GEORGE Osborne unveiled sweeping changes to the way the City is regulated last night, scrapping the Financial Services Authority and giving a beefed-up Bank of England huge powers.

Bank governor Mervyn King is set to become one of most influential central bankers in the world under the shake-up, with responsibility for maintaining the overall stability of the financial system as well as setting interest rates.

Despite considerable opposition from his Liberal Democrat coalition partners, the chancellor used his first Mansion House speech to confirm the government “will abolish the tripartite system”.

“The Financial Services Authority will cease to exist in its current form,” Osborne said, explaining the watchdog will be wound down over the next two years .

Last night, King fired a warning shot to the City, saying his role in ensuring financial stability would be “to turn down the music when the dancing gets a little too wild”.

A new prudential regulator – which will operate as a subsidiary of the Bank of England – will replace the FSA when it is fully abolished in 2012.

In an astonishing U-turn, Hector Sants has been persuaded to stay on as chief executive of the FSA, and will then assume the top job at its replacement. He will also become a deputy governor of the Bank of England.

As late as last week, Sants was telling friends he would begin six months of gardening leave in July and said he was looking forward to spending more time with his family. Last night, an aide to the chancellor confirmed Sants had only been convinced to stick with the job “within the last few days”.

When Osborne announced Sants was staying on, his Mansion House audience responded with the biggest cheer of the night.

Treasury officials said FSA chairman Lord Turner would continue in the interim, although he is not expected to move to the prudential regulator with Sants. Last night, he insisted he was “happy” with the changes.

A new Consumer and Markets Authority will also be created, tasked with the protection of consumers and the day-to-day policing of financial firms, alongside an economic crime agency.

Meanwhile, the chancellor confirmed he will hit the banks with a new levy in his emergency Budget on 22 June. “There are real issues of fairness. That is why we will introduce a bank levy and demand further restraint on pay and bonuses,” he said.

And Osborne announced the launch of an independent commission into the future of banking, tasked with deciding whether the government should pursue a full-scale separation of investment and retail banking.

Former OFT chairman Sir John Vickers will lead the commission, along with former Barclays chief Martin Taylor, ex-Ofgas boss Claire Spottiswoode, former co-head of investment banking at JP Morgan Bill Winters and columnist Martin Wolf.

In a fillip for the chancellor, King threw his weight behind Osborne’s plans for early and quick spending cuts, arguing the reduction of a “very large structural deficit” could not be “postponed indefinitely.”

And in a sign of how the Bank will go about tightening monetary policy, the governor indicated he would hike interest rates before selling off the gilts bought through the programme of quantitative easing.

“The monetary policy committee will not hesitate to begin to withdraw the current degree of stimulus when we judge that is necessary. That is most likely to be through a rise in the Bank rate, with asset sales being conducted later,” he said. MORE: P3, P4, P5