Jeremy Warner: Royal Bank likely to end up nationalised

Outlook: New Labour is understandably still terrified of revisiting Britain's bankrupt history of nationalisation

Notwithstanding the stock market's downbeat reaction to the latest bewildering array of Government initiatives on the banking crisis, slowly but surely ministers seem to be stumbling their way towards a workable solution. Unfortunately, they are not there quite yet.

The end game may still turn out to be outright nationalisation of one or more of the mainstream British banks – it was in part this realisation which caused the renewed slide in bank share prices – but provided this is done for the right reasons, it may not be the disaster some might suppose, either politically or economically. In any case, if that's where we are going to end up, the sooner we get there the better. There's little point in further political procrastination. To the contrary, it will only further prolong the economic and financial pain.

Yet because the Government feels compelled to answer to multiple constituencies, the messages being sent out are still alarmingly mixed. The primary purpose of yesterday's package is to get the credit markets operating again, so that economic activity can revive. Everyone can agree on this as a desirable and urgent policy objective.

Yet to make the hundreds of billions of pounds of additional public support for the banking sector seem more politically palatable, the Prime Minister must be seen to be as tough on the banks as he dares. This only undermines their profitability, and further poleaxes share prices, making capital raising from investors virtually impossible. The constant barrage of bank bashing is also designed to place the blame for Britain's economic travails with the banks, just in case anyone might be tempted to think it lies rather with the man who has been in charge of the economy for the past 11 years.

Banks are thus lambasted for their failure to come clean (does Mr Brown mean Barclays?) on their bad debts and for loans to Russian oligarchs and other extreme examples of reckless overseas lending. Astonishingly, there's a £400m write-off on Bernie Madoff in yesterday's RBS losses.

It's the banks wot got us here, and it is the banks that are dragging their feet in getting us out again, the PM seems to be saying. Part of the purpose of public policy is therefore to be seen to punish the banks for their misbehaviour, as well as to make the public believe they will eventually get their money back.

The only problem is that if the Treasury is too tough on the banks, it might prove self-defeating by causing them further to draw in their horns. The Government wants banks both to lend more and to deleverage so as to get their balance sheets back in order. It scarcely needs saying that the two aims are mutually contradictory.

As it happens, the Government support already provided to the main UK banks means they are managing to lend more to the domestic economy. Despite its record-breaking losses, Royal Bank of Scotland yesterday disclosed it had increased its UK small business and mortgage lending by 10 per cent last year.

The saving on interest costs once the Government converts its preference capital into ordinary shares means there will be a further, additional £6bn of lending by RBS this year. Regrettably, these increases are not enough to make up for the myriad of foreign banks which have folded their tents in the past year, quit the UK market and gone home. What Gordon Brown referred to yesterday as "deglobalisation" of credit has left a huge hole in the heart of UK lending which for the time being must be filled by the only institution still in a position to borrow at will – the UK Government.

Many in the City believe the Government, which they suspect is still driven at heart by latent socialist ideology, welcomes the opportunity presented by the present crisis to nationalise so that the state can be put back in control of the commanding heights of the economy. I cannot pretend to have a window in on the PM's innermost thoughts, but I doubt that this reversion to Old Labour thinking is really what Mr Brown has in mind. Nationalisation, certainly of RBS and possibly of others too, may nonetheless end up as part of the solution, but for rather different reasons. Let me explain.

Yesterday's package divides up into a number of distinct policy initiatives. First, there is to be an "asset purchase facility" which will allow the Bank of England to buy up a further £50bn of "high-quality assets" from banks in exchange for tradable Treasury bills. This ought to have the effect of freeing up capital for other lending. To begin with, the facility will be fully funded, in the sense that the bills will count as part of the Government's borrowing requirements, but ultimately the Bank of England may be given discretion to expand its balance sheet for monetary policy purposes – so-called quantitative easing, or the printing of money as it is sometimes referred to. In any case, the quantity of available credit is supposedly expanded. So far, so good.

Separately, the Government proposes a scheme to guarantee new asset-backed securities in mortgage, corporate and consumer debt along the lines suggested last year by Sir James Crosby, the former HBOS chief.

In addition, the Bank of England is to start offering one-year money at its discount window, the Financial Services Authority will look at ways of easing the capital requirements on banks, which ought to release further lending capacity, and the already nationalised Northern Rock is to ease up on its programme of mortgage redemptions, which will again free up lending capacity elsewhere in the banking system.

Yet it is the "asset protection scheme", which for a fee and a commitment to lend offers insurance on toxic assets, that potentially provides the most helpful way forward. This is similar to the "bad bank" idea, under which the Government would buy the toxic assets from the banks, only apparently better, in that the taxpayer is not obliged to fork out up front.

As I say, all this is very welcome and may even work. But it is still not enough. Most really serious banking crises ultimately end up in nationalisation of one or more of the major banks and a more overt version of the good bank/bad bank idea. The Government's aversion to the bad bank concept is understandable enough. In the US, the authorities have run into apparently intractable problems with the "Troubled Asset Relief Programme" (Tarp), not least the difficulty in deciding which assets to buy and at what prices.

Yet the UK Government-favoured insurance scheme is likely to encounter very similar difficulties in establishing which assets to underwrite at what prices. In any case, it may struggle to provide the clarity which the markets demand. The piecemeal policy approach pursued thus far is in danger of sinking under its own complexity. It has become Hydra, a many-headed monster of confusion.

Nationalisation provides a possibly cleaner and simpler solution. I never thought I would argue this, for there are obvious dangers in putting politicians in control of credit allocation. The banks have made some terrible errors of strategy and risk assessment, but the UK economy would surely be in even worse shape if all bank lending was driven by public policy. Already, more than 40 per cent of the UK economy is public sector. That's quite large enough when all the evidence is that the mixed approach to economic enhancement is the more successful. The system would also become wide open to pet projects, hidden subsidy and pork-barrel politics. That's obviously not the way forward. What's more, it might reasonably be argued that RBS is as good as already nationalised, with nearly 70 per cent of the bank state-owned after conversion of the prefs. What's the point of going the whole hog? It is this. Once fully in the public sector, RBS can properly begin the process of restructuring which will allow the "good bank" to be separated from the legacy "bad bank".

The object of the Government's manoeuvring is to recreate a decent flow of credit to the UK economy. Weighed down by past bad debt and the fear of yet more of it to come, the last thing on bankers' minds right now is providing new credit. To the contrary, all they want to do is shrink back to a position where they can self-confidently say they are solvent once more. If these legacy assets are taken away from them and put into some kind of long-term workout fund, then the new bank that emerges will be cleansed and free to lend afresh.

New Labour is understandably still terrified of revisiting Britain's bankrupt history of nationalisation. It didn't work for Labour in the past. Squillions were wasted in a doomed attempt to save dying industries and jobs. Worse, well over half of RBS's balance sheet consists of overseas lending. It's hard to justify taking assets irrelevant to the UK economy on to the Government's books. And if the Government starts nationalising the big banks, where to stop? Why shouldn't Woolies and others be similarly rescued?

Yet provided the purpose of nationalisation isn't that of state control, but rather of restructuring so as to allow a better, more tightly restricted, bank to emerge phoenix-like from the ashes which is able to borrow and lend again freely and could be quickly reprivatised, then that seems to me a reasonable solution to the problem. Yesterday's package is fine as far as it goes, but it is still a sticking-plaster solution. What's needed is a full-scale amputation of the bad limbs. Only then will the market confidence necessary for renewed lending be restored.

The Government is still frightened of the political consequences of nationalisation, even though the idea is now privately supported by a number of leading City figures. Mr Brown has already claimed to have saved the banks (or was that the world?) once. Nationalisation would be tantamount to admitting that in fact he hadn't. Yet he's also got nothing to lose. Being seen to take decisive action is the only thing standing between Mr Brown and political oblivion.