As the tide goes out in financial markets we can see, as Warren Buffett predicted we would, who has been swimming without their trunks. It's not a pretty sight.

“Not all investors fully understood the complex financial products they were buying,” the chairman of Deutsche Bank told the Treasury Select Committee on Tuesday. Too right they didn't: they went greedily along with the party mood and the delusional rating agencies. “I don't believe we were reckless,” asserted the European CEO of Citigroup. Well he may cling to that belief, but most of us are grown up enough to know that playing pass-the-parcel with dodgy debt was utterly childish.

Since the music stopped in August, the self-pity in the City has been almost as exasperating as the arrogance that preceded it. Baleful bankers cast a pall over social events. The special pleading is deafening.

Yet Schadenfreude aside, the big question now is to what extent their pain will become our pain. The answer looks increasingly bleak. The economic slowdown that we are now seeing is largely the result of the financial crisis of the past four months. Yesterday's decision by the Bank of England to cut interest rates by a quarter point reflects the growing concern about the worsening outlook. The trouble is that while the cut will provide welcome relief to borrowers, it will have little impact on the crisis of confidence in the City, which is partly of the Bank's own making.

On Monday the interbank lending rate hit a nine-year high. With the wholesale credit markets in paralysis, it is no longer clear whether the financial system will be able to provide enough investment to maintain economic expansion. Commercial property funds have pretty much collapsed in recent weeks. The harder it becomes for banks to raise funds, the more they will rein in lending. Britain is particularly vulnerable to this problem because so many of our banks have astonishingly high ratios of loans to deposits.

In times like this, the job of a central bank is to calm nerves and restore the normal functioning of the financial system. That is what the US Federal Reserve and European Central Bank have been doing since August, when they were quick to start pumping millions into the money markets and to engage the players in discreet conversations. The US Treasury quietly prompted Bank of America to prop up Countrywide, the American equivalent of Northern Rock, this summer. It is now working with the banks to try to create various stabilising vehicles. While not all of these may work, the contrast with the UK is stark. While the US authorities have rolled their sleeves up, the Bank of England and Financial Services Authority have vacillated, blamed each other and fanned the flames of panic.

Mervyn King may have been right in principle to refuse to extend liquidity to banks that he believed should face the full consequences of their actions. But in practice the Governor of the Bank of England's tough line stoked a crisis of confidence. His U-turn in September came too late to prevent Northern Rock going bust.

Far from quietly talking, the UK regulators have spent much of the past four months shouting “I told you so”. That is not a grown-up response to a financial crisis. They have pointed smugly to the many excellent reports they wrote on what might go wrong. But reports are no substitute for action. The FSA's analysis of Northern Rock's weaknesses only made it more culpable for failing to ask the company what its contingency plans were. The Bank of England's warnings about financial stability only make it harder to understand how it and/or the Treasury (each blames the other) let the proposed takeover by Lloyds TSB slip through their fingers. The FSA is claiming that 1.4 million homeowners may struggle to find an affordable mortgage deal when their fixed rates end next year, if they can get credit at all. That statement of the obvious would be more impressive if the FSA had not continued to be bullish on the mortgage market even in May. Having done nothing to prevent financial institutions overextending themselves, the FSA seems to be revelling in blaming them for doing so.

Tone is just as important as action when confidence is at stake. But the tone is still wrong. Senior City people are furious at the alternately aggressive and complacent remarks from officials at the Bank, Treasury and FSA — the tripartite system set up when the Bank was made independent in 1997 — who they feel are lacking in expertise.

It would have been prudent, with an academic like Mervyn King running the Bank of England, to place a market expert at his right hand. But his respected deputy, Rachel Lomax, is a career civil servant. So is Sir John Gieve, who was foisted on Mr King by Gordon Brown and whose lamentable performance in the wake of the Northern Rock debacle cemented the impression around the world that, as Richard Lambert said at the time, Britain was behaving like a banana republic. That the Bank has had to bring back an ex-deputy governor in the past few weeks only seems to underline Sir John's inadequacy.

Hindsight is easy, of course. But four months into this crisis, UK regulators are still behaving more like a think-tank than an engine of stability. With the banking system on a knife edge, it should not have taken the Bank of England four months to make its first cut in interest rates. Some economists believe that the Fed has cut too far, too fast. But the Fed reckons that too deep a cut, which could be corrected, would be better than recession.

The quiet coup recently engineered by Sir David Walker, the former chairman of Morgan Stanley, who has coaxed private equity firms into signing a code of conduct, shows what can be done with trust and market expertise. Perhaps Sir David should be given the task of turning the tripartite system back into an effective regulator. For if the Bank of England loses the confidence of the markets, it loses control. And that we literally cannot afford.

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