Legal & General, the UK's largest investment group, on Thursday urged the government to reconsider its terms for bailing out three high street banks that could block them from paying dividends for several years.

The government agreed this week to inject up to £37bn in Royal Bank of Scotland, HBOS and Lloyds TSB in return for a mix of preference and ordinary shares. But one of the conditions of the bail-out is that the banks will not pay dividends on ordinary shares until all the preference shares are redeemed.

There has been an outcry from the banks, which claim that the terms will stop investors taking up new shares and make it inevitable that the government ends up with big stakes in them.

Tim Breedon, L&G chief executive, said on Thursday: "The dividend block is probably counterproductive and has raised the barrier for both private and institutional investors to invest alongside the government in recapitalising the banking sector. While we applaud the [recapitalisations], we urge the government to look again at this particular barrier."

Mr Breedon also threw his weight - as a top three investor in both Lloyds TSB and HBOS - behind the proposed merger of the banks, eclipsing rumbling doubts raised by other investors.

He said: "A combination of Lloyds/HBOS through an all-share merger to create a stronger bank is probably desirable, given current difficult circumstances."

Being a 5 per cent holder of the combined group was probably a better outcome than holding 5 per cent in separate banks in this economic climate, he said. The united group would be stronger in the short and long term.

His comments echo other investors such as Standard Life.

Lloyds TSB agreed to take over HBOS last month when the Scottish bank ran into difficulty. Lloyds TSB offered 0.833 of one of its shares for every HBOS share.

But it renegotiated the terms last week, offering 0.605 of its own shares for each HBOS share.

Some Lloyds TSB investors worry the bail-out commits the bank to raising capital on onerous terms. HBOS is raising £8.5bn in fresh equity and £3bn in preference shares; Lloyds TSB will raise £5.5bn, including £1bn in preference shares. The banks are committed to paying a 12 per cent coupon on the preference shares while paying no dividends to shareholders. Shareholders are also concerned the state could end up with a 43.5 per cent stake in the combined bank if investors do not claw back shares issued to the government.

HBOS will post documentation to its investors in mid-November and will hold its meetings for shareholders to approve the deal in mid-December.

HBOS shares slipped 1.87 per cent to 84.1p, while Lloyds TSB was flat at 150p.