The stock market was in denial about the crisis in the financial system, City pessimists were saying last week. Not any more. After the brief rally sparked by the US bank bailout plan, share prices came down to earth with a sickening thump yesterday.

At the end of last week, British banks were saying that the combination of the bailout and the more aggressive provision of liquidity by the Bank of England should ease the problem in time. But time is running out.

With banks collapsing all over Europe and governments running around in all directions, the money markets remain frozen despite the efforts of central banks.

The collapse in share prices will in itself further dent confidence. It will also make it more difficult for financial institutions to raise capital. And there is widespread agreement that ensuring that banks are better capitalised should now be a key part of the authorities' response.

It is no longer sufficient for Mervyn King, the Bank of England Governor, to say that banks are still undercapitalised. The Bank and the Government need to do something about it.

All the signs are that they are serious about injecting government money into the banks. The banks are indignant. They say that they are well-capitalised and meet all the regulatory requirements. They don't want or need government money.

That may well be true. It may be true that each bank individually does not need more capital. It may be that we are going through a crisis of liquidity, not solvency. But there is no doubt that the financial system as a whole would benefit if the banks had more capital.

The reason most banks are finding it difficult to borrow at reasonable rates for any reasonable length of time - other than from the Bank of England - is that lenders are nervous. They are nervous that they might not get the money back.

If those banks had more capital, lenders would be more confident. Lenders would be more confident, even if the banks had the same capital but had a guaranteed access to more capital if they needed it.

This is where a government capital scheme could come into play. Merely setting up a facility from which banks could draw capital could bring real benefits.

The big snag is getting over the problem of stigma. The first bank to take advantage of the scheme would immediately be labelled desperate, which would act as a severe deterrent.

This is why some observers believe that the scheme would have to be compulsory. But this would penalise banks that really do not need more capital, such as HSBC. A voluntary scheme would be infinitely preferable.

Among the many plans being floated, Hugh Osmond, the financial entrepreneur, proposes that the Government offers to buy preference shares in banks paying a high and rising rate of interest. These would come with free warrants that convert into shares, depending on how much preference stock the bank sold and how long it took to redeem it.

This looks just the sort of plan that would be worth trying. If the voluntary approach fails, it would always be possible to force banks to hold more capital by increasing the regulatory requirements, allowing them to raise the money from the government scheme or from private sources if the price was better.

Such a scheme could help to stop the rot in the banking system. It would be much easier to implement and would have a more immediate impact on confidence than a US-style toxic asset dump. But we might as well try that, as well.

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