Rushing to the aid of troubled American financial institutions represents the same moral hazard for the US Federal Reserve as the Bank of England faced in its botched rescue of Northern Rock.

The prospect of a collapsed Bear Stearns or Citigroup is too horrible to contemplate and most people agree that, despite persistent rumours that a bank was going under, the Fed will do all it can to keep America's troubled financial institutions afloat.

If only one institution were allowed to go bust, it would lead to a firesale of assets that would create a serious domino effect for the others. If one collapsed, a second would follow quickly, pushing down asset prices farther and creating a panic that would set off a vicious chain reaction.

“The central banks would never let a Bear Stearns or a Citigroup go bust,” one banker said last night. “They would get together and say: 'We're going to help you.' The knock-on impact of not doing so would be too severe.”

Northern Rock's near-collapse saw an already tight interbank lending market freeze almost entirely, and the same would occur if the market got whiff of a near-failure once again. The Fed has a history of bank bailouts. Continental Illinois was once the seventh-largest deposit bank in America, but in May 1984 it became insolvent because of bad oilfield loans that it bought from another bank. In the month before the bank went bust, a run saw depositors strip $10 billion from the coffers of Continental Illinois. The Fed and the Federal Deposit Insurance Corporation, a body set up in 1933 to protect bank deposits, were worried that if Continental Illinois collapsed, there would be widespread instability in the financial sector, so they pumped $4.5 billion into the bank and removed the bank's executives.

Continental Illinois shareholders lost their stake but bondholders were protected. The bank ran for ten years with 80 per cent of its shares owned by the US Government, until it was bought in 1994 by the Bank of America.

Explore Economics

• Autumn Budget 2007

• Budget 2008

• World Economic Forum

• The Times MPC

Times Recommends

• BA chief waives bonus after T5 fiasco
• Prospects of cheaper loans hit as Libor soars
• Rice price dives as US and Japan set to unlock grain pact