too many firms are put off from applying in the first place," he added.

Umunna said that as well as raising taxes and cutting spending too far and too fast, ministers have failed to get the banks to lend which is "hitting business confidence, choking off growth and stalling job creation".

“In the Autumn the government announced to great fanfare that it would be bringing forward credit easing to relieve the credit squeeze on businesses," he said.

"However, months have passed and businesses are still waiting for details of how and when it will be up and running. While the wait continues, too many firms are going under.”

John Walker, national chairman of the Federation of Small Businesses, was equally critical. He said the numbers showed that the money intended for "new and fledgling firms" is going to bigger businesses.

"The Project Merlin figures are likely to show that overall the banks have missed their lending targets to the smallest of firms – although some of the banks have already said they met their individual targets. We have long said that targets are the wrong instrument to encourage lending and growth.

"Even though overall lending is above target, this shows that money is going to bigger businesses and not new and fledgling firms that need it to take advantage of growth opportunities that are there even in these challenging times."

Walker added that the Federation's research shows that over the past two years a third of businesses are refused credit and this could be reflected in the fact that newer businesses are using more of their own money to fund their business rather than turn to the banks for help.

"What we need to see is better promotion of the alternatives available and for the Government to put in place their bold credit easing plans, which will help small businesses access finance on better terms."

Royal Bank of Scotland, which is 83% owned by the taxpayer, is the culprit for the shortfall in small business lending after the other four lenders came forward and confirmed they had beaten their targets.

Under the Project Merlin agreement, Britain's top five banks said they would increase lending available to SMEs to £76bn this year and boost lending available to all businesses to £190bn.

The British Bankers' Association (BBA) said the overall lending figure demonstrated the banks' commitment to help UK businesses and pointed to Bank of England data that showed SMEs' demand for credit had fallen in three out of the last four quarters.

A spokesman for the Merlin banks said: "The banks' efforts to encourage customers to come forward with borrowing proposals are set against this overall challenging economic environment. The business demand for credit remains weak."
Chancellor George Osborne is likely to face questions over whether any penalties will be put in place for the banks' failure to hit the SME targets.

Lee Hopley, chief economist at EEF, the manufacturers' organisation, said SMEs continue to be frustrated by the cost and terms and conditions around lending.

Ms Hopley said "a lack of competing sources of finance outside of banks remain part of the problem" and added: "The challenge for 2012 is how to offset the forces dampening demand for finance by improving the conditions of supply."

The Project Merlin agreement will not be repeated this year - although the Government plans to launch its credit easing programme, which will initially see £20 billion made available over the next two years under a National Loan Guarantee Scheme.

The National Loan Guarantee Scheme will issue new low-interest loans and overdrafts to businesses with a turnover of less than £50m.

Following a leak of the figures last Friday, Mark Hoban, Financial Secretary to the Treasury, said: "Ensuring that businesses can access the credit they need to grow and create jobs is vital, which is why the Government is now making up to £21bn of guarantees available through credit easing.

"But banks need to play their part by continuing to support British business going forward."

RBS chief executive Stephen Hester defended his bank's performance, pointing out that its lending will not be far short of all the other banks combined.

He said: "There is no bank in this country coming close to punching above their weight in the way we are. Forget Project Merlin and how it's defined - that's damn impressive. People have lost sight of that."

Barclays said it exceeded targets by 13% last year, after it handed out £43.6bn of new lending to businesses, including £14.7bn to SMEs.

Chief executive Bob Diamond said he was "proud" of the performance as the bank claimed to have supported 108,000 start-ups and returned 1,900 existing businesses to health.

Part-nationalised rival Lloyds Banking Group also beat its target after lending £12.7bn to SMEs, compared with its £11.7bn benchmark.

Santander UK lent £8.7bn to businesses in 2011, a 25% increase on the previous year and exceeding its target of £6.7bn. Of this, £4.3bn went to smaller firms - £300m more than its target.

Last week Stephen Hester defended the RBS lending rates. He said: "Our lending will not be far short of all the other banks combined"

On Monday, the CBI predicted that Britain would narrowly avoid recession, despite slashing growth forecasts.