Leading article: Toxic debts and the need for more liquidity

Today's breakfast meeting between Gordon Brown and executives from the financial sector will not be the first such get-together since Mr Brown became Prime Minister; but it will certainly be the most sombre. The global credit crunch shows no signs of abating and the threat of recession seems to grow larger by the week.

We are told the focus of this meeting will not be the cost of mortgages. But that was certainly the topic uppermost in the mind of the Prime Minister and the Chancellor, Alistair Darling, at the weekend. And it would be remarkable if mortgage rates are not discussed today given that the higher cost of servicing a home loan is how most British people are experiencing the effects of the credit squeeze.

The Government's complaint is that three interest rate cuts by the Bank of England since last December have not been passed on in full by lenders. Ministers fear that thousands of homeowners due to come off fixed-rate mortgage deals, arranged two years ago when credit was cheap, are going to be pole-axed by today's higher rates.

We need a little perspective here. Credit was too cheap, for too long in Britain. It is actually welcome that the banks are now insisting on proper deposits and tightening their lending criteria. The housing boom needed to end. Yet there is still a danger that a rapid drop in house prices could destroy consumer confidence and plunge us into a recession. British retailers are already issuing profit warnings. A housing collapse could send our economy over the brink.

What we need is a soft landing. To this extent, Mr Brown and Mr Darling are justified in demanding that the banks try harder to pass on the rate cuts, rather than using the liquidity to shore up their ravaged balance sheets. Yet the Government's critics in the City are correct that this pressure to pass on interest rates rather misses the point. The core reason banks are unwilling to lend to each other is that, despite billions in bad loan write-downs over the past six months, there is still considerable uncertainty over which institutions are holding the most toxic mortgage debt. The failure to pass on rate cuts is a symptom of this fear in financial markets. Banks are hoarding cash, rather than lending it, because they are terrified they will either not get it back, or will need it themselves in the near future.

After last week's rate cut, the inter-bank lending rate actually increased. That shows just how little effect the Bank of England can have on this crisis through the traditional lever of monetary policy. It is increasingly clear that cutting interest rates alone cannot break this deadlock. Retail banks are pushing for the Bank of England to lend them funds for longer and accept, in return, a claim on some of their more questionable mortgage assets. Another solution to the liquidity crisis that has been floated is a Government "Kitemark" scheme for debt instruments to inject some confidence into the mortgage-backed securities market.

It may be that, in the end, such a course of action will be the only way out of this mess. But there will need to be a quid pro quo for such unprecedented assistance from the state for the financial sector. There will need to be regulatory compulsion on the banks to come clean over just how exposed they are to the toxic debt in the global financial system.

There can be no more hoarding of cash and hoping that the situation will improve. If public money is to be put into action to rescue the banks and avert a looming economic disaster, it needs to be made clear to the financial sector that the days of irresponsible lending are over and must never return.