Late last week, five central banks engaged in a coordinated plan to stop the panic in the financial derivatives markets, and return the banking system to some semblance of normalcy.

They failed.

The Bank of England alone poured in £49.5 billion ($100 billion). The markets took a sniff, shrugged, and went back to doing what they are so good at: herding themselves in the direction of the generally perceived trend.

The central banks now are reeling, shell-shocked. If the rescue effort last week didn’t work, it appears they don’t have the foggiest idea what will.

As the Financial Times of London, headlined its story on Monday: “Hold tight, the central banks have no plan.”

This has been the year when many deeply held beliefs have been challenged. One such belief was that central banks have the toolkit to sort out any conceivable economic or financial crisis.

Last week’s co-ordinated liquidity action by five central banks taught us that this is not the case. The idea was that a co-ordinated response would reassure the markets, but it had the opposite effect. It turned out that market participants are not infinitely stupid. They know by now that this is not a liquidity crisis at its core. If it had been, it would be over by now.

It is a fully fledged solvency crisis that has arisen because two giant and interlinked bubbles burst simultaneously – one in property, one in credit – leaving banks and investors on the brink of bankruptcy, some hanging on by their fingertips. Yet there is nothing the central banks are offering at this stage to alleviate a solvency crisis.

Did you catch that? The banks aren’t just having a liquidity problem, meaning they’re a little tight for cash right now, but come back in two or three days, and we’ll have plenty. Noooo, this is a SOLVENCY crisis. As in, we don’t have any money right now, and we’re not sure when we’re going to have any. Or, as our wonderful British cousins would say: “Well, gov’nr, there ain’t no cash. Now, PISS OFF!”

Taking a knife to the entire Western banking system.

So, if the central banks can’t save the system, are there ANY options left?

Yeah – just trash the system.

And that’s what the central banks are thinking of doing. They’re just going to suspend the rules for a while, let the banks go on as if nothing has happened and nothing is wrong, and hope the problem eventually goes away. Hey, it worked when the dot com bubble burst in the late 1990s, why not now?

In its report of last week’s central bank debacle, the London Telegraph noted that the Bank of England’s Executive Director for Markets, Paul Tucker, was trotted out to float this idea of using the “nuclear option.”

Tucker is the guy responsible for the Bank of England’s open market operations. That is, when the Bank of England wants to adjust or change its policy, it is Tucker who directs the buying and selling of securities with the primary commercial and investment banks in London to achieve the desired result. Tucker is also the chap who manages Her Majesty’s Government’s foreign currency reserves AND “manages the risk” of those reserves (i.e., Tucker also gets to play in the derivatives markets with HMG’s money). Finally, Tucker is responsible for “market intelligence,” meaning he’s supposed to know what the hell’s going on. The Bank of England’s formal description of this duty sounds very impressive indeed: “market intelligence and analysis supporting the Bank's monetary and financial stability core purposes.”

“Financial stability core purposes.” That’s worth repeating a few times, since we’re talking about THE central bank here (The City of London is a bigger financial center than New York City, a fact all those conservative patriotic blow-hards thankfully haven’t latched onto yet).

So when Tucker speaks, folks who worry about these things best sit up and notice. And as the London Telegraph notes, Tucker does not speak very often.

It was the first time the Bank's executive director for financial markets had given a speech in almost six months, and in the intervening period the money markets - his aegis - had degenerated from a calm, smoothly functioning machine into a torrid mess.

So what did this chap, Tucker, have to say? Here’s the one crucial sentence, and the Telegraph’s explanation of what it means:

"Regulatory authorities around the world are monitoring banks' liquidity and capital positions, including in the context of Basel II."

It may seem like an bland piece of bank-speak, but Mr Tucker's comments are in fact one of the first indications that the financial authorities in the UK are now considering the nuclear option of taking a knife to the regulations that underpin the entire Western banking system.

OK, OK, I know you’re wondering how one little sentence can mean so much. The key to understanding this is to know what Basel II is. According to Wikipedia:

Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse.

Yeah. Uh huh. Well, obviously, that didn’t work so good. So now we’ll just get rid of the rules, and voila, there’s no more crash!

The Telegraph’s explanation is quite good, and it’s worth your time to pop over there and read the entire article.

I would love to copy it here, but the Telegraph’s website has a pretty stern warning about copyright infringement. I don’t want to get them angry. I mean, these guys are in London, right?, and that’s where my fate and your fate is now being decided.

Also posted on DailyKos and TPMCafe