Those desperate for cash say lending has deteriorated dramatically despite last month's £37bn bail-out funded by the taxpayer. On the other hand the banks, eager to protect their reputations, are churning out statistics suggesting lending has, in fact, increased in the past year.

It is an argument that began slowly, with individual businesses reporting problems accessing loans or renewing their overdraft. But last week it turned into a full-blown tug of war.

On Tuesday, Bank of England governor Mervyn King sided with Britain's army of small businesses when he told the Parliamentary Treasury Select Committee that lending to both businesses and households over the past month has been "extremely weak".

He told MPs: "The single most pressing challenge to domestic economic policy is to get the bank system to resume lending in any normal sense. It's more important than anything else at present."

But Angela Knight, chief executive of the British Bankers' Association, has come out all guns blazing in defence of the UK's biggest financial institutions, wielding figures that suggest lending to small businesses increased by £950m between July and September this year. This, argues the association, is just short of the £1.086bn increase in lending recorded during the same period last year.

The Organisation for Economic Cooperation and Development last week caused a few pink cheeks in Whitehall when it kicked the Government's growth forecasts into touch almost as soon as they had come off the printing press. Therefore, Chancellor Alistair Darling is eager to stop any further disagreement. On Tuesday, he announced the Government is to conduct a full inquiry into bank lending, with Lord Mandelson at the helm. With the Government eager to look prepared to dish out rigid punishments if required, talk of nationalising the banking sector later leaked out of the Treasury.

In a characteristically gritty statement, Mandelson made it clear he would be no pushover, declaring: "It's completely unacceptable to the Government and to business in this country for banks indefinitely to stop functioning as banks. We are in very intensive discussions with the banks, believe me."

But with contradictory claims emerging from both sides, anxious businesses and households are left this weekend asking: what is the real state of lending in Britain? And will further Government measures to improve lending be required?

Publicly, the banks are putting up a good defence. Royal Bank of Scotland insists total lending to small businesses has increased by 12% between October 2007 and October 2008. Lloyds TSB says its lending to small firms has risen 18% over the past 12 months. Barclays has also published figures showing lending and overdrafts to small businesses grew from £9.6bn in September 2007 to £10.1bn in September 2008.

Meanwhile, HSBC says small company lending has remained at "similar" levels to last year. "The tap hasn't been turned on and off," stressed HSBC spokesman Mark Hemingway. "The tap has always remained on. On the mortgage side we are lending more than we did in 2007."

But at the coal face, Britain's businesses tell a different story. Peter Hughes, chief executive of Scottish Engineering, is unable to mask his fury at the brick walls he says companies are coming up against when they speak to their bank managers. "The banks are getting away with daylight robbery on a daily basis at the moment," he says. "Arrangement fees are being hiked dramatically. I had a call from one SME (small and medium sized enterprise] which has actually been quite good in the past at getting its overdraft down. They have just been told their overdraft over the next 12 months will be base rate plus 7%. That's just criminal. We have thrown £37bn at those people (the banks] and they are not doing what they have been told to do."

It's a similar story at the Federation of Small Businesses. In a recent survey, a third of its members reported an increase in the cost of existing overdrafts and loans. A similar number said new loans had become more expensive and only one in 10 members felt credit had become more readily available in recent months. The CBI in Scotland says a third of its members who have applied for new credit recently have been turned away.

It's a confusing picture for Mandelson and his Treasury officials as they wade through their inboxes brimming full of policy papers, with each side purporting to have statistics to back up their case. But behind the public statements, sources say the landscape is very different.

Under pressure from the Government and the Financial Services Authority (FSA) to ensure they have enough cash to withstand another economic shock, banking executives privately admit they are, in fact, looking at pulling in credit lines. One insider insisted it is a natural part of the "process of adjustment" as UK banks cope with the aftermath of the debt-fuelled recession. They were heavily criticised for giving away credit so easily in the run up to last summer when the US sub-prime crisis hit. Now they have to try and limit how much they lend, and to whom. "There needs to be a correction," said one insider. "You have to question how sensible it is for the Government to insist on increasing lending into a downturn."

Nic Clarke, a banking analyst at Charles Stanley stockbrokers, says the banks are receiving contradictory instructions. Regulators now require them to satisfy higher capital ratios than international competitors to avoid another banking meltdown in Britain.

But at the same time as being warned to conserve cash, the Government is telling them to continue and, in some cases, even increase lending to the rest of the economy. "It's a very difficult position the banks have been put in," Clarke says. "Banks have got to be careful they don't overreach themselves."

Colin McLean, managing director of Edinburgh-based SVM Asset Management, predicts banks will have to reduce their overall lending by around a quarter over the next couple of years if they are to restore their balance sheets to a stable position. Lending has substantially outweighed the amount of money banks have accumulated in deposits over the past ten years, he says, and this trend will have to soften if the banking sector is to recover.

"The extent over the last five years of excess lending over and deposit growth is about £700bn and if we are to bring the banks into a model where they are lending a sum that is backed much more clearly by secure deposits... there's going to have to be quite a shrinkage in their lending and also in their facilities (such as overdrafts] as well."

Analysts point to the Bank of England's recent Credit Availability Survey as further proof that behind the bold press statements, banking executives are pessimistic about the immediate outlook for lending. In the survey published last month, they admitted to a reduction in the amount of unsecured credit they are prepared to make available to both UK small businesses and households. They also admitted they are tightening conditions by introducing stricter lending criteria. "Looking ahead, lenders expected a further reduction in overall unsecured credit availability, which would be associated with a further tightening in credit scoring criteria and declines in approval rates," the report warned. "Lenders reported that the decline in credit availability was driven by concerns about the economic outlook and a reduced appetite for risk. These factors were expected to contribute to a further tightening in credit availability over the next three months."

However, sources close to Whitehall confess the picture isn't entirely clear on the other side of the fence either. Insiders say there is "considerable" politics involved as the Bank of England and the Government keep one eye on their own reputations, which will take a serious knock if the banks are seen by the public to be defying the conditions of last month's £37bn bailout. As one source explained: "Quite a lot of it is not to be seen to be too cosy to the banks."

Analysts suggest a loosening of the capital ratios imposed on UK banks would be a sensible way forward as part of the measures the Chancellor has asked Mandelson to look into. But there are few who believe he has any intention of carrying out the threat to nationalise banks which don't comply. "The last thing the Government wants to do is nationalise all of the banks. It's probably more a threat than something they would actually carry out," said Clarke of Charles Stanley.

The City is currently divided over the fate of the banking sector over the next 18 months. While some suggest the Government must be prepared to inject further funds into the banking system to avoid the UK from slipping into the same economic downturn as Japan experienced during the "lost decade" of the 1990s, others argue many of the banks will be fairly well capitalised thanks to the Government's £37bn bailout.

Whichever measures the Government adopts, they will be of little comfort to small businesses which can only watch helplessly as their lending costs go up while their order books look increasingly volatile. But economists warn that while the Government can play a role in limiting the extent of the cost rises – particularly in those banks in which taxpayers now hold a majority stake – small firms and households will have to face facts that the era of cheap and easy credit is over. At least for now.

"There is going to be no dramatic improvement in the overall availability of credit," says Ian Stewart, associate director of research at Deloitte. "I'd be very surprised if credit conditions didn't remain very difficult for the next year."