The Northern Rock bail-out was formally a joint decision of the UK Treasury, the Financial Services Authority and the Bank of England. However, their Memorandum of Understanding (MOU) states that “ultimate responsibility for authorisation of support operations in exceptional circumstances rests with the chancellor [of the exchequer]”. This makes sense: the taxpayer is on the hook when public resources are put at risk. Unfortunately, it is the Bank’s reputation that is damaged. It had to provide credit after the governor took a strong public stand against bail-outs.

Following rapid expansion financed by high-risk funding, Northern Rock depended on the government to survive. Three-quarters of its funds came from the wholesale markets instead of depositors. When global financial turmoil hit, Northern Rock could no longer refinance its maturing obligations. It had engaged in reckless borrowing; it gambled and lost. Now it must find itself a buyer with deeper pockets. That the government bailed it out is hard to understand. The MOU states that a bail-out should only be undertaken if there is, “a genuine threat to the stability of the financial system”. The demise of the fifth-largest UK mortgage lender would hardly be a systemically significant event.

The Bank’s primary role is to ensure price stability. For this, it needs credibility. The Northern Rock debacle damages this credibility. Restructuring Lender of Last Resort responsibilities is necessary. The Bank should support key financial markets and institutions such as the payments and clearing and settlement systems. Bailing out individual banks should be left to the FSA, which has the expertise, and the Treasury, which has the power to tax. Ending the active role of the Bank as a lender of last resort would require only that the FSA have a credit line with the Bank, guaranteed by the Treasury, and a change in the MOU.

The Bank is not blameless in the Northern Rock debacle, however. A bail-out might not have been needed if the Bank had a more sensible collateral policy for its open-market operations and discount-window borrowing. The ECB accepts private securities rated at least A-; the Bank should too. If Northern Rock had a eurozone subsidiary, it could have borrowed from the ECB, using its high-grade mortgages as collateral.

The Bank should also intervene in the three-month, as well as the overnight, money market. Its own money market Objective 1 says: “Overnight market interest rates to be in line with the official Bank Rate, so that there is a flat money market yield curve . . . out to the next MPC decision date”. In early September, a month before the next MPC meeting, the one-month (unsecured) interbank rate should have been close to the policy rate of 5.75 per cent; instead, it was 6.68 per cent: just below three-month Libor. As the policy rate is unlikely to rise, this spread must be some combination of a pure term premium, a counterparty risk premium and a liquidity risk premium. We believe it reflects primarily liquidity risk.

Currently liquid banks are reluctant to make interbank term loans today, even at nearly 7 per cent, because they fear they and their borrowers may be illiquid three months from now. The Bank should inject liquidity with a three-month maturity to reduce the liquidity premium and kick-start lending. Accepting a wider range of eligible collateral – punitively priced – would enhance the effectiveness of this.

We know that the chancellor authorised the Bank to support Northern Rock. But is the support uncapped and open-ended, as Northern Rock informs us? What is the premium? Exactly what collateral will be offered and how will it be priced? Taxpayers’ money is at risk. The chancellor should make public this information and if he does not, parliament should insist.

The Bank’s credibility is being sacrificed for a bail-out of a systemically insignificant mortgage lender that looks at least partially politically motivated. The chancellor wants to protect depositors and does not want a bank failure on his watch. Depositor protection, however, is the job of the FSA and the Financial Services Compensation Scheme. Redistribution of income is the Treasury’s province. If the Bank is part of the inevitably political bail-out of individual banks, its independence in the realm of monetary policy could be compromised.

Willem Buiter is professor of European political economy at the London School of Economics European Institute; Anne Sibert is professor of economics at Birkbeck College, University of London