Jeremy Warner's Outlook: The financial storm continues to build

There's a famous perversion of the old saying "it's always darkest just before the dawn", sometimes attributed to the former Chinese leader Mao Zedong, which goes: "It is always darkest just before it is completely black".

That's how it looked at the time of writing after a day of high drama in financial markets, involving multiple nationalisations of European banks, culminated in Congress rejecting a $700bn bailout plan, already substantially modified to buy off political opposition. From George Bush to Warren Buffett, Hank Paulson and Ben Bernanke, they'd all lined up to warn that it would be the end of the world if it failed, so what happens now?

As ever with US politics, it's never over until it is over, and yesterday's vote isn't the finale. Pork-barrel politics now enters the equation as potential swing voters are persuaded to change their stance. Yet massive uncertainty now persists as the world waits to see if Congress is prepared to take the immediate actions necessary to save the financial markets, or in bloody-minded obstinacy is destined to plunge the world into a severe recession.

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Credit spreads are off the scale and the price of insuring against default through credit default swaps is soaring, not just for banks but even for mainstream industrial companies. Meanwhile, even the most unflappable of moneymanagers are taking their money out of banks, now perceived as almost universally unsafe, and sticking it into Treasuries and other government bonds. There's already a pecking order, by the way, with British and US bonds seen as not quite as safe as Germany and France. What to date has been a relatively measured stock market correction is turning into a full-blown crash.

Before last night's dramatic Congressional vote, I was tempted to write that yesterday's nationalisations were the bottom, the final death rattle of the credit crunch, with things gradually improving from here on in, at least for financial markets if not the real economy. This now looks far less clear. Dawn has again been postponed.

The danger of the credit crunch has always been that a bad downturn in the real economy would start to kick in before the banking system had had a chance to recover from the traumas of the sub-prime crisis, and this is indeed what now seems to be happening.

Worse, the "deleveraging", or balance sheet contraction, which the banks are undertaking in response to the credit crunch, is now adding substantially to the woes of the real economy. According to figures from the Bank of England yesterday, British banks reduced their lending to the UK economy by nearly £600m in the six months to the end of August. That process will have accelerated since. The contraction now apparent is after a long period of substantial growth, so the effect of the deprivation will be felt doubly hard in the real economy.

As the economy heads south, both in the US and Europe, a whole new raft of bad debt experience will take over from where the credit crunch is leaving off, causing confidence in the banking system to be further undermined. Nor has the policy response in attempting to reignite trust and confidence in banks been as brilliant as it might have.

The decision in the US to let Lehman Brothers go to the wall was plainly a mistake, causing some $400bn of liquidity to be sucked out of the system, thereby hugely increasing the magnitude of the funding challenge for other banks. At the same time, it collapsed confidence in the banking system more generally because of fears over which banks might be allowed to fail next. The upshot is that a solvency problem has been piled on an existing liquidity crisis. Indeed, it has become impossible to disentangle the two, with the fear that banks may not have enough capital to cover their bad debts understandably making banks even more wary of lending to one another.

The nationalisation of banking assets without compensation for equity holders, which began with Northern Rock and is now being repeated with Bradford & Bingley, hasn't helped matters. The same policy mistakes have broadly been mirrored in the US.

Fund managers and bankers who were prevailed upon by the Financial Services Authority only a few months back to put up fresh equity to recapitalise Bradford & Bingley have found themselves completely wiped out. They are unlikely to oblige regulators again. From here on in, it's going to be difficult to persuade the private sector to recapitalise the banks in the manner now so obviously required.

All this supports the contention that whatever happens to the $700bn bailout, things are going to get more difficult still before they get better. The pain in the real economy is in any case yet to come. Fast rising unemployment now looks a done deal. As for the crisis in financial markets, it remains impossible to tell how things will play out.

Certainly, a lot more needs to happen before we can be confident of things being on the mend. Europe and Britain must quickly start cutting interest rates. In Britain, the special liquidity scheme needs to be reformed to make it easier and faster for banks to access its liquidity. Similar "bad bank" arrangements to those proposed for the US, allowing banks to sell their illiquid assets to the taxpayer, may have to be established in Europe. There may, regrettably, also need to be a lot more banking consolidation.

The way things are going, the Lloyds TSB merger with HBOS could be just the hors d'oeuvre. Royal Bank of Scotland, owner of National Westminster Bank, found its share price again under sustained attack yesterday. This wasn't just because of its entanglement with ABN Amro, an ill-judged takeover which has already helped sink Belgium's Fortis; it was also because of concern over funding. RBS is quite heavily dependent on short-term, wholesale funding.

Like HBOS, RBS is too big to be allowed to fail. With so many tentacles in the UK economy, such an event is unthinkable. A nuclear winter of economic hardship would follow. But even more so than HBOS, RBS is also too big to nationalise. If the worst came to the worst, it would have to be taken over. The only British-based bank capable of doing so would be HSBC. Is such an outcome even remotely conceivable? In these markets, anything is possible.