How does a bank work? In very simple terms, a bank collects deposits from savers, and lends the money to borrowers. It pays interest on the deposits, charges a higher rate of interest on what it lends, and keeps the difference as profit.

This we all know. But what if all goes wrong? What if the people the bank lends to don’t pay them back? What if too many savers want their deposits back? Basically, what if the bank runs out of cash?

Northern Rock posed this question last year. As well as using deposits, the Rock also topped up its lending from the money markets. But then the money markets seized up, and it was game over.

So the question was asked - what should be done now that it’s all gone wrong? It stumped the powers that be. The FSA, the Government, the Bank of England - they all scratched their heads. They scratched and they scratched, for several months, until they’d worn holes in the tops of their heads.

A bank is a private business. A bank that runs out of money, like any business that fails, can expect to go bust.

But, as we all know, that didn’t happen with Northern Rock. Once the head scratching was over, Northern Rock was nationalised. This marked a major deviation from the way private enterprise is supposed to work.

So now, the Treasury is drawing up plans for something called the special resolution regime (SRR). The idea is that in future the SRR would swiftly liquidate a failed bank, strip it of its assets and appoint new executives. Just as would happen with a failed business in any other sector.

But there’s a problem. Who will run the show? The FSA didn’t come out of the Northern Rock crisis very well. But the regulator would no doubt argue that its past performance should not be taken as a reliable indicator of the future.

Bank of England governor Mervyn King has reservations. He suggests there could be reluctance on the part of the FSA to pull the trigger if another bank fails. His reasoning is that this would be an admission of failure on the part of the regulator who allowed said bank to fail in the first place.

But the FSA counters that involving the Bank with a final decision would mean it would also inevitably become involved in monitoring, duplicating the FSA’s role.

Personally, I don’t really care who wins this little turf war. If I had to pick a side I’d go for the Bank. Call me a traditionalist.

A more fundamental question is how on earth have we got into this situation? As noted above, a failing bank should… well, fail. Adam Smith’s Invisible Hand is supposed to allocate the spoils of business to those most deserving. Those who get it wrong get less… if they get it really wrong they get nothing.

But the workings of the market have been gummed up by regulation. That and political fear (runs on banks don’t look good on the telly. Better do something, quick!)

It’s this political fear that creates moral hazard. The banks knew the Government would never risk letting them fail. So they were happy to take big risks.

Now an institution, the SRR, is being created to effectively force punishment upon banks that mess up.

Welcome to the age of the Visible Hand.

Hold your nerve, Merv!

Hurrah! It’s the day before the Bank of England’s Monetary Policy Committee (MPC) meets to decide what to do with interest rates.

Because I’m a sad man, I set up our very own Fleet Street Daily shadow MPC. Better-looking than the official MPC, our committee comprises seven wise men, one wise woman and Glenn, a bloke from Grimsby.

And my, was it close! A five-four split in favour of a quarter-point cut.

Not that this is what we expect the Bank will do. Nor necessarily what it should do.

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The Bank faces a tough call tomorrow. There’s a lot of ‘bad data’ doing the rounds - the service sector is slowing, manufacturing and output are lower than expected, the mortgage market remains depressed. Lots of ammunition for the doves.But on the other side of the equation, inflation isn’t going away. It’s 0.5% above target. Today we read that soaring food and energy bills are leaving families with the lowest levels of disposable income in 17 years.

“And there’s also talk of US interest rates rising,” adds colleague Frank Hemsley. “That would put sterling in serious trouble! Especially if the Bank of England cuts our rates.”

Indeed. A weak pound would make imports - including food and energy - even more expensive. Meaning more inflation, and pressure to put rates back up if the Bank adopts a US Fed-style aggressive rate cutting policy.

Personally, I’d favour keeping rates on hold. Businesses and consumers are rational. They see the economy is struggling, and they’ve changed their behaviour accordingly. This is why each day we see new ‘bad data’. Cutting the base rate by a quarter-point will do little to change prevailing sentiment.

What it will do, though, is further undermine the Bank’s reputation as an independent inflation fighter. So I’m hoping the Bank stands firm and leaves rates where they are. It won’t be popular, but being popular is not the Bank’s job.

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