A dark and dirty game

Wednesday, October 01, 2008

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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We get what we deserve

To judge from the US press – which has "exploded" with news and discussion on the "mark to market" rule – David Cameron should be congratulated for yesterday putting his finger on the one issue which, in the judgement of an increasing number of experts, is wholly responsible for perpetuating the current financial crisis.

Putting this into perspective, one only needs to quote the Wall Street Journal editorial. It says, "Mark-to-market accounting rules have turned a large problem into a humongous one." Many experts, Congdon included, are attributing this rule to the failure of Northern Rock, Lehmans and, most recently, Bradford and Bingley, all of which were solvent by traditional accounting rules and need not have gone down.

The problem having been identified in the US, the responsible authority, the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB), which sets U.S. accounting rules, have moved with speed to "clarify" the rule, bringing comment from The Washington Post, theLA Times and hundreds of US media outlets.

There has been discussion on all the main US TV channels and the US blogs have been hosting a storming debate about the rule, its meaning and what needs to be done about it, with blogs like Powerline offering an example of the type of informed comment for which the best US political blogs are rightly valued.

So intense has been the discussion and interest that now, as the Paulson's "bailout bill" goes back to Congress, a proposal is being considered to scrap the rule altogether. If this happens, by the weekend, "mark to market" will be toast. If the experts are correct, the US banking system will be well on its way to recovery. According to some, it may not even need Paulson’s $700 billion bailout.

So, what of the UK scene?

Despite Cameron's perceptive - if belated - intervention, his exact comments have been retailed in only two mainstream newspapers, The Scotsman andThe Daily Express, without comment or explanation. As for the "political" (or any) UK blogs – apart from this one - my initial search yielded only one which, with unintended irony, tells us:

Finally, he suggested that he would support the government in its endeavours to address the complex issue of "marking to market", a process whereby banks price daily their assets which, it is argued, is causing bank stocks to fall even further. The proposal is that this practice should be suspended. Quite how this would work, Cameron did not explain, therefore, we can assume that it will be challenging or perhaps, not even possible.

The author is dead right when he writes that, "we can assume that it (suspending the rule) will be challenging or perhaps, not even possible", the reason being that "elephant in the room", the fact that "the practice" is locked into an EU directive. Thus, while this issue in the US is being chewed over in 21,390 blog posts under "mark to market", the issue over here is simply not on the agenda. The media and the the bulk of the British political blogosphere are silent. The chatterati don't "do" Europe, policy or anything serious - with the (now) admirable exception of Centre Right.

Despite that, here in "Europe", the government is acting. Not the posturing bunch of fools we have in London, but our real government in Brussels. This we learn from Retuers with a piece published on the net, by Business Day - a South African magazine, for Chrissake!

This piece tells us that the EU will "look at whether mark-to-market accounting rules … could be eased." But that will not be until 15 October, two weeks hence. And, if they do "look", they will not make any immediate decision. For anything to happen, the whole laborious process of EU decision-making must kick in. It could be months, if not years, before anything is changed.

Thus, while Brussels fiddles, the banks burn.

That, more than anything illustrates where politics stand in the UK. Contrasted with the United States, where there are still some vestiges of democracy, the issue is widely chewed over in the public domain. Then, with speed, the authorities and elected representatives react.

In this country, where the power lies with Brussels, discourse is suffocated under a stultifying blanket of deception, so pervasive that the government does not even mention the problem.

We have a leader of the opposition who cannot even bring himself to mention an "EU directive" resorting instead to the euphemism, "international regulation". Nor does he dare to say that we have to go cap in hand to Brussels to resolve the issue but instead resorts to babbling about having "our regulatory authorities, together with the European regulators," address "this difficult issue."

Even what Cameron did say, though, should have sounded the alarm bells – yet nothing. When politicians actually talk about policy and solutions they are ignored. Small wonder they resort to the theatre. That is how they get the attention and the headlines.

The problem lies thus not only with the politicians. It lies with the media, with the bulk of the blogosphere and the rest, who prefer entertainment and trivia to dealing with real issues, real policies and real world solutions. To that extent, we get what we deserve and deserve what we get.

Behave like infants and you will be treated like infants. To see what happens when grown-ups get involved in politics, look to the US – and weep.

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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. This must be read in conjunction with Directive 2006/48/EC, the pair of Directives together implmenting the agreement. 

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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