Leading article: Nationalisation of our banks edges ominously closer

The massive losses announced by the Halifax Bank of Scotland at the end of last week have done nothing to lift confidence in our battered banking sector. The Lloyds Banking Group, which absorbed HBOS last year, is in serious trouble itself. A third of its value was wiped off in the stock market last Friday. And more punishment could come today.

There is a bitter irony for Lloyds here. The bank was in reasonable shape compared with its peers when the credit turmoil struck in the autumn of 2007, having not over-extended itself in the boom. But now there is speculation that Lloyds might need to follow RBS into majority public ownership. The Government, which encouraged the Lloyds takeover of HBOS, waiving competition rules in the process, stands accused of facilitating this latest disaster. The shadow business secretary, Kenneth Clarke, says the merger should never have taken place.

But while it seems difficult to justify now, it is worth bearing in mind the circumstances in which the takeover deal was done. HBOS was already in serious trouble last summer. The Government believed that encouraging a takeover by the healthier Lloyds group would prevent it going the way of Northern Rock. And keeping the bank in private hands was widely perceived to be preferable to another nationalisation. Then in September the massive American investment bank Lehman Brothers collapsed and the global financial system suffered the equivalent of a heart attack. The weaker members of our banking sector suddenly faced going under completely.

Over a tense few days in October, the Government agreed to inject £37bn of capital into RBS, HBOS and Lloyds to reassure investors and depositors that these banks would be able to meet their considerable liabilities. The formal Lloyds takeover of HBOS proceeded in the weeks following this unprecedented Government rescue.

Should the Government have called off the merger after the recapitalisation? It is true Lloyds would be in better shape now if HBOS had stood alone. But HBOS itself would almost certainly be in complete public ownership if it had not been absorbed by its competitor. Lloyds' shareholders might have a case against the Government were it not for the fact that they themselves voted for the deal, persuaded by the argument of the bank's management that the merger would put them in a commanding market position when the recovery came. The principle of caveat emptor would seem to apply.

But what of the taxpayers' interest? From this perspective, there is not much difference between a hobbled Lloyds and a wholly nationalised HBOS. Both are equally unpalatable. The dispute about the merger is actually something of a sideshow. The important question is not whether the merger was a mistake, but whether outright nationalisation of the banks is the only way to prevent our economy entering a prolonged slump. As Mr Clarke pointed out yesterday, the October recapitalisation has not succeeded in unblocking the credit taps. Businesses are still being squeezed as the banks seek to shrink their balance sheets.

It is possible that the only way to ease the flow of credit to the wider economy will be to take the entire sector into temporary public ownership. At the moment, ministers keep repeating that the banks are best kept in the commercial sector. And the Government quite clearly has no appetite for further nationalisations. But any further losses like last week's and the markets might well give the Government no choice.