The government will not extend a deal with banks requiring them to meet fixed lending targets to businesses, a Treasury source said, scrapping a scheme designed to revive the ailing credit markets that have formed a barrier to economic recovery.

Since the financial crisis of 2007, many smaller firms not able to raise funds on capital markets have found it difficult to borrow to finance investment.

The Conservative-led coalition government struck a deal with Britain's major banks last year to boost lending to businesses, but the 'Project Merlin' scheme was criticised for doing little to alleviate tight lending conditions for firms.

Data indicated on Friday that institutions had failed to provide enough credit to small companies.

The Bank of England will publish the final Project Merlin lending figures at 0930 GMT on Monday.

While lenders are broadly on track to meet their overall target of 190 billion pounds, lending to small firms may fall slightly short of the 76 billion target.

Figures published so far by four of the five banks show credit facilities to SME's in 2011 came in at 63 billion pounds, suggesting the final outcome will be lower than expected.

The BoE's own data shows that net lending by the Project Merlin banks -- HSBC, Barclays, Royal Bank of Scotland, Lloyds Banking Group and Santander -- fell by 9.6 billion pounds in 2011.

Part-nationalised Lloyds said on Friday it lent 12.5 billion pounds to SMEs in 2011, ahead of its target of 11.7 billion.

CREDIT EASING

Chancellor George Osborne has already flagged that he doesn't consider lending targets to be a permanent solution, saying that credit easing will help channel money directly to where it is most needed.

Critics of the scheme have argued that the targets are of little use, as they only measure gross lending, not net new lending and gauge only credit facilities made available rather than how much money has actually been lent.

In reality, many small firms have still encountered difficulty getting loans, while banks have blamed the weak economic outlook for crimping credit demand.

Bank of England Governor Mervyn King weighed into the debate last October, urging the government to think of ways to boost lending, such as giving banks a fiscal incentives to lend to SMEs.

Under pressure to find ways to boost Britain's flagging economy, Osborne last year unveiled a separate, 21 billion pound credit easing scheme which aimed to lower the cost of borrowing for firms by providing government guarantees for banks' funding.

But details of the National Loan Guarantee Scheme, which was supposed to lower the cost of borrowing for small businesses by around 1 percentage point, have been thin on the ground.

Delays have occurred because of disagreements over how to make sure banks pass on the savings in borrowing costs to small firms, and also over how to charge banks for access to the funding, according to the Treasury source, though he stressed the aim is to get the scheme up and running within a few months.

Last month, the government launched a first phase of the scheme, under which it will invest up to 1 billion pounds alongside private sector investors in funds that lend directly to medium-sized businesses with a turnover of up to 500 million pounds.

(Additional reporting by Sudip Kar-Gupta; Editing by Catherine Evans, John Stonestreet)