Leading article: The banks must pay a price for their hubris

Unprecedented crises demand unprecedented solutions. It may have been expected, but no one should underestimate the seriousness of the Bank of England's decision yesterday to allow the banking sector to swap its illiquid mortgage assets for government bonds. This means that the state will, effectively, be taking billions of pounds of private sector mortgage debt on to the nation's balance sheet.

But the seriousness of the crisis in credit markets should not be underestimated either. The banks are not lending to each other because the market for their mortgage-backed securities has utterly collapsed. Everything in high finance is connected. Because the banks are not lending to each other, they are not lending to the wider economy. This withdrawal of liquidity has the potential to send Britain into a painful recession.

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With this in mind, the Bank of England's solution to the credit freeze-up is the least bad option available to economic policymakers. Yet it is important to be clear about what this package represents, and what it must not become.

First, it must not be a "bail-out" for the banks, to rescue them from the consequences of their previous foolish lending. If these mortgage-securities turn out to be worth less than the banks estimate, banks and their shareholders, not the taxpayer, must ultimately make up the balance. Second, the purpose of this operation must be to inject liquidity back into the economy and cushion the downturn, not to keep homes expensive through cheap borrowing rates. Rightly, the Bank of England has stipulated that the banks cannot use these swaps to finance new lending. We have some sympathy with those homeowners who are slipping into negative equity as the market begins to fall, but the fact is that we have experienced a damaging bubble over the past decade. The price of homes must descend to more realistic levels and lending must be more scrupulously rationed for the overall good of the economy.

Unprecedented measures also demand unprecedented scrutiny. Providing this plan succeeds in unblocking the credit markets, policymakers must turn their attention next to the roots of this crisis. The culpability of the banking sector should now be obvious. The banks packaged up housing and other debt into opaque and complex financial instruments to finance further, increasingly risky, lending. Thanks to the bust, the banks have found themselves with enormous losses. Worse, thanks to the complexity of the financial instruments they had been churning out and trading among themselves, they do not even know for sure which of their number are most exposed to the toxic debt. What they do know, however, is that that, since many of the financial instruments are pegged to the value of the falling US property market, the bad debt problem is getting bigger all the time. This uncertainty is the driving force behind the credit crunch.

The arrogant arguments of the banking sector that they, rather than regulators, are better placed to manage risk have been exposed as nonsense. The price of their hubris must be better regulation and pre-emptive action to curb their profit-driven excesses in future.

But regulators have been remiss, too. The tripartite regulators – the Bank of England, the Financial Services Authority and the Treasury – should never have allowed the banks to behave in this fashion. They failed in their responsibility to safeguard the public from the excesses of the financial sector. What is required is a non-partisan inquiry to determine how the regulatory system broke down; and what measures are needed to prevent the nation ever being brought to the brink of recession by the recklessness of high finance again.