Who would have thought that the bank most hurt by the credit crunch would turn out to be the Bank of England? The Old Lady of Threadneedle Street peered through her pince-nez at the US sub-prime mortgage debacle six weeks ago, and shuddered in distaste at the US Federal Reserve’s decision to tide over banks that found themselves temporarily unable to borrow. How vulgar, she said. Britain will never advance cheap money to greedy fools. Let them get themselves out of the mess they’ve made.

In her high-mindedness, she forgot one thing: that silly decisions by banks, if they undermine confidence, damage the whole economy. Her own silly decision to turn up her nose at the Fed’s strategy has done more to destroy confidence than all the overpaid idiots who played pass-the-parcel with packages of dodgy debt.

The Governor of the Bank of England may think that his passable performance at yesterday’s Treasury Select Committee means that the storm is over. In fact, it is just beginning. Financial services fuel about a fifth of the UK economy. Their most precious commodity is confidence. And confidence is crumbling. History tells us that an unstable financial system wreaks havoc with the economy, hurting ordinary people as much as financiers.

America had its own Northern Rock: it was called Countrywide. It is America’s biggest home loan lender, and its exposure to sub-prime mortgages sent its share price plummeting this summer. But the Fed quickly stepped in. It pumped billions into the money markets to encourage banks to keep lending to each other. It prompted Bank of America to take a stake in Countrywide. Show over. No Weimar Republic-style queues. No panic.

Mervyn King, the Governor of the Bank of England, claimed yesterday that Northern Rock was so “highly illiquid” that no one would lend to it, and so the Bank was forced to act as lender of last resort. That is disingenuous. Northern Rock was illiquid because of the Bank of England’s own refusal to accept mortgages as collateral for a loan. In Europe and America, distressed bankers have been flocking to the pawn shops which have been effectively set up by the Fed and the European Central Bank in August. They have been able to pawn pretty much any asset – even the mortgage-backed securities that caused all the fuss – to get cash.

The Bank of England set up a pawn shop too. But until this week it was far too precious to accept anything but the most pristine assets, the ones no one needed to borrow against, and rarely for more than 24 hours at a time. If the Bank of England had offered the kind of three-month loans it has now finally decided to offer, Northern Rock would probably never have needed a lender of last resort at all. The Bank’s U-turn is welcome, but it leaves it looking ridiculous.

Mr King is arguing that legislation had hobbled him. He is absolutely right that Britain’s weak deposit insurance made savers more nervous. But he also said that an EU directive had prevented the Bank from swiftly transferring ownership of the Rock to a hard place. But how could he imagine that news of a potential Lloyds TSB takeover could ever possibly have panicked the public in the way that the bailout did?

There has been a catalogue of institutional failure. The Bank of England’s job is to provide funds to ensure that the economy and the financial system run smoothly. The Financial Services Authority is supposed to supervise companies. Yet despite Northern Rock growing three times faster than its competitors last year by running risks that others would not, the FSA does not seem to have had the wit to ask it what it would do if credit dried up.

Sir John Gieve, Deputy Governor of the Bank of England and a member of the FSA board, said irritably yesterday that “Northern Rock is responsible for its business model”. So what do we pay the regulator for? Sir John admitted that he had not read the Rock’s interim financial statement on July 25. He and his colleagues have been cautioning about the market dangers for months. But they had not translated this into active concern for the company most vulnerable to a credit crunch – even though that company was frequently being mentioned in the City and the press.

“Who was in charge?” asked Michael Fallon, MP, at one point yesterday. There was a stunned silence from the three men on the panel. Then: “What do you mean by in charge?” asked Mr King. Cue stunned silence from the audience.

It has never looked like a better time to revisit Gordon Brown’s decision of 1997, to separate responsibility for banking supervision from the management of inflation. It is easy to forget now that Sir Edward George, Mr King’s predecessor, almost resigned over it. Maybe he realised that the Bank would lose its understanding of financial services and would come to see the grubby business of moneymaking as somehow beneath it. That was very much the impression given, ever so politely, by the highly educated men on yesterday’s panel.

Northern Rock has not hit the rocks. But it is hard to overstate the damage that its queues have done. Those pictures have told every consumer that the live-now-pay-later party is over. Yes, the air did need to come out of the credit balloon. But if it comes out too fast, with the US economy weakening, then we are heading for recession. There are more bad loans yet to be exposed. And British banks are still hoarding cash more than anywhere in the world, because they trust neither other lenders nor their own central bank.

Our noble institutions put two and two together and made zero. Mr King is an enormously likeable man of great integrity but he has to go. His successor needs to be more market-savvy.

Times Recommends

• Fragility always gets my sympathy vote
• Double it and you get the real jobless total
• Has al-Megrahi paid his council tax?