Banks will be able to borrow cash from the Bank of England at cheaper interest than the base rate if they increase or maintain their lending to consumers and businesses, reveal details from the new Funding for Lending Scheme (FLS) published by the Treasury.
Government and the Bank hope this credit easing scheme will boost the amount of affordable lending to the wider economy, such as loans for small businesses and mortgages for home buyers, in a bid to pull Britain out of its double-dip recession and towards recovery.
"This joint action by the Bank and the Treasury creates strong incentives for banks to expand their lending to the real economy," Mervyn King, Bank of England governor, said in a statement.
"The more banks expand lending, the more they can use the Scheme. That will encourage banks to make loans to families and businesses both cheaper and more easily available."
The Bank of England will lend to banks at 0.25 percent in the form of UK Treasury Bills with a maturity of up to four years.
This price depends on net lending between 30 June and the end of 2013.
If a bank that borrows from the scheme sees its lending decline, it will pay an extra 0.25 percent interest for every 1 percent reduction in lending, to a maximum of 1.5 percent.
Banks will initially be able to borrow cash worth up to the value of 5 percent of their existing lending to the real economy.
They will then have access to FLS loans over and above the 5 percent in direct correlation to the amount they increase affordable lending to the real economy.
There is no upper limit on these loans, but banks must provide collateral - in the form of loans to businesses and households and other assets - for each transaction.
FLS will close at the end of January 2014, but four year loans will be available up until this date. In theory this could take FLS through to 2018.
Eurozone crisis weighs on UK banks
King and Chancellor George Osborne announced FLS at the annual Mansion House dinner.
It comes on top of £375bn in quantitative easing from the Bank.
In an appearance before MPs King said that there are "no guarantees" the credit easing scheme will work.
Banks may feel that, despite the financial incentive offered by the Bank of England, increased lending to the wider economy is still too risky.
Worries in the eurozone - Britain's biggest trading partner - continue to weigh on the UK economy, draining consumer, business, and banking confidence about the prospect for future stability.
A catastophre in the eurozone, such as a disorderly exit of a struggling state, could drag other surrounding single currency area economies down.
Spain continues to flirt with unsustainable borrowing costs amid the diminishing political viability of austerity and fears that a €100bn recapitalisation of its struggling banks still is not enough to prop up the finance sector, hurting from a significant unwinding of bloated asset prices.
Italy, the eurozone's third biggest economy, has just been downgraded by rating agency Moody's by two notches to Baa2 - near junk status.
Many feel there is simply not enough cash available to bail out huge economies such as Spain and Italy.
A eurozone collapse would have serious implications for UK banks, which are heavily exposed to private sector borrowers in the area.
"If contagion were to spread, there would likely be significant disruption through secondary channels, such as increased counterparty risk and stresses in funding markets, with adverse feedbacks to the macroeconomy," said the minutes from a 22 June meeting of teh Bank of England's financial policy committee.
"A disorderly unwinding of asset prices could result in direct losses on UK-owned banks' exposures to the region, which for some banks were significant."
Britain's recession - its second in four years - looks likely to extend into the second half of 2012 after a set of disappointing private industry data showed a slowdown in the service sector and continued contraction in output in the manufacturing and construction sectors.