Top banks fell short of their government targets to lend to small businesses last year, official data showed on Monday, dealing a blow to the Conservative-led coalition's hopes of removing a barrier to economic recovery.

The Project Merlin deal had obliged banks to meet fixed lending targets in recompense for state aid during the financial crisis, and banks' failure to meet their goal will raise pressure on the government to toughen its stance on the sector.

Prime Minister David Cameron's government is already under fire for not doing enough to curb bank bonuses at a time when many borrowers are being hit by punitive bank charges.

The government is looking to the private sector to drive economic growth as it cuts spending. Since the 2007/08 financial crisis, many smaller firms have found it hard to borrow to expand, and they complain that Project Merlin failed to help them enough.

The finance ministry has already said it will not extend the agreement, and will replace it with a loan guarantee scheme aimed at lowering the cost of borrowing for small firms.

The Bank of England said the five banks that signed up to the Merlin agreement failed to meet their target for lending to small and medium-sized businesses, making 74.9 billion pounds available, below the 76 billion pound target.

However, banks beat their overall 190 billion pound target, making available a total 214.9 billion pounds. The figures confirm data from the British Bankers' Association on Friday.

Financial Secretary to the Treasury Mark Hoban said the Merlin scheme had at least encouraged banks to bring forward lending. What we need to do now is focus on ... how we actually reduce the cost of credit to businesses, he told Sky television.

TIGHT CREDIT

The government had hoped that its Merlin deal with Royal Bank of Scotland, Lloyds, HSBC, Barclays and Santander UK would boost private sector investment to offset its own spending and job cuts.

But a survey by the Federation of Small Businesses showed that the proportion of small businesses that have used a bank overdraft or loan has fallen in the past two years.

Critics of the Merlin scheme argued that the targets were of little use as they only measured gross lending, not net new lending, and gauged only credit facilities made available, rather than how much money has actually been lent. The Bank's own data showed net lending fell by 9.6 billion pounds last year.

These targets were fairly meaningless in the first place and there are plenty of reasons to expect credit growth to remain a constraint on the economic recovery for a while yet, said Vicky Redwood of Capital Economics.

EEF manufacturers' organisation said the high cost of borrowing and stringent terms and conditions for bank loans had deterred many small firms from seeking credit.

The government's Credit Easing initiatives will be challenging to implement but seem to offer a prospect of making some improvement on access to finance, EEF chief economist Lee Hopley said of the loan guarantee scheme.

(Reporting by Fiona Shaikh; Editing by Ruth Pitchford)