The success of the UK banking rescue plan will depend importantly on yet-to-be-announced terms and conditions. The authorities need to strike a balance between protecting taxpayers’ interests and providing some upside for equity holders – necessary to stem the downward spiral in share prices and attract new private sector capital.

A key issue is the fee to be charged by the government for guaranteeing an expected £250 billion of bank debt. As argued previously, the effectiveness of the special liquidity scheme has been reduced by its perverse fee structure. The Bank of England charges banks the spread between three-month LIBOR and the three-month rate on government borrowing. This means the scheme becomes more expensive when LIBOR rates rise – the time banks most need to use it.

The fee charged for guaranteeing debt must reflect the strength of the institution concerned but should not depend on volatile market assessments, such as credit default swaps. One possibility would be to base the charge on the amount borrowed and the credit rating of junior bank debt.

Similarly, the terms of new government-subscribed capital issues should not be unduly onerous. Demanding a Buffett-style 10% yield along with interference in dividend policy and other decisions affecting future ordinary shareholder returns might generate short-term political plaudits but could prove self-defeating.

The £100 billion expansion to £200 billion in the special liquidity scheme does not represent a new initiative, since there was no previous upper limit on banks’ access to the facility. The extension of the definition of eligible securities for the scheme to include new government-guaranteed bank debt also appears of little consequence – it is unclear why banks would wish to pay a fee (charged on top of the guarantee fee) to swap such government-backed paper for Treasury bills of the same credit rating.

Unlike the Fed and the ECB, the Bank of England has yet to allow securities rated lower than AAA to be used as collateral in its money market operations. This may partly explain the undersubscription of its £40 billion auction of three-month funds this week. It is doubtful that the long-awaited plans for a new discount window facility, to be revealed next week, will loosen collateral requirements further.