Rishi Sunak has backed down in his longstanding power struggle with the Bank of England over plans to let ministers overrule City regulators and force them to take advantage of the “opportunities of Brexit”.

The prime minister had proposed a controversial new “intervention power” for ministers, which BoE governor Andrew Bailey warned would seriously undermine the independence of financial services watchdogs.

Sunak wanted to loosen City rules so that insurers would have to retain smaller capital buffers, hopefully releasing tens of billions of pounds to be spent on infrastructure, including green technology.

One senior minister had claimed the BoE was being “intransigent” over proposed reforms to the EU’s Solvency II regime for insurers. The proposed “call-in power” was intended to force regulators to act.

But the Treasury on Wednesday announced that the new power, originally proposed by Sunak when he was chancellor, would be dropped.

The U-turn coincided with a compromise deal between the Treasury and the central bank over Solvency II reform, announced in last week’s Autumn Statement by chancellor Jeremy Hunt.

The chancellor’s Hunt’s allies said this proved the BoE was willing to balance the need to generate growth with its mandate to maintain financial stability.

City minister Andrew Griffith announced: “The government has decided not to proceed with the intervention power at this time.”

Griffith said existing provisions in a new financial services bill were sufficient to allow Britain to “seize the opportunities of Brexit by tailoring financial services regulation to UK markets to bolster our competitiveness”.

“We have always been keen to find the right balance between increased responsibility for the regulators, with clear accountability, appropriate democratic input, and transparent oversight,” added Griffith.

“We remain committed to the operational independence of the financial services regulators.”

The decision will come as a huge relief to the BoE, which feared that confidence in City regulation would be undermined if ministers could simply overrule any decision they did not like.

The issue came to a head over Brexit: Sunak wanted to loosen City regulation to demonstrate some tangible benefits of Britain’s departure from the EU, while the BoE warned that such a move could risk financial stability.

As chancellor, Sunak intended to add a new “power of intervention” to the financial services bill, currently before parliament — a position confirmed by the Treasury to the Financial Times this week.

But Bailey and Sam Woods, head of the BoE’s Prudential Regulation Authority, warned against the move, as did Nikhil Rathi, chief executive of the Financial Conduct Authority.

Woods told a City audience last month: “A power which allowed ministers to override regulatory decisions just because they took a different view of the issues involved would represent a significant shift away from a model of independent regulation.

He added: “Some might think that such a power would boost competitiveness. My view is that through time it would do precisely the opposite, by undermining our international credibility and creating a system in which financial regulation blew much more with the political wind.”

Sunak’s retreat marks an end to attempts by senior Conservative politicians to undermine the authority of the BoE. Liz Truss, former prime minister, said during her bid for the Tory leadership that she would review the central bank’s mandate.

Meanwhile Hunt repeatedly declined to tell MPs on Wednesday whether a Sunday Times story suggesting the UK might seek a “Swiss-style” relationship with the EU had originated from a Treasury source, but he insisted it was wrong. 

The chancellor said the government would not deviate from the basic “trade and co-operation agreement” negotiated by Boris Johnson and that he was committed to diverging from EU rules, as with Solvency II, if it made economic sense.

But he added it was his “public position” that technology might be used to soften physical barriers to trade “in the way that happens on the Franco-Swiss border”.