ALEX BRUMMER: The day banking changed for ever

The global financial system is a very different place now that Lehman Brothers, an institution which traces its roots back to 1850, has filed for bankruptcy.

Nowhere was this clearer than in Canary Wharf, where 4,500 Lehman employees were instantly fired - losing not just their jobs but much of their savings, since one-third of the company was owned by staff. The disdain among employees for Dick Fuld, the chairman and chief executive who led the house to oblivion, was palpable.

Bags packed: A worker leaves the Canary Wharf offices of Lehman brothers

Even more startling, in many respects, was the sight of Merrill Lynch, the world's largest stockbroking firm with 16,000 brokers, being rescued from oblivion by Bank of America.

The 'thundering herd', as Merrill Lynch is known, with its logo of a bull to represent bullish or buoyant markets, is not just another Wall Street giant. Its investment arm was developed from its retail banking division, so Merrill is still a presence on every high street across America - the place where 'Mom & Pop' savers go to invest their savings and buy their pension plans.

The loss of these two giant banks, together with that other Wall Street giant Bear Stearns which collapsed in March this year, means there are only two global investment banks left - Morgan Stanley and Goldman Sachs.

They might have been smarter and more cautious than their rivals but

the truth is investment banking itself - in which giant financial institutions risk everything by making complex bets on the future performances of their investments - must now be in severe doubt.

A trader reacts on the Chicago Mercantile Exchange as the markets fall

As if all of this were not enough in one day, a terrible crisis also erupted at AIG, the group regarded as the world's largest and most sophisticated insurer. Last night it won an £11billion lifeline from Wall Street's private banks. But its balance sheet is loaded up with 'toxic' securities - it has pledged vast amounts of insurance against bad loans - which cannot be valued.

It is this uncertainty over valuations which is the most disturbing aspect of the credit crunch. The crunch began on August 9 last year after the leading French bank BNP Paribas announced it could not value assets in two of its investment funds because of the toxic securities they contained.

The City and Wall Street immediately became concerned that, hidden in the funds and balance sheets not just of banks but of insurance companies and pension funds, there were tens if not hundreds of billions of assets which have turned bad and might be worthless.

Only now at Lehman, Merrill Lynch, AIG and elsewhere is the true size of the black hole being recognised. At Lehman, for example, the figure for suspect or toxic assets more than doubled from £17billion to £44billion in the course of last weekend alone.

It is the lack of credible and verifiable information about the health of the balance sheets of major banks around the world, including our own high street lenders, which is so terrifying.

Tourists take pictures in New York's Times Square as the days financial news is displayed on the news-ticker

These doubts about asset values mean professional investors have become allergic to financial shares of all kinds.

At one stage yesterday, Britain's biggest mortgage lender Halifax Bank of Scotland (HBOS), suffered a 25 per cent drop in its share price even though it raised £4billion of new capital earlier this year.

Throughout the financial crisis the Bank of England has taken a tougher line than other central banks in Europe and the Federal Reserve in America which looked determined to try to prop up failed institutions - not least with this month's multi-billion dollar takeover of the two biggest mortgage companies in the U.S., Fannie Mae and Freddie Mac.

But now the Federal Reserve is no longer willing to subsidise investment banks such as Lehman which, in their search for profits, over-extended themselves by borrowing up to 30 times their capital, only to invest the cash in foolish securities and real estate.

By allowing Lehman to go to the wall, the Fed is making clear that it is no longer in the business of bailing out 'wholesale' banks where it is Wall Street players - rather than high street consumers - who are directly affected by the failure.

The message is stark: The Fed means to purge the system of firms who abandon prudence for profit.

In the past, this approach has worked: after the Wall Street investment house Drexel Burnham Lambert was allowed to go bust in the late 1980s, others cleaned up their act by investing more judiciously. The same thing happened after Britain's oldest investment bank Barings failed in 1995.

People look out of the window at the Lehman Brothers Holdings as they consider their future

But today it is more difficult because of the modern practice where loans are repackaged and disguised by one institution, then sold on over and over again to others.

It means the contagion of toxic securities has infected any number of finance houses and disaster in one may spell trouble for others. The closure of Lehman Brothers, for example, immediately triggered multi-million-pound losses at the Swiss bank UBS. Another problem is that

City and Wall Street banks are now so absorbed in trying to sort out their own problems that funds are being diverted from keeping the wheels of commerce turning.

Billions of dollars is being lavished by the investment banks on support operations within the banking sector itself - which means the supply of credit to ordinary consumers and businesses is drying up.

The U.S. is experiencing a deep downturn. Germany and Spain, two of the UK's biggest export customers, are already in recession. In Britain, both the OECD and the European Commission forecast that recession is on the way.

Worryingly, Britain is most vulnerable because, over the last couple of decades, we chose to develop the financial services sector as the nation's chief strategic industry. We are therefore set for an extraordinarily painful adjustment - far worse than for several decades.

The shape of banking will be changed for ever by the events of the last year. The fashion for exotic financial instruments, which disguise the true nature of bad debt, will go. So will the habit of over-ambitious gambling by Wall Street and City investment houses.

The good thing about the free market is that it is self-correcting in the end. We might all have to endure several years of pain - banking crises typically take up to a decade to repair themselves - but eventually the demand for improved living standards will stimulate growth again.

This crunch might - as the former Fed chairman Alan Greenspan says - be a 'once in a century' event. But in what is becoming an ever-growing crisis, the optimist can at least argue that the deeper and longer the downturn the stronger the eventual bounce back.