The Bank of England’s Governor yesterday set his face firmly against taking action to bail out banks struggling with mounting strains on lending conditions triggered by the worldwide credit crunch.

In a staunch defence of the Bank’s handling of the credit squeeze, Mervyn King insisted that the crisis was rooted in a careless mispricing of risks by institutions.

To ride to banks’ rescue now would encourage them to repeat this behaviour in the belief that it was cost-free, the Bank argued. It would also prolong markets’ reassessments of risks and add to the danger of even bigger crises in future.

“If risk continues to be underpriced, the next period of turmoil will be on an even bigger scale,” Mr King told MPs in a submission to the Commons Treasury Committee.

The Governor did make clear that the Bank was ready to take far stronger, emergency action, both to cut interest rates and to flood financial markets with capital, if this proved necessary to avoid grave economic damage.

Mr King emphasised, however, that the Bank would set a high hurdle for such measures. He repeatedly put the onus on the banks themselves to cope with the credit crunch, arguing that they were more than strong enough.

“The current turmoil . . . has disturbed the usual serenity of recent years, but, managed properly, it should not threaten our long-run economic stability,” he said.

Holding out the prospect of rate cuts if the crisis escalates, Mr King conceded that the higher market interest rates caused by banks hoarding cash meant that “effective borrowing rates faced by households and companies will rise . . .” But in a signal that the Bank will be wary of rushing into any moves, he added: “It is too soon to tell how persistent and how large any change in credit conditions will prove to be.”

Mr King reinforced his hardline stance in the face of City demands for the Bank to pump extra billions into money markets, both by accepting more risky securities than usual as collateral for its loans, and by lending over longer than usual periods – actions taken by the US Federal Reserve and European Central Bank (ECB).

“The provision of such liquidity support undermines the efficient pricing of risk by providing ex-post insurance for risky behaviour,” he insisted. He emphasised the danger of so-called “moral hazard”, where institutions act irresponsibly because they believe they will be bailed out. “That encourages excessive risk-taking and sows the seeds of a future financial crisis,” he said. Central banks “could not sensibly entertain” such actions, which would also be unfair on institutions that had acted responsibly.

Mr King urged that the credit squeeze be kept in perspective and banks’ ability to cope be recognised. He noted that, unlike more risky assets, interest rates on high-grade corporate bonds were unchanged, while companies could issue long-term debt.

While banks were being forced to inject funds into some investment vehicles, “as a whole [they] are well capitalised and should be able to do this . . .”

While a process of adjustment for institutions “may not be smooth”, Mr King said that it was “likely to be temporary”. His cool assessment was backed by Simon Johnson, chief economist of the International Monetary Fund, “We don’t see any reason to think that this is any more than a mild slowdown in the US,” Mr Johnson said.

As the ECB injected another €75 billion (£51.3 billion) of funds into euro-zone markets, Mario Draghi, Italy’s central bank governor, also played down the situation. “You cannot call it a crisis, but turbulence,” he said.

Despite Mr King’s tough stance, Angela Knight, chief executive of the British Bankers’ Association, told The Times that at talks with Bank of England officials today she would be calling for it to take a more active “enabling role”. She pointed to the way that the New York Federal Reserve orchestrated a private sector rescue of Long Term Capital Management in 1998 as an example of the sort of guiding hand that could help. “This is quite a serious issue,” she said. “Is there a way the system can be unblocked? I’m going to convey to the Bank some of the views expressed by our members.”

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