The smoking gun

Wednesday, October 01, 2008

The smoking gun

By general accord, much of the current financial crisis arises from "regulatory failure", something to which numerous references have been made, not least by the shadow chancellor over the weekend, when he complained that "Gordon Brown's regulatory mechanism has comprehensively failed".

Osborne has though been reticent about identifying the specific failure and it took his boss David Cameronyesterday to hint at the specifics. There is a need, he said, "to break the self-fulfilling cycle that is reducing banks' ability to lend." The problem is this, he added:

When the value of financial assets falls, a new international accounting regulation called "marking to market" automatically downgrades the value of banks. They are less able to raise the money to carry on their business. That in turn causes further falls in the value of financial assets. And this is making the financial crisis worse than in previous downturns.

Cameron himself, however, blurs over the precise cause of this problem and it took The Guardian to add more detail. The paper tells us:

A European Union directive passed in 2001 and adopted as a new accounting standard in the UK in 2006 dictates that banks have to value their assets on a daily basis. To do this they must base their calculations on the market value of each asset if it were liquidated that day. The problem with this is that as share values tumble in response to the credit crisis, millions of pounds are wiped off bank balance sheets causing a spiral of decline in asset values.

Actually, The Guardian has got it wrong. The "European Union Directive" in question is Directive 2006/49/EC of 14 June 2006 "on the capital adequacy of investment firms and credit institutions". Its short title is the Capital Adequacy Directive.

That it is an EU directive, though, does not tell the whole story for it is this directive which implements crucial parts of the now notorious Basel II agreement. It is that agreement that which is the heart of the current problems which the banks are experiencing.

That Basel II is the problem – the "smoking gun", so to speak - has been widely promulgated for some time by acknowledged experts, most notablylast December by Prof. Peter Spencer, of the Ernst & Young Item Club, regarded as "one of Britain's leading economists". It was then that a report of his views said:

…conflicts caused by the Basel system of banking regulations, which determine how much capital banks must raise to keep their books in order, are the root cause of the crunch and were serving to worsen the City's plight.

The regulations meant that banks forced to take off-balance sheet assets from troubled structured investment vehicles on to their books had little choice but either to raise money from abroad or cut back dramatically on their spending, he said.

He warned that, if London's money markets remained frozen and the authorities retain the strict Basel regulations, the full scale of the eventual credit crunch and economic slump could be "disastrous".

Dismissing the assumption that banks are not lending to each other on the money markets because they lack confidence in each others' potential solvency, he argued that they were, in practice, prevented from lending the cash at all because it could leave their balance sheets falling foul of the Basel regulations.

"If these funding routes are not reopened it will have massive consequences for the economy as a whole," he said. "It will make 1929 look like a walk in the park."

He dismissed as "window dressing" the move announced by central banks around the world this week to pump extra money into the money markets and increase the type of collateral they will accept in return, in an effort to get them running again.

"This won't get to the core of the problem: the fundamental lack of collateral. As these problems drag on, the consequences for the macro-economy of not relaxing [the Basel regulations] are unthinkable."

Not only do the regulations, which stipulate that banks must have a minimum of 8pc capital among their liabilities, deter banks from lending to each other, they will also limit the amount they can lend to households and businesses. This could escalate the anticipated economic downturn next year significantly, he said.

This theme was picked up by Ambrose Evans-Pritchard a few days later, who cited Spencer saying that, "the global authorities have just weeks to get this right, or trigger disaster."

The Spencer analysis was then essentially repeated at the end of January by another acknowledged expert, Prof. Tim Congdon.

In the context of the Northern Rock affair, Congdon asserted that, "the Basel rules have failed", then arguing that "the scientific precision of the Basel rules was shown to be hocus-pocus." Banks, he wrote:

…did not know the true state of each other's capital and, hence, their ability to repay loans. Inter-bank markets seized up. If one bank - such as Northern Rock - ran out of cash, it had only one place to go, its central bank. But the assumption that the central bank would, quickly and reliably, extend a lender-of-last-resort loan to a solvent, but illiquid bank - an assumption written into banking textbooks for decades - was invalidated by the Bank of England's reluctance to lend in crisis circumstances last August.

So it was yesterday that Cameron stood up in front of the Conservative Party conference and declared that "…our regulatory authorities, together with the European regulators, need to address this difficult issue."

He did not name the Basel II agreement and, crucially, neither did he identify the more immediate cause of the problem, the EU Capital Adequacy Directive. Had he done so, of course, there would have been uproar, and the EU would have been catapulted to the top of the political agenda, which is the last thing Cameron would have wanted.

And it is the Directive which is now the problem. The reason for this is that, although the original Basel II agreement was produced in June 2004 with the assent of the British authorities – which had pushed hard to their adoption – the sponsoring organisation, the Basel Committee on Banking Supervisiondoes not produce legislation.

Instead, it "formulates broad supervisory standards and guidelines" and recommends statements of best practice in banking supervision "in the expectation that member authorities and other nations' authorities will take steps to implement them through their own national systems, whether in statutory form or otherwise."

Had the UK been an independent country in 2004 and subsequently, the government would have implemented the Basel II agreement into UK legislation, either through an Act of Parliament or through Regulations (SIs) – or a combination of both.

The trouble was that, not only was the UK a member of the European Union, financial services regulation was (and is) a "competence" of the EU and the UK had thereby ceded authority to legislate in this area. Thus, instead of being adopted into British law directly, it was adopted via an EU Directive.

That, at the time, did not present the government with a problem as it has been an enthusiastic supporter of the agreement. But, now that the flaws in the agreement have been exposed, or shown to be "hocus-pocus" as Congdon maintains, the provisions cannot be changed unilaterally by the British government. They are now part of EU law so, in order to achieve change, all we can do, as Cameron euphemistically put it, is have "…our regulatory authorities, together with the European regulators," address "this difficult issue."

And that equivocation is also part of the problem. One might ask why, if Cameron is now so (rightly) certain as to where the problem lies, his shadow chancellor has not raised it before.

To be fair to him, he has. He raised it on 21 April 2008 in the House of Commons in response to a statement by Alistair Darling on "financial stability". But it was only one sentence where he told Darling that the moves he had announced "should include reforms to the Basel accords."

Then, in a Newsnight interview on 17 September, just a few days ago, he mentioned it again, a reference which met with the approval of Telegraphcolumnist Gerald Warner, who noted:

Osborne did not overreact to the crisis by rushing to propose a host of regulations to monitor the stable door now that the horse has bolted. Instead, he proposed revisiting the Basel II Accord, which is now four years old.

Thus, while Osborne has belatedly come to the view shared by Spencer and Congdon, and evidently passed this view to his boss, neither he nor Cameron have mentioned Directive 2006/49/EC, nor even the European Union. Yet it is the Directive which must be changed.

Yesterday, Cameron entitled his speech, "Together we will find a way through". What he did not specify, however, was how he was going to "find a way through" the EU labyrinth to remove a damaging piece of legislation that is at the heart of this crisis.

Thus, while Osborne is accusing Labour of being "in denial" over its role in the financial crisis, the Conservatives too are indulging in their own form of denial.

The elephant has re-acquired its cloak of invisibility.

The picture shows the headquarters of the Bank for International Settlements in Basel, which hosts the Basel Committee on Banking Supervision meetings.

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Tuesday, September 30, 2008

Go figure

Markets are up: "Dow unofficially closes up 4.72 percent, or 489.35 points; S&P500 rises 5.44 percent; Nasdaq climbs 4.97 percent". Never mind. The sky is bound to collapse tomorrow.

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Dear me!

We are all getting a little overwrought. So let me say that I do not think we are doomed. Nobody is ever doomed. Things will change and they might get worse. But the world will not collapse and even capitalism will not end, simply because it is the only economic system dynamic enough to produce the kind of lifestyle we are all, and not just our masters in politics, the EU and the media, accustomed to. It is the only economic system dynamic enough to lift people and countries out of poverty. It will not die, no matter what EU Commissars and Guardian journalists might say.

Der Spiegel also quotes the egregious Peter Mandelson fulminating about partisan politics in the USA. Well, nobody could accuse our Peter or his colleagues of partisan politics unless the partisanship is of them against the rest of us.

For his and everybody's information, about 40 per cent of the Democratsvoted against the bail-out Bill and about a third Republicans voted for it. I wonder whether anybody has done any kind of study as to how those Congressmen and women who are coming up for re-election in November voted.

The truth is that, no matter what the British, European and much of the North American media tell us, the Bill was not overwelmingly popular.

A new poll by the Pew Research Center found weakening public support for the bailout. The September 27-29 survey said Americans only backed the plan by a 45 percent to 38 percent margin.

And those despicable American legislators who are so partisan are accountable to their electorate while EU Commissars like Peter Mandelson are not.

If one trawls through the American blogosphere, one realizes that there is a great campaign going on across the country of people trying to stop their Representatives from voting this Bill though. People are phoning and e-mailing politicians and that may well have had an effect on the votes (as did Nancy Pelosi's screaming outburst). Parliament has not even been recalled because it is quite clear that they can do nothing without the permission of the EU and the various committees already in existence. Communicating with one's representative on this subject in Britain is a pointless exercise.

So when the article says that "Europe is furious at Washington's failure to agree on a bailout plan, calling Congress 'irresponsible'.", what it really means is "Increasingly, EU leaders feel the answer to financial instability lies in greater international oversight." You bet they feel that. Ever more power to the people who created much of the mess through their regulatory structure has always been a cry of the bureaucrat and, as I have pointed out (she repeats with gritted teeth), those EU leaders do not have to stand up and justify their behaviour to the electorate.

Well, some of them might have to and quite soon, too. Chancellor Merkel is up for re-election next year. President Sarkozy is safe at the moment, though his popularity is not of the highest despite the constant appearance of his ultra-glamorous wife. Prime Minister Brown is still the least popular prime minister for many a long year.

Somehow or other, they and their acolytes in the media assure us that the answer is to fling large amounts of taxpayers' money at this mess, rescue banks who made egregious mistakes, stupid people who borrowed when they had no idea how they would pay back the loans, and the hides of politicians who have contributed to this mess.

Do we actually know that Europeans or, rather British, Germans and people of the Benelux want their taxes to rocket to finance the bail-out packages? Oh well, who cares? They are merely peasants whose job it is to feel gratitude that their betters take such good care of them. Except that even peasants have been known to riot over taxes and there has been the odd revolution or two in European history.

Do we know for certain that all businesses are happy with the idea of more government control? But then, we are ruled by people who instinctively hate businessmen and women; we have a media who, with very few exceptions such as the economic journalists of the Times and the two Telegraphs, routinely lambast the most important people in our economy - the City financiers; and we have a public that repeats the ignorant, envious, poisonous rubbish that the politicians and the media feed them. Still, that same public will not like it if the despicable financiers stop bringing in the lolly and taxes go higher and higher to pay for all that "international" regulation.

Above all, we are told, partisan decisions are wrong. There must be a consensus in order to save the financial system and the European banks. Of course, a consensus has to agree on somebody's idea and it is just possible that not all parties and politicians agree. What should they do if they think bailing out banks through taxpayers' money and even more oversight from international and transnational organizations will make the situation worse? If they oppose it they are cursed as contemptible partisan politicians; if they go along with it they find themselves supporting activity that they know to be harmful. On the other hand, if they choose the second option they will be praised for taking part in consensus politics.

It so happens that the outcome of consensus politics has been displayed once again in Austria this week-end.

The governing coalition between the center-left Social Democrats and the conservative People's Party collapsed in July after a shaky 18-month alliance that hit snags over tax reforms and EU policy changes.

Two rightist parties — the Freedom Party and the Alliance for the Future of Austria — won a combined 29 percent in Sunday's balloting. Both parties advocate an end to immigration and the expulsion of foreigners and asylum seekers who commit crimes.

In contrast, the People's Party and the Social Democrats had their worst showings since World War II.

Despite some news of probable far-right vandalism the truth is that the people of Austria have expressed more than anything else their dislike of that cosy consensus they have been fobbed off all this time; the consensus that is being presented to us all and the Americans as being a superior political system.

The response to the people's vote was predictable. The President has reappointed the government as caretaken, though this, as Forbes points out, is standard procedure in a country where every government has to be a coalition.

More to the point, as Wiener Zeitung reports, the broad left-right coalition that collapsed in July and has been defeated in the election, is being reconstituted under a new leader of the "conservative" People's Party, Josef Pröll. Right. So that's all that vote was about - a new leader for the disliked People's Party.

Political analyst David Pfarrhofer said a remake of the centrist coalition would have to show significant differences from the last to convince a public that came to despise it over the past two years. "Above all, the style has to change. There is a lot of discontent. People don't want quarrels, they want a government," he told Austrian radio.

The main parties have been hit by voter frustration over their bickering and concern at a looming economic downturn, inflation and immigration -- a mix which allowed the far right to make significant gains. But Pröll's appointment could mark a fresh start for the conservatives.

It is, of course, entirely possible that the people of Austria would like the political establishment to listen to what they are saying, which is clear enough. They do not like the ruling coalition and do not want it to govern. But what do they know? They seem dissatisfied with the consensus and that makes them baddies - almost as bad as those terrible partisan politicians in the United States who pay attention (sometimes) to the electorate.

As Edward Lucas says in today's Daily Telegraph, that cosy post-War consensus is coming to and end in many European countries and it is not necessarily a bad thing. Consensus is the antithesis of real democracy.

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