The Bank of England is in no mood to bail out banks that have engaged in "risky or reckless" lending, its governor Mervyn King warned yesterday.
In a letter to the chairman of the Commons Treasury Committee setting the scene for a hearing set for September 20, Mr King described the decision of whether to pump long-term cash into the money market to push down excessive interest rates as "the most difficult issue facing central banks at present".
He came down firmly in favour of charging "an appropriate penalty rate" for such general injections of funds as banks take hard-pressed spin-off investment vehicles on to their own balance sheets.
Otherwise "they would encourage in future the very risk-taking that has led us where we are", he warned.
He added: "The provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises."
But he also noted: "All central banks are aware that there are circumstances in which action might be necessary to prevent a major shock to the system as a whole. Balancing these considerations will pose considerable challenges and in present circumstances judging that balance is something we do almost daily."
Mr King distinguished this crisis management from the Bank's short-term management of the money market and its interest rate policy seeking to meet the Government's two per cent inflation target. Echoing comments by the European Central Bank's president Jean-Claude Trichet on Tuesday, Mr King said that banks, as a whole, are at present well enough capitalised enough to handle their losses.
"The current turmoil, which has at its heart the earlier under-pricing of risk, has disturbed the unusual serenity of recent years, but, managed properly, it should not threaten our long-run economic stability," he concluded.
His letter was widely interpreted as a signal that the Bank is likely to leave its official interest rate at 5.75 per cent.
George Buckley, chief UK economist at Deutsche Bank commented: "In other words, the crisis has removed the need to hike but not yet led to the need for a cut."