Chancellor sets out proposals for G7 to tackle credit crisis

The Chancellor, Alistair Darling, has written to fellow European finance ministers setting out detailed proposals for the Group of Seven club of large Western economies to deal with the credit squeeze. In words that will do little to appease jittery money markets, Mr Darling said "the primary responsibility for managing risk is, and must remain, with individual financial institutions and investors".

Mr Darling's letter echoes calls from the French finance minister, Christine Lagarde, and her German counterpart, Peer Steinbrueck, for a review of the aftershocks of the American sub-prime crisis and follows similar proposals from Washington. The US Treasury under secretaries David McCormick and Robert Steel have called for a "timely examination" of financial institutions' liquidity and the role of credit-rating agencies. They also called for a study of how derivatives are valued and oversight of off-balance sheet trading. The Basel-based G7 Financial Stability Forum, created after the Asian financial crisis of 1997-98, will be asked to propose ways to limit turmoil in times of financial stress.

Some query why ministers and central bankers in the UK and elsewhere have taken until now to act on the explosion in credit, and are questioning the focus of their attention. Simon Johnson, the chief economist at the International Monetary Fund, said that European governments should be wary of pointing fingers, as hedge funds have not been the source of the turmoil and that some of the banks that have suffered have been on their watch. he said: "Hedge funds this time around are not the central issue. Letting regulated banks go off and make money off-balance sheet – that's something we should look at now."

The issue will be on the agenda at tomorrow's "informal" meeting of EU finance ministers in Portugal. This activity comes as warnings about the impact of the credit squeeze on the economy intensify. The European Central Bank's monthly bulletin cautioned that: "While the global repercussions of the US economic slowdown have so far been limited, it remains to be seen whether the recent financial market turmoil will lead to a lasting reappraisal of global financial market risks and a loss in confidence with possible implications for the real economy."

Meanwhile, the respected independent Item Club, which uses the Treasury's own model to forecast developments, predicts that growth will suffer. Item believes that "given that the US sub-prime mortgage market is $1.5trillion, a reasonable estimate of the losses could be $100bn to $150bn, with low-grade debt and leveraged buyout defaults adding $40bn and $25bn of losses respectively.

Peter Spencer, the chief economic adviser to the group, said: "It is hard to forecast ... however, a worst-case scenario of a full-blown credit crunch scenario would reduce UK growth by around 1 per cent in 2008 and 2009. For the eurozone, the impact would be lighter, while for the US it could be as high as a 1.5 per cent reduction."

He added that "the public finances will be one of the victims of the collateral damage". Given City bonuses and the contribution financial services make to the economy losses to the Exchequer will run into billions. This will stretch the public finances and need to be reflected in next month's pre-Budget report and Comprehensive Spending Review.

In terms of immediate action the Bank of England said it will allow banks more leeway to borrow – without penalty – to meet daily needs. The policy is designed to lower overnight lending rates and restore order to the money markets.