Banking crises have real-world effects. The collapse of a large Austrian bank, Creditanstalt, in 1931 holds a salutary place in modern history. It precipitated a terrible chain of events in Europe that destroyed people's savings, and provided fertile ground for the spread of xenophobia and political extremism.

The crisis now threatening the global financial system is less politically dramatic but still ominous. When confidence in the banks fails, then a self-reinforcing spiral of collapsing investment, job losses and recession awaits. The efforts of governments and central banks this week to support the financial system and get banks lending to each other again seem well judged. The next question is how policy and bank regulation can be improved so that future crises are anticipated and their collateral damage contained.

Calls for stronger regulation will be merely platitudinous if they fail to allow for the possibility that hasty action might stifle enterprise. Banks serve an essential function in a complex economy, by allocating scarce capital to businesses that can use it productively. Stronger regulation should aim to make the financial system more stable, not damage legitimate, measured risk-taking. These are the principles that governments and regulators must follow once the detritus of the banking crisis has settled.

The origins of the crisis lie in the US housing market. Banks have packaged up mortgage debt and sold it to investors in the form of marketable securities (so-called securitisation). That debt has gone bad because house prices have collapsed. There is thus no longer a market for these mortgage-backed securities. Banks are left holding large volumes of what have become “toxic assets”, against which they are unable to borrow. This is why governments are now replenishing the banks' capital, so that the interbank lending market can be unfrozen.

The obvious policy response is to tighten controls on mortgage lending. And the ease with which borrowers during the housing boom could obtain mortgage loans, which they were unable to repay, often without declaring their income, was certainly a disaster in the making. But this is almost incidental to preventing future bank crises. Mortgage debt is only one type of asset that banks hold on their balance sheets. In prin- ciple, a credit crunch might arise when other types of assets collapse in price. And because financial markets are characterised by periodic bubbles and crashes - in stocks, bonds, foreign exchange or property - this will be a recurring risk for the Western economy. Better economic management, in which excessive credit expansion is curtailed at an earlier stage by governments and central banks, would help. But politicians, like everyone else, have imperfect information and make mistakes. And therefore regulation needs to be in place to prevent banks from irresponsibly exploiting bubbles in asset prices.

The most significant regulatory failure that the credit crisis has exposed concerns bank capital. The current rules are codified in an international agreement, known as Basel II, which specifies how much capital banks must hold. These rules focus too narrowly on capital, however, without taking sufficient account of the liquidity of the assets that banks hold (that is, how quickly the cash value of the assets can be realised). In addition, banks have been able to expand their lending by creating special vehicles that can be kept off their balance sheets. These are where much of the toxic assets associated with the US housing bubble have ended up. These are regulatory loopholes that the banks have scandalously exploited. In closing them, regulators would help to restore financial stability - without which no democracy can long survive.