The City's financial watchdog last night sought to shore up confidence in Britain's biggest mortgage lender, HBOS, after a 40% fall in the bank's share price following two days of market turbulence caused by the collapse of Lehman Brothers.
After a second day of sharp share falls in HBOS, the government was ready to activate longstanding contingency plans to ensure financial stability.
The Financial Services Authority, in a rare public comment on a specific bank, said: "We can confirm that, as HBOS already stated, HBOS has a strong capital base and continues to fund satisfactorily."
In the US, early this morning the government was on the brink of a deal to take control of the world's largest insurance company, AIG, after a share collapse.
The FSA, the Bank of England and the Treasury spent yesterday monitoring the health of Britain's banks after another nervous day in which central banks pumped more than $200bn into global markets but failed to stem the selling pressure or ease the logjam in money markets. London's FTSE 100 index closed at its lowest in three years amid forecasts that the credit crunch could see more than 100,000 jobs shed by the UK's financial sector over the next year.
Government sources said they had learnt lessons from the collapse of Northern Rock a year ago, adding that they had thought about what they might do if a similar situation ever arose again.
The authorities were, however, keen to play down any talk of a crisis, and Mervyn King, the governor of the Bank of England, dropped no hint that he supported an early cut in borrowing costs when he wrote to the chancellor, Alistair Darling, to explain the latest rise in the inflation rate to 4.7% - more than double the 2% target.
With oil almost $60 a barrel down on its peak of $147 in August, King said he expected inflation to peak at around 5% but to remain above target well into next year. Borrowing costs in the City's money markets soared yesterday amid evidence that institutions were only prepared to lend for short periods and at high rates.
Last night, Barclays appeared to have secured a deal to buy a large part of Lehman Brothers, the fourth biggest investment bank on Wall Street that sparked turmoil in the markets when it filed for bankruptcy on Monday.
Barclays president Bob Diamond was reported to have addressed Lehman staff on the trading floor in New York, telling them: "You have a new partner."
The fall in the HBOS share price forced the bank to issue a statement insisting it had a "strong capital base" which helped stem the slide. But the shares ended 22% lower after rating agency Standard & Poor's downgraded a crucial measure.
The plunge in HBOS, which with 2 million shareholders has more investors than any other company and accounts for one pound in every five saved in the UK, caused Liberal Democrat Treasury spokesman Vince Cable to call on the FSA to stop the "short selling" of bank shares by hedge funds. Darling said yesterday that the government was concerned about the short-selling of sound financial institutions and the Treasury said last night the chancellor was consulting on ways to toughen up the FSA's policing of the practice.
In the US last night, America's central bank, the Federal Reserve, left interest rates on hold at 2%, prompting boos on the floor of the New York stock exchange. However, the Dow Jones industrial average was later up more than 100 points.
On Wall Street , AIG's share price fell 40% in after-hours trading. After a day of emergency talks, congressional leaders were briefed that the Federal Reserve had agreed in principle to lend $85bn to AIG in return for an 80% stake. The arrangement is highly contentious because it renders AIG's shares virtually worthless. The administration will also face tough questions about why it is willing to rescue AIG but allow Lehman to go bust.
Earlier, the Fed said in a statement: "Strains in financial markets have increased significantly and labour markets have weakened further." It added, however, that it was as concerned about inflation as it was about growth.
Asian and European stockmarkets fell heavily after Monday's 500-point drop in the Dow Jones. Tokyo's Nikkei index was down 5%, while London's FTSE 100 slipped 178.6 points to a three-year low.
Angel Gurria, secretary general of the Organisation for Economic Cooperation and Development, said the turmoil in the markets had put back recovery by a year. "It has turned into a much bigger, more widespread and more threatening situation, " Gurria told the Guardian.
"Recovery was going to be the end of 2008 but that has now gone. It will now be a year from now."