The recent drying-up of credit, reflecting the wholly dysfunctional banking sector, has had major implications for hard-pressed businesses and households, at a time when the economy is probably already tipping into recession. Before the rate cut, mortgage rates were rising again and the eligibility criteria were being tightened.

Recent Bank of England data suggested that mortgage approvals all but collapsed in August. Loan rates for businesses, too, were rising – at a time when many were facing falling orders and falling sales. And the Bank of England's recent credit conditions survey made grim reading all round. Credit availability had deteriorated and was expected to deteriorate further. For households and businesses facing recession,
this was exactly the wrong development and it clearly needed to be reversed. And it needed to be addressed with urgency.

The banking sector, love or
hate it, is a vital part of the economy and, uniquely, has the ability to wreck the rest of the economy. We are living in desperate times and there has been a critical need for radical, prompt measures. Desperate times call for desperate measures. The Government has, after some nerve-racking dithering, responded.

Before this week's monumental response, the Treasury, along with the Bank of England, had combated the worst aspects of the financial crisis by a series of piece-meal actions. They focused on nationalising failed banks, injecting liquidity of increasing magnitudes into the credit markets and raising the level of state guaranteed deposits from £35,000 to £50,000.

But the large infusions of funds clearly failed to stabilise the banking system and kick-start the credit markets back into life. Concomitantly, it was becoming increasingly clear that the current liquidity crisis had a more fundamental cause than mere shortages of liquidity and funding. And that was the lending institutions' fear of insolvency of their counter-parties

Re-capitalisation of the banking system had, therefore, become a priority. But, given the parlous state of the stock market, in general, and the bank shares, in particular, there were few private sector takers. The only institution that could provide the capital was, effectively, the Government. The Treasury's rescue plan has, rightly, grasped this issue square on as the central part of its strategy.

The Treasury will make available at least £50bn of new capital in order to re-capitalise banks which have a substantial business in the UK and building societies. Such injections of capital are expected to be in the form of preference shares or Permanent Interest Bearing Shares (PIBS). £50bn is a very substantial sum and should be sufficient to keep the banking system functioning in these challenging times. £25bn is to be made available to the eight major banks that have confirmed their participation in this Government-supported re-capitalisation scheme, though they are under no pressure to take the capital, and at least another £25bn is to be made available for other eligible financial institutions.

The eight major banks are the Abbey, Barclays, HBOS, HSBC Bank plc, Lloyds TSB, Nationwide Building Society, Royal Bank of Scotland and Standard Chartered.

There is now every hope that these newly capitalised banks will be regarded by their "colleagues" in the money markets to be sound and solvent. Banks will then start lending to each other and unfreeze the credit markets for the benefit of all.

There are two other, helpful, parts to the rescue plan.
Firstly, the Bank of England will take all actions necessary to ensure the banking system has access to sufficient liquidity. This includes at least £200bn being made available under the Special Liquidity Scheme (which allows banks to swap their mortgage-backed securities and other illiquid assets for Treasury bills). And, secondly, the Government will guarantee bank loans at commercial rates to encourage banks to lend to each other. The Treasury expects the take-up of the guarantee to be of the order of £250bn.

The taxpayer is, of course, funding the rescue plan, but it is quite possible that the Government's losses will be modest.

After all, the Government will effectively be buying shares of these battered banks at knock-down prices. As the banking sector recovers, so should the share prices and the value of the Government's stake.

But, more to the point, the alternative to this rescue plan was the continuation of a dysfunctional banking system with all the problems
for hard-pressed households and businesses, as already discussed.

Inevitably, the recession would have been more painful and more people would have lost their houses and jobs. Far better, I suggest, for the Government to pursue this rescue plan.

The Government's plan, by providing much-needed capital as well as unlimited liquidity, should underpin confidence in the solvency of the banks. It is a very big, and comprehensive, step towards the normalisation of the banking system and the unfreezing of the credit markets.

Ruth Lea is economic adviser to the Arbuthnot Banking Group, and was head of the policy unit at the Institute of Directors between 1995 and 2003.