The Chancellor announced £20bn of guarantees over the next two years to increase the supply of loans and cut the cost of them to businesses with an annual turnover of less than £50m.

The National Loan Guarantee Scheme will allocate funding to banks according to how much they lend to small and medium enterprises (SMEs).

The scheme will cut interest charged on new loans to eligible smaller companies by one percentage point, Mr Osborne said. A business borrowing £5m at 7 per cent today could save up to £50,000 and the scheme will be up and running within months, he said.

It is the centrepiece of the Mr Osborne’s plan for “credit easing”, announced early last month. The Chancellor has faced extreme pressure to get credit flowing to small businesses, which generate more than half of Britain’s economic output.

Small firms have been particularly badly hit by the banking crisis because they rely on bank loans whereas bigger companies can raise money in the financial markets.

The Government agreed “Project Merlin” with the banks in February to get £76bn of new finance to small companies this year but the banks are lagging behind on the target and businesses claim they face punishing interest rates.

The scheme “will work on the simple principle that we use the hard-won low interest rates that the Government can borrow at to reduce the interest rates that small businesses can borrow at,” Mr Osborne said. “With the strain on the financial system increasing, the important thing is to get credit flowing to Britain’s small businesses.”

Ed Balls, the Shadow Chancellor, said the plan was an admission that Project Merlin had “patently failed”. Mario Cientanni, a partner at accountants Barnes Roffe, warned that after the “severely flawed” Merlin deal the banks could still run rings round the Government.