Money being supplied to the banks is not being lent through. Banks are parking the money in short dated government securities in anticipation of their own funding requirements.

Around $2-3 trillion of assets are returning to bank balance sheets from the "shadow" banking system of off-balance sheet structures that can no longer finance themselves. In addition, banks have large amount of maturing debt (estimates suggest $1.5 trillion by the end of 2008) that they must fund. Fear of bank failure (especially after the bankruptcy of Lehman and restructuring of WaMu) and shortages of capital also limit ability of bank’s to on-lend.

The initiatives do not address the required re-capitalisation of banks to enable them to take on risk assets and also reduce fear of default allowing normal activity between institutions to resume.

Ultimately, "all the king’s horses and king’s men" cannot prevent the de-leveraging of the financial system under way. At best, the actions can smooth the transition and reduce the disruption to economic activity. The risk is that well-intentioned steps prevent the required adjustments from taking place, delay recognition of problems and discourage action that must be taken by financial institutions, corporations and consumers.

The extent of de-leveraging is substantial and likely to take time. It is clear that all asset prices must adjust significantly.

The key issues are availability of capital and liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage. As the system de-leverages, it is becoming clear unsurprisingly that available capital is more limited than previously estimated. Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in US dollar denominated US Treasury bonds, GSE paper and AAA rated asset-backed securities. It will be difficult to mobilise the funds and convert them into the home currencies of the investors without large losses.

Government and central bank actions need to be focused on managing the transition to a lower debt world. Actions should be directed to three areas.

Banks must be forced to write-off bad loans without delay even if this means breaching minimum solvency capital requirements. Bank capital needs must be addressed by forced mergers and restructuring, new equity issues and (in the absence of other options) nationalisation or liquidation. Central banks need to guarantee (for a fee) all major bank transactions to reduce counterparty risk enabling normal transactions between banks and other parties in the financial markets to resume.

Elements of these actions are already in place but the absence of a co-ordinated global strategy reduces effectiveness.

A global conference (along the lines of Bretton Woods) under a respected chairman (Paul Volcker is the obvious choice) must be convened. It would bring together all the major players including the vital creditor nations – China, Japan etc – to develop a framework for the major economic reforms (currency policies, fiscal disciplines, trade barriers) to work towards a resolution of the crisis.

A principal objective of this conference would be ensuring supply of funding for the US in the transition period. Recent comments by China about US responsibility for the crisis and its resolution miss the point. As China’s Premier Wen Jiabao observed, the U.S. financial may "affect the whole world". As Wen noted: "If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital…" All creditors have much to lose if the deleveraging process becomes disorderly.

Like a giant forest fire the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.

The Arabian Nights had a happy ending: The king, after 1,001 nights of enchantment and three sons, pardons the beautiful Princess Scheherazade, who becomes his queen.

The fairytales that investors are putting their faith in currently, the deleveraging that is at the heart of the current financial crisis, may not have such a happy ending.