This financial crisis is a challenge for our political system. Political parties and the independent financial authorities must show the character and judgment necessary to make the right decisions under pressure. Our response will have profound implications for the future prosperity of the country. It was not the stock market crash of 1929 that caused the great depression of the 1930s, but the banking crisis and the failure of the policy response that followed it. Last week’s US congressional wrangling and evidence that bank lending in the UK has all but ground to a halt means that a concerted policy response is vital to avoid serious economic consequences.

That is why I said last week that we are ready to put aside party differences to help bring stability and reassurance. There may need to be a marshalling of public support behind some big decisions and we cannot allow the bitter partisanship that we saw in America to happen here. This does not mean signing a blank cheque and we will not suspend our critical faculties. But the shadow chancellor George Osborne and his team have already met the chancellor and senior Treasury officials to discuss how we can smooth the passage of the banking bill to be introduced this week. This will include the Bank of England-led special resolution regime for dealing with failing banks that we have been calling for since last year. I am glad to see that our advice on deposit protection has been followed with the announcement that the guarantee limit will be raised to £50,000. That needs to be kept under review as it may need to rise further.

To deal with the crisis we need action in three areas – liquidity, asset quality and bank capitalisation. Liquidity is the immediate priority, particularly in the wholesale money markets. Dramatic increases in spreads and banks’ increasing reliance on overnight funding have created a fragile environment. As one leading banker put it to me, a hair trigger has been created. Let us hope that Tuesday’s intervention by the Bank of England to broaden the range of collateral with which banks can access the Special Liquidity Scheme will un-cock the gun.

The impact of the Irish guarantee on bank deposits has emphasised the need for international co-ordination to prevent unintended consequences of unilateral action to preserve liquidity.

Once liquidity is restored we need temporary action to tackle the failure of illiquid markets to value asset quality. In the current crisis mark-to-market accounting is exacerbating a self-fulfilling cycle of falling asset values and restricted lending. Regulators should work with their European counterparts to address this difficult issue.

If liquidity and degraded asset quality are the short-term challenges, the ultimate cause of the crisis is excessive debt and a poorly capitalised banking system. The current ad hoc approach is running out of road. We need to rebuild strong banks that can play their proper role of supplying credit to companies and individuals.

In the longer term we have proposed a new Debt Responsibility Mechanism, whereby the Bank of England would monitor market-wide risks from excessive lending. The Bank would be able, through an open letter system, to instruct the Financial Services Authority to take account of these risks by ensuring that banks put aside more capital during debt-fuelled booms. If these arrangements had been in place over the past decade we would be less vulnerable to the current crisis.

The least that we need right now is orderly private sector recapitalisation. Sensible banks are already reducing dividends and raising capital. Regulators must ensure that shareholders and creditors play their part. Even that may not be enough and more drastic capital measures may be required. It is possible to imagine the circumstances in which government injections of capital, with proper safeguards and strict conditions, may be the best way to protect the long-term interests of the taxpayer.

I will discuss the crisis on Monday with Carl Bildt, the Swedish prime minister who 15 years ago showed how a centre-right government can intervene decisively in a financial crisis while protecting the taxpayer. Conservatives support government action when the foundations of the banking system upon which free markets depend are threatened. We will approach any proposals in a constructive and pragmatic way. Our guiding principle should be to protect the taxpayer where possible and preserve the stability of the system where necessary.

The writer is the leader of the British Conservative party

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