THE Governor of the Bank of England and the Chancellor of the Exchequer last night announced measures designed to prevent a new credit crunch that would push Britain's economy deeper into recession.
The move was a clear sign that the Governor and the Treasury are alarmed by the prospects for the economy in the face of potential financial shocks from the eurozone.
Speaking at the annual Mansion House dinner in the City of London, the Governor, Sir Mervyn King, and George Osborne said the Bank and the Treasury were working on a liquidity operation - a "funding for lending" scheme - which would provide private banks with cheap funding in exchange for a commitment from lenders to provide cheap loans to ordinary businesses and households.
Sir Mervyn said he expected the scheme to be up and running "within a few weeks".
Last night, the Treasury said it hoped the measures would increase annual lending flows to the economy by about 5 per cent, or AU$124.27 billion.
The scheme would permit private British banks to pledge their existing, illiquid loans as collateral at the Bank of England in exchange for highly liquid UK government bonds, which they could then sell on. In return for this cheap financing, banks would be required to commit to using the proceeds to increase the volume of loans to businesses and households, and to make that lending cheaper than it otherwise would have been.
Sir Mervyn said the eurozone crisis had created a 'black cloud' over the financial sector and instilled 'extreme uncertainty', which was pushing up banks' funding costs and crushing lending to the real economy.
The operation would be similar to the AU$310.67 billion Special Liquidity Scheme, established in April 2008 during the financial crisis, in which the Bank of England (BofE) allowed lenders to swap mortgage-backed securities for UK sovereign bonds in order to ease the flow of lending to households.
The SLS was wound down this year, but the International Monetary Fund advised the BofE last month to re-establish something similar in order to boost the economy.
Sir Mervyn and Mr Osborne said another scheme intended to ease funding pressures on banks - the Extended Collateral Term Repo Facility - would activate shortly.
Sir Mervyn said the BofE would start auctioning six-month sterling loans to help UK banks to weather any shocks emanating from Europe.
The Chancellor said the new measures showed the Government and the BofE were not standing idly by waiting for the eurozone crisis to hit Britain.
"We are not powerless in the face of the eurozone debt storm," he told financiers and dignitaries at the Mansion House.
"Together we can deploy new firepower to defend our economy from the crisis on our doorstep. We are rolling up our sleeves and doing everything possible to protect British families and firms."
Mr Osborne confirmed that the new Financial Policy Committee - the 'super-regulator' based at the BofE - would be given a mandate to support growth as well as ensuring financial stability.
Some City figures have complained that new capital requirements being imposed on banks by the Government and regulators are choking off lending to the real economy.
The Chancellor said he supported a eurozone banking union as a means of calming financial markets over the future of the single currency, but reiterated his pledge that Britain would not allow the UK to be bound by it.