Little more than 18 months ago, American International Group estimated that it had $20 billion more capital than it needed and declared that it was throwing off so much cash that it planned to increase its dividends by 20 per cent a year – indefinitely.

Now it is virtually bust. The reckless actions of a few executives in its financial insurance unit have brought the world’s biggest insurer to its knees.

Some fear that its failure would bring the financial system to its knees, too. The size and complexity of its role in capital markets insurance make it very hard to estimate the precise impact of its possible collapse, but it could be very serious indeed. Ken Lewis, the chief executive of Bank of America who agreed to buy Merrill Lynch at the weekend, said that it would be much more serious than the collapse of Lehman Brothers. And regulators on both sides of the Atlantic agree.

Part of the problem is that while there have been many questions about AIG in recent years, its fundamental financial strength was not in doubt. Lehman and other Wall Street investment banks were always seen as much more risky.

That means that the institutions that invested in AIG or used its insurance are less well prepared for its possible failure and the impact would be that much more damaging. Lehman’s biggest unsecured creditors are well-capitalised Asian banks with relatively small holdings of its bonds. AIG’s $169 billion of bonds were core holdings for US public sector pension funds, which treated them as almost as safe as US Government debt. If AIG went under, it would leave a nasty hole in those funds.

If AIG collapsed, the impact on those institutions that had taken out financial insurance with it could be even worse.

As the implications sank in yesterday, European markets went into a funk. Financial stocks tumbled and money markets were in seizure. The overnight dollar borrowing rate spiked to more than 10 per cent at one stage, reflecting a frantic search for liquidity. Investors fled from usually rock-solid investments into the safety of government debt.

By the time that New York opened, the markets had become convinced that AIG had to be saved. Attempts by the US Federal Reserve to pull together an emergency loan facility seemed to be struggling.

So it was widely assumed that, despite all earlier signals, the Fed would cut interest rates to calm the markets. When it failed to do so, stocks sank – but within an hour the rollercoaster lurched up again, amid hope that the authorities would come up with some sort of bailout for AIG, possibly the conservatorship used to nationalise Fannie Mae and Freddie Mac.

At home, yesterday’s biggest casualty was HBOS, where short-sellers dragged the price down by 40 per cent at one stage, before it made a partial recovery. It is still down by 35 per cent in two days.

According to the head of one of Britain’s biggest financial institutions, the markets were filled with the “stench of fear” yesterday, while a top regulator predicted that the next few days would be “turbulent”.

If the US authorities do bail out AIG there is likely to be a sharp relief rally. But, as with the rally that followed the rescue of Fannie and Freddie, it may last no longer than the next shock.

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