Alistair Darling's footling initiatives yesterday were a sideshow. There is one overwhelming challenge facing the business world and it is not going to be addressed by £10 million more for science teachers or £12 million for women entrepreneurs.

Western capitalism is, bluntly, being haunted by the spectre of a catastrophic domino-like collapse of financial institutions, one that if not prevented would without question lead to an economic ice age.

Mr Darling did at least acknowledge that a number of credit markets were “barely functioning” but then moved on to more trifling matters. Outside Westminster, however, fears remain that a major financial institution is close to collapse, or that policymakers at least believe it could be. Nothing else explains Tuesday's co-ordinated campaign by central banks and their increasingly desperate measures to pump more liquidity into a system showing fresh signs of paralysis. As one senior City figure put it yesterday: “There's the smell of death all right but no one can locate the corpse.”

En masse, the world is de-leveraging. On an individual level, moves by banks to call in debt and tighten loan conditions make perfect sense. Collectively, they could be devastating. Asset fire sales lead to falling prices which lead to shrinking collateral values and the need for more fire sales. It would not take all that much to tip the credit markets from the current state of paralysis (bad) to panic (much worse).

The toolkit of policymakers is looking depleted. They have tried liquidity injections; they have tried loosening their collateral terms; they have tried interest rate cuts. The next step in the US could be the outright purchase of mortgage books. That comes close to nationalisation.

Regulators are faced with scary choices. One false step could precipitate an unthinkable chain reaction of banking failures. Systemic failure is an outcome that must be anticipated and prevented at any cost. The temptation is therefore to turn on the hosepipe and so raise all boats on a tidal wave of liquidity on the grounds that even the smallest collapse could lead to bigger and more serious casualties.

Banks can be allowed to fail without the roof caving in. We have learnt that from Barings and from BCCI. But their demises were in the financial Stone Age - when contagion moved at a slower pace and banking relationships were more transparent and simpler. These days, a fiendishly complex cat's cradle of opaque derivative contracts links each bank to every other bank. The challenge to central banks as they survey this perilous landscape is to decide which banks cannot be allow- ed to fail under any circumstances - and which can and should.

patrick.hosking@thetimes.co.uk

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