WASHINGTON (Reuters) - Companies receiving public money under a U.S. government financial rescue program must use it for lending or they will be violating the law, the powerful chairman of the U.S. House of Representatives Financial Services Committee said on Friday.

“Any use of the these funds for any purpose other than lending -- for bonuses, for severance pay, for dividends, for acquisitions of other institutions, etc. -- is a violation of the terms of the act,” Rep. Barney Frank, a Massachusetts Democrat, said in a statement.

Frank was referring to a $700 billion financial rescue law passed by Congress earlier this month. The Treasury Department plans to use $250 billion of that amount to inject capital into financial institutions to unfreeze credit markets and restore lending.

A growing number of Democratic lawmakers have demanded more restrictions on banks receiving government money.

U.S. Treasury Secretary Henry Paulson must make it “absolutely clear” to a participating bank that the federal government will insist on compliance, Frank said.

Frank later told CNBC television on Friday that if banks do not honor the “principle” of using the funds to increase lending, Congress could fail to authorize the final $350 billion of the rescue plan.

The Treasury Department had no immediate comment.

Addressing lawmakers’ questions last week, Neel Kashkari, the Treasury’s interim manager for the rescue program, said the final purchase agreements between the Treasury and individual banks will have specific language on lending.

But he did not rule out the possibility of the capital injections being partly used to encourage acquisitions, saying that if a stronger bank acquires a weaker bank that has not been in a position to lend, the community is better served.

“We want our banks to lend,” Kashkari said during the Senate Banking Committee hearing last week. “But we also didn’t want to be in a position of micromanaging on this.”

NO STRINGS ATTACHED

A “no strings attached” policy by the government would be smart, because it allows banks to operate in areas they have the most expertise, one banking analyst said.

“I just don’t think the public gets it, and certainly Congress doesn’t get it,” said Anton Schutz, president of money managers Mendon Capital Advisors Corp in Rochester, New York.

For example, a bank that receives $25 billion through the bailout program could buy $250 billion in asset-backed securities from Fannie Mae or Freddie Mac, Schutz said. “That lending may not be direct, it may be in purchasing securities, but that’s helping to unfreeze the market,” he said. “You got to let those companies do what is economically sound.”

Under the Treasury Department program, the first $125 billion went to nine large U.S. banks, and the remaining $125 billion will be injected into community and regional banks.

In exchange for fresh capital, banks must give preferred shares to the government. The program also includes some restrictions on executive compensation and forbids banks from raising dividends and or making stock repurchases.

In recent days, some lawmakers have pressed the Treasury Department to attach more conditions, including a ban on all dividends and restrictions on the type of lending allowed.

Such conditions could be imposed through administrative guidelines and bank regulators could restrict banks’ activities if they don’t follow them.

A group of Democratic senators, including Charles Schumer of New York, last week asked the Treasury Department to issue guidelines on the type and amount of lending that participating banks must execute, and the level of oversight needed for their executives’ compensation.

The Bank of New York Mellon BK.N said it is abiding by the government's conditions.

“We are using the $3 billion (injection) to provide liquidity to the credit markets,” spokesman Kevin Heine said. “Our clients are primarily institutions, and we provide short-term funding to them. We will not use the $3 billion to pay dividends or bonuses.”

PNC Financial PNC.N said last week that it would buy National City Corp NCC.N, the ailing Cleveland lender, with help from a $7.7 billion government capital infusion.

Other recipients of federal capital have remained silent on how they will use the money.

Goldman Sachs GS.N, which received $10 billion from the government, declined to disclose its plans for the capital. Bank of America BAC.N, JPMorgan Chase JPM.N and Merrill Lynch MER.N declined to comment.

A White House spokesman said on Friday that banks receiving capital injections should not use that money “to increase dividends or pay dividends.”

One day earlier, a Bush administration official criticized calls to ban any dividend payments by participating banks. The official, who spoke on condition of anonymity, said such a move would discourage participation in the capital program, jeopardizing its chance to unfreeze credit markets, or would send investors fleeing to other companies that could still pay dividends, thus making the banks even weaker.