Twitter for Will Hutton: Banking's Marshall Plan

Revenge is a dish best served cold. Of course overpaid, irresponsible financiers who have landed the world in its worst recession since 1945 should pay for their excess and avarice. But the way we are making them pay is hurting us more than it is them. It is time to cool down.

Policy should have one overriding focus. It should be directed at reforming a broken financial system so it works again, if on very different principles. Interest rate cuts and fiscal boosts are right. But arguably the most crucial aim is to revive shrinking bank lending, the recessionary impact of which on the economy is greater than any reflation.

The banks may be alive courtesy of taxpayers, but they are far from functioning normally. In the recent financial stability review, the Bank of England showed they have loans which exceed their UK deposit base by £700bn, and are bridging the gap with savings from abroad. Over the last two months foreign investors have withdrawn more than £200bn from Britain. So, on top of the caution created by property market collapse and recession, the banks are being forced to recalibrate their balance sheets very quickly. Inevitably, they are lending only on the most onerous terms.

This is a calamity. It infects the mortgage market, businesses and the high street alike. Recession could translate into depression if it continues. One of the important reasons is that the government, reflecting the public's desire for revenge, has designed a bank rescue package that is far too tough.

There are a number of areas in which it needs to change rapidly, bringing forward proposals in the pre-budget report. First, it is stipulating a 12% interest rate on the coupon rate it is charging when it invests in banks via preference shares. This makes the cost of capital high, and encourages the banks to charge high margins to deliver the profit to pay off the government loan quickly. The lending crisis is made worse. The coupon should be halved. Barclays, instead of paying an even higher 14% rate to Arab sovereign wealth funds to escape the scheme, should be required to accept cheap UK government money.

Second, the insurance premium for guaranteeing £250bn of unsecured debt (mainly interbank lending) is based on credit default swap rates in the 12 months up to October - a period when the swap market was imploding and the insurance cost racing up. The failure of the scheme is reflected in the London Interbank Offer Rate being locked at a crazy 150 basis points above bank rate. The insurance premium should be lowered: this will allow borrowers to benefit from the full impact of interest rate cuts.

Third, the Treasury must stop blocking the proposal for insuring the nominal value of residential mortgage-backed securities. Without insurance this market will remain shut, and foreign money will continue to flee the country. This is a cheap way of helping stricken homebuyers and stabilising sterling. On top the terms of the Bank of England's special liquidity scheme must be relaxed - and in the medium term new institutions and risk markets developed.

Officials like none of this because it offends the canons of sound finance. They should be silenced. Meanwhile politicians are wary of being called the bankers' friends. But why, pray, is the Treasury drawing up such timid guidelines on bonuses? Let's have some American-style indictments and public hearings. But let's be generous to banks so that they resume lending to businesses, homebuyers and consumers. Mean reparations after the first world war ended in disaster. The generous Marshall Plan and Nuremberg trials after the 1939-45 war were transformatory. It is that approach we need to borrow for today's financial system.

will.hutton@observer.co.uk