The Bank of England is looking at ways to help cash-stricken banks borrow money and stop firms from taking risks that could potentially leave their customers exposed.
The governor of the UK's central bank, Mervyn King, today told British banks that financial stability is his key aim. He also revealed that the Bank of England is planning to unveil a scheme designed to counter continuing instability in the money markets.
"We intend to put in place a liquidity facility that works in all seasons both 'normal' and 'stressed',” he said.
King hopes the new scheme will remove the stigma involved with borrowing from the Bank of England, and will also allow a badly-run bank to fail without undermining confidence in the economy as a whole.
The Bank of England's new scheme means that if another bank does fall into difficulty in a similar way to that of Northern Rock last year, then it will probably be allowed to fail as long as this didn't put the economy at risk.
"Companies which have misjudged risks or their business model should generally be allowed to fail to encourage prudent behaviour by others," says King. "But the failure of a bank can have an impact that goes well beyond the importance of that bank alone – so-called systemic risk.
"It can then be difficult for the authorities to make a credible commitment that in future banks will be allowed to fail. And that can in turn encourage banks to take greater risks – both in maturity transformation and lending – enabling them to earn higher profits."
King believes this system means banks have an incentive to "take more risk today".
Since the bail out of Northern Rock in September last year, many banks have been wary of going cap in hand to the Bank of England for help. In April, King unveiled a special £50 billion liquidity scheme which allows banks to borrow money in return for harder to trade mortgage-backed securities.
Although initially the scheme helped to lower Libor and swap rates - the interest rates at which banks borrow from each - rising inflation has seen this increase again to 100 basis points about base rates.
In the space of 10 days, swap rates have surged from 5.80% to 6.30%, prompting many economists to predict that mortgage rates will top 7% in the next few months. “With demand in the housing market already so weak, this would represent another huge blow to the housing market outlook,” said Ed Stansfield from Capital Economics.
This is a problem the Bank's governor is well aware of. “We are passing through the most prolonged period of financial turmoil that most of us can remember," warns King. "The crisis is not over yet.”
Meanwhile, the British Bankers' Association (BBA) has announced a package of changes to the way Libor is set.
Libor - which the BBA says is used to set rates for financial products worth around $350 trillion - has recently come under the spotlight as a barometer of the credit crunch, as it follows the rates at which banks perceive borrowing risk in the markets.
Because this risk is currently considered very high, Libor rates have increased, making it more expensive for banks to borrow money and in turn causing interest rates on loans such as mortgages to increase.
The BBA proposes "tighter scrutiny" of the rates contributed by banks and increasing the numbers of contributors to some of the rate-setting panels.