The elephant dives for cover

Thursday, October 02, 2008

The elephant dives for cover

In a way, it is rather funny, although perhaps in equal measure pathetic, the way stories of great moment are paraded through much of the media with never a mention of that giant elephant looming in the undergrowth.

We refer, this time, to the great Irish Bank Saga, where that oh socommunautaire Irish government has stepped in to give an unlimited guarantee to Irish savers – in breach of EU law, on at least two counts.

The law governing investor compensation is Directive 97/9/EC, known as the "Investment Compensation Schemes Directive".

This directive sets up an EU-wide minimum compensation requirement – currently €20,000 but no maximum. Member states are specifically permitted by the directive to set their own maxima, but subject to two conditions.

Firstly (see recital 15), the EU is concerned about "levels of cover higher than the harmonized minimum within the same territory," leading to "disparities in compensation and unequal conditions of competition between national investment firms and branches of firms from other Member States."

In order to counteract those disadvantages, therefore, those branches have to be "authorized to join their host countries' schemes so that they may offer their investors the same cover as is provided by the schemes of the countries in which they are located."

Secondly, the directive states quite clearly (recital 23), that the cost of financing such schemes must, in principle, be borne by investment firms themselves. Further, it states that the financing capacities of such schemes must be in proportion to their liabilities and then goes on to state that these schemes "must not, however, jeopardize the stability of the financial system of the Member State concerned."

Yet, reviewing the media coverage this morning, you would be hard put to find any reference to this law, much less any mention that the Irish government is in clear breach of it.

We thus get the Irish broadcaster RTE reporting that British banks have complained that the Irish legislation "would distort competition," while the British Bankers' Association is to deliver a letter to the [Irish] Government later today. From that source, and The Guardian we learn that British chancellor Alistair Darling has "approached [Irish] minister for finance Brian Lenihan on the legislation", saying that, "in no uncertain terms that the scheme was a problem for the UK."

And, of course, the BBC coverage is entirely devoid of reference to the elephant in the undergrowth. 

However, it is the Irish Times which gives the game away. It reports that, "British Prime Minister Gordon Brown's office said Ireland's plan to guarantee all bank deposits will be studied by European Union regulators," citing Downing Street spokesman, Michael Ellam, saying: "Where there is a policy of one of the member states that impacts on single market rules, it is to be looked at by the European Commission."

But even Mr Ellam does not seem to have got the point. This is not [just] a matter of "a policy … that impacts on single market rules." The Irish move is in breach of specific provisions of an existing directive.

Bizarrely though, the elephant is keeping its head down. According to theIHT, EU competition commissioner Neelie Kroes "declined to criticize the Irish move outright," although she "noted that the Irish had failed to coordinate its move with other EU members."

All we thus get is the anodyne statement that, "Her office said it would investigate whether Ireland was guilty of unfair practices," and a little whimper from the corner. "I would like to plead to national governments," she says, "not to act unilaterally, but rather to continue their practice of consulting the (European) Commission when they are confronted with problems that may require state aid to the banking sector."

Then we get Ireland's own EU representative, financial services commissioner Charlie McCreevy, suggested that his colleague was being unrealistic. Governments like Ireland "don't have the luxury of waiting forever and a day to make up their minds about critical matters," says the former Irish financial minister.

It is almost as if the elephant, having dumped its pile of ordure in the room, is hastily retreating and denying responsibility for the mess. And, as usual, everyone is ignoring the smell.

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Senate has passed (a somewhat different) Bill

House will vote on Friday. Instapundit has a comment and Powerline argues against a House approval. Don't let them tell you it's rescue package. It's a bail-out and the American taxpayer will pay and pay again. When they have to pay over the odds, we all suffer. That's before our own government, the European Union, starts introducing its own bail-out packages.

Let us be happy at the opportunity we have been given of saving a system that clearly does not work, reckless banks, people who borrow knowing they cannot pay it back and the sorry hides of politicians who have helped to create the system.

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The heart of the crisis

A number of British newspapers have picked up on the US "mark to market" story. Bizarrely, though, none cross-link the story with Cameron's speech on Tuesday.

One of the very small crowd is The Daily Telegraph which headlines, "Financial crisis: SEC cheers finance companies with mark-to-market ruling".

Writer Jonathan Sibun then tells us that the Securities and Exchange Commission brought some much needed cheer to the US financial sector after issuing accounting guidelines that could help curb the billions of dollars of writedowns reported by the country's leading banks.

The US regulator, according to Siburn, has told banks that despite fair-value accounting regulations they did not have to use only fire-sale prices to value bad assets but could also use their judgement.

What is really interesting though is the response of the New York Stock Exchange, which conjured up a "late rally" leaving the Dow Jones index up 485.2 to 10850.7 and the S&P 500 up 58.3 to 1164.7, its biggest one-day rise in six years.

As background, Siburn tell us that: "Fair-value accounting requires companies to value their assets at current market prices." He adds that, "Banks have been forced to push through billions of dollars of writedowns in recent months after valuing assets at the same prices raised by ailing companies undergoing last-ditch sale." Thus, we are told that the SEC move effectively allows banks to switch from mark-to-market accounting to hold-to-maturity accounting.

Actually, one of the value of forums and engaging on blog comment section is that these lazy assertions are challenged, prompting more research.

The problem, per se, is neither "mark to market" (or "marking to market" as Cameron inexpertly put it). Nor is it that other jargon issue: "fair value accounting". As Wikipedia helpfully tells us, both accounting devices developed among traders in the 19th Century. There is nothing new about either.

Where the problem lies is in the extraordinarily laborious system of risk assessment, combined with a requirement to structure different types of asset, giving rise to entirely artificial under-valuation, which is the current cause of the bank liquidity problems.

It was this system which emerged from the Basel II process and which was adopted by the United States, the EU and other financial administrations.

Interestingly, the inherent problems with the system were recognised months before the Basel II agreement was signed, when in January 2004, none other than the Financial Services Authority noted: "There's a potential that the capital requirements for some banks and investment firms could rise during a slowdown in economic activity, at the same time that asset values are reduced and mark-to-market losses are incurred."

This is the precise problem that the US authorities have addressed and to which Cameron referred on Tuesday.

It now emerges that EU financial services commissioner Charlie McCreevy was fully aware of the problem in March 2008 when, in front of the Chartered Insurance Institute in London, he questioned the "mark to market" rule, asking whether it was: "always the correct rule when it comes to illiquid assets - or to liabilities for that matter." He continued:

Does it make sense for example that the worse the credit or liquidity risk attached to a company's bond liabilities gets, the greater the boost to that company's balance sheet net assets becomes, as the "mark to market" value of those bond liability falls? Are the "mark to market" rules having unintended consequences especially in these times of turmoil?

It was then that he announced that he was calling for an "analysis" of the issue in order to "draw the lessons from the use of 'mark to market' in the light of current market conditions."

Yet, nothing of this percolates the Telegraph story, even though the very same rules that applied to the US until yesterday still apply to the UK and all other EU member states. All we get is the bland statement that, "Nicholas Sarkozy, the French President, is expected to call for a relaxation of fair-value accounting regulations in Europe…".

We do not even get that much from The Guardian, which is another paper to cover the story. It offers the headline, "SEC gives banks more leeway on mark-to-market," but has nothing on the EU dimension and, like theTelegraph fails to make the Cameron link.

The Times, on the other hand, does frame its story on UK experience, oddly not referring to Cameron either. It tells us that:

The heavy losses that many banks have taken on these assets have seriously weakened their balance sheets, forcing them either to raise more capital or rein in new lending. A number of leading banks have pressed for a suspension of the mark-to-market rules. But others, notably Goldman Sachs, have argued strongly against.

The critics say that such a move would be very dangerous and point to the experience of the US savings and loan crisis, in which the lack of such accounting rules meant that the insolvency of scores of lenders went unrecognised for a prolonged period with very costly consequences.

But if it would be dangerous to scrap fair-value accounting permanently, that does not mean it should be ruled out as a temporary emergency measure. If the American bank bailout plan fails, it should be seriously considered.

Then the great Anatole Kaletsky has a go. He informs us:

In recent years, however, accountants and regulators have replaced such probabilistic judgements of economic fundamentals with a principle called "mark to market". Under this new approach, promoted passionately by conservative financiers and academics who believe that "the market is always right", banks base their profits not on how much income they expect to receive in the future but on how much money they could raise immediately if they sold all their loans and mortgages in the market at the best price they could fetch.

This reform didn't make much difference when markets were working smoothly and financial prices reflected long-term asset values. But in the wildly volatile and panicky conditions of the past 12 months, mark-to-market accounting has contributed hugely to the crisis.

That last sentence ties in exactly with the warning given by the FSA in 2004 and so the conditions have come to pass where the banking system is frozen into immobility by a system devised for the good times, and which is wholly inappropriate for the current crisis.

What is so bizarre about all this is that the MSM around the world is full stories about the freezing of London inter-bank lending – the so-called Libor system.

There can be no doubt of the severity of this aspect of the crisis. The Sidney Morning Herald - to name but one newspaper – is noting that the market is seizing up but, like so many, is missing the real cause and putting the reluctance to lend down to "trust" – something completely dismissed by Prof. Peter Spencer. Thus, says this paper:

All the banks are hoarding their cash, bolstering their balance sheets so they can settle their own obligations. They won't let the cash out of their sight. The total disintegration of trust and confidence is feeding on itself and the disaster scenario is, according to some observers "the mother of all bank runs" should foreign banks panic further and pull their money out of the US system.

Not one media organ has put the whole story together, linking this seizure with Basel II and the EU's implementing directives, the heart of this current phase of the crisis and the very mechanism that prevents it being solved.

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Wednesday, October 01, 2008

A short rant ....

... over on BrugesGroupBlog. Never let it be said that I pollute this blog with ranting.

A dark and dirty game

Even as of today, The Daily Telegraph is asking why parliament is not being recalled to discuss the financial crisis.

Certainly, by contrast with Congress where, as my co-editor observes, we have seen democracy in action, naked in tooth and claw, the quiescence here of the political classes seems a little odd.

In truth, though, there is very little point in parliament reconvening. As is gradually emerging, there is very little it can do as the main levers of powers, with which to address the crisis – as Cameron hinted at – have passed to Brussels.

That much is an indication of how the wider debate is gradually turning. Although the MSM is still largely wedded to the idea that our government is still in charge, here and there we some recognition.

Over the weekend, we saw some comments on blogs, denying that there was any EU involvement in financial regulation. Now, we see grudging admissions, but with the proviso that the regulation is "a good thing" and, in any case, the UK is not only supportive but also a leading player in pushing for EU regulation – something which is largely true.

Soon enough, the reality might dawn on some commentator in the MSM, although so far, all the Telegraph can manage is a letter from a reader pointing out some of the EU involvement.

The reality is, of course, complicated. Financial services legislation is currently in transition between legacy rules and structures devised by member states, and new EU laws, imposed under a wide-ranging programme. Already, we have had the Financial Services Action Plan (FSAP) which was set for 1999-2005 (but has somewhat over-run).

The plans for 2005-2010 have already been set out in a White Paper and the latest state of play can be found in the 2007 European Financial Integration Report.

Although the EU has made no secret of its ambitions, it is nevertheless in no hurry. It fully appreciates the complexity of financial services and has not hitherto had the structures in place that could wholly supplant national systems of control and regulation.

Part of that stems from the lack of homogeneity within the EU itself, with its multiple institutions including the ECB, the EIB. the EU parliament, the Council and the commission. Even within the commission itself, responsibility is split, between Neelie Kroes's competition directorate and Charlie McCreevy's financial services directorate.

The EU has addressed that problem, in part, by setting up and Inter-institutional Monitoring Group (IIMG), which has a mandate to bring all the parties together and make sure they are all singing from the same hymn sheet.

In addition, behind the scenes, the EU has been setting up its own complex of regulatory and advisory structures, progressively to take some of the day-to-day load of the commission. 

Leader of the pack is the Committee of European Banking Supervisors, of which few people are aware but it is an official EU body set up by acommission decision in November 2003 to "fulfil the functions of Level 3 Committee for the banking sector in the application of the 'Lamfalussy' Process."

As well as that body, there are also – as the commission helpful informs us - the Committee of European Insurance and Occupational Pensions Supervisors, the Committee of European Securities Regulators, European Insurance and Occupational Pensions Committee and European Banking Committee. 

All of these bodies are part of the regulatory and advisory structure which helps "to ensure consistent implementation and enforcement of rules across the EU," and which will eventually form the core of the integrated European financial services regulatory apparatus.

At international level there are already the established bodies such as theBasel Committee on Banking Supervision, the World Bank, the International Monetary Fund and the OECD. What we are seeing there is that, increasingly, either directly or through the ECB, the EU is assuming the role of the lead player, representing the member states and thus taking over their negotiating roles on the basis of a pre-determined "common position". 

Gradually, but inexorably, therefore, the EU is moving its troops into place ready for the final take-over, but even then it has no definite timetable for the final push. As we said, it is in no hurry.

Thus, in the current crisis, the EU is keeping its head down. While legacy regulations and systems still form a considerable part of member state capabilities, the commission is distancing itself from the crisis, declaring that the responses are down to the member state governments.

That is only true to a point but, by downplaying its own role, the EU – and especially the commission – can point to the chaos and uncertainties in the system – and argue for a more "coherent" EU approach.

This is precisely what it is doing with today's announcement, re-warming already existing plans in the hope of capitalising on what for the EU has become yet another "beneficial crisis".

However, benefit will only accrue if the public in general do not realise quite how much the agenda is already dictated by Brussels and how much a hand they have in current regulation.

EU financial services commissioner Charlie McCreevy (pictured), therefore, is playing that game, constantly emphasising that it is for member state governments to solve the crisis, then offering a package of already planned measures, given a "populist" spin to meet the mood of the moment.

He readily admits, though, that the proposals would not solve the current banking meltdown. They should strengthen market confidence and banks' resilience when they come into effect in two years' time, he says, illustrating the long-term view being taken by the commission.

He is, of course, supported by his boss, José Manuel Barroso who is glibly "stressing" that the European Union needed "to inject credibility in the European response." This is why, he said, "we are asking and urging member states for closer cooperation," putting in comfortable, neutral terms.

Meanwhile, David Cameron, who yesterday told us that "We need to understand how this [the financial crisis] happened, and how we're going to get out of the mess," then promising: "I will address those questions in my speech tomorrow," failed completely to do so in his speech today.

The "elephant", briefly paraded before the audience in Birmingtham yesterday, is very firmly back in its pen and nobody is saying nuffink. But that does not mean that the looming presence of the EU has evaporated. It is there for anyone with eyes to see and the will to look.

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No shortage of warnings

Mark Wadsworth draws our attention to the Institute of International Finance, reported in The Financial Times on 4 April 2008.

The IIF then said there was an "urgent need" for policymakers to consider changes to mark-to-market accounting rules to avoid "unintended procyclical consequences which could prolong credit market problems".

It is now 1 October. The US is just beginning to act and the EU is to "look" at the problem on 15 October. That's "urgent" for you!

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