Sunday, October 12, 2008

They've known it all along!

As previewed last night, we have discovered cast-iron evidence that the EU commission has known for at least a year that there have been disastrous "shortcomings" in its system of financial regulation. This system includes the measures for the application of the "mark to market" rules which lie at the heart of the current banking crisis.

The commission has also known that changes to the system were urgently needed to prevent a repeat of the "market turmoil" of the summer of 2007. Yet, despite a massive effort, it has only just been able to deliver drafts of these vitally needed changes.

What is particularly damning though is that the commission is actively hiding its part in what amounts, probably, to the most serious regulatory failure in the history of mankind – certainly the most expensive.

To avoid having to admit openly that its own regulatory system is at fault, it sneaked out its changes to the legislation earlier this month. Amid a barrage of deliberately misleading press coverage, it sought to camouflage the amending laws by blending them in with a raft of long-planned and well-signposted additional laws.

The changes the commission is proposing directly address – in its own words - the "shortcomings" in the law officially known as Directive 2006/49/EC – the "Capital Adequacy Directive". It is this that we pinpointed as the major cause of the current meltdown in the financial services industry.

To confuse matters though – we think intentionally – the commission has since unofficially relabelled this law and its partner in crime, Directive 2006/48/EC, collectively as the "Capital Requirements Directive" (singular). This means, amongst other things, when you google the official title, this one does not show up.

The commission proposals are included in a 45-page draft EU parliament and Council amending directive. This aims, inter alia, to correct and improve the rules on the crucial area of "crisis management market value" – at the heart of the current crisis.

This document is accompanied by two other highly technical "Commission Directives", one 14 pages and the other 7 pages, plus a 148-page impact assessment document.

Had the commission openly admitted its "shortcomings", there is an outside chance that the media would have picked up the story and made an issue of it. And, in this febrile climate, with the hunt for scapegoats in full cry, this could have been highly damaging to the EU.

Thus, in what has all the hallmarks of a carefully orchestrated deception plan, the documents were slipped out into the public domain, the clear intention being that they should not be noticed.

This sleight of hand took place on 1 October, three days after David Cameron had given his unscheduled speech to the Conservative Party conference in Birmingham, calling for the changes which the commission is now addressing.

In what was clearly part of the deception – effectively a variation of "hiding in plain sight" the publication of the new commission proposals was announced at a press conference in Brussels on the afternoon of 1 October.

Fronting the deception was financial services commissioner Charlie McCreevy. Using the newly-minted and misleading "Capital Requirements Directive" title, he launched into a dense, highly technical speech. It was entirely misleading in its content and bore no relation at all to the nature of and primary reasons for the changes. It succeeded in throwing the bored journalists off the scent.

To accompany the speech, the commission had to produce a press release. This is routine and not to do so might have aroused suspicions. Thus, the convention was followed and, in due course, one appeared on the commission "rapid" press website.

This was slightly more revealing, but so densely worded that it was (and is) easy to miss the crucial detail. We looked at it on the day, and several times afterwards, and missed its significance – as was no doubt intended.

Interestingly, this was accompanied by an opaque memorandum, which was very obviously part of the plan. This purported to deal with the changes the commission wanted to make. It was set out in the form of a "frequently asked questions" explanatory note. But it made no direct reference to commission's changes. Instead, it told a direct lie. "The proposals to change the banking rules," it said:

… may be useful for strengthening market confidence and institutional resilience in more stable periods. However, the proposed measures will come into effect in about two year's time and will be way too late to have any impact on the current meltdown of the financial system.
Only later, on the official "Single Market" website did we finally see the commission declaring, with unexpected candour, the real nature and reason for the amendments. This was set out a little way down the page (screen-grab below):

In text, this read: "The Commission has adopted a proposal to amend the CRD in certain key areas. These amendments address the shortcomings in the current regulatory framework and are a direct response to the financial turmoil."

It is the "explanatory memorandum" to the draft Council and Parliament directive, however, which completely gives the game away. It states: "The revision … has been prompted by the financial market turbulence that started in 2007 and is aimed at ensuring adequate protection of creditor interests and overall financial stability."

As to the other two draft Commission Directives, "Amending certain annexes to directive 2006/49/EC of the European parliament and of the Council as regards technical provisions concerning risk management," the very titles tell you what is going on. This is what has been the problem all along – the "risk management" model associated with "mark to market" that artificially under-valued sound assets, drastically reducing the liquidity of the banks.

If there could still be any doubt, but one part of the main amending directive nails the nature and purpose into place with "point 6.4.5" on "Liquidity risk (Annexes V and XI of Directive 2006/48/EC)". It tells us that:

The current market turmoil has highlighted the fact that liquidity is a key determinant of the soundness of the banking sector. The proposed changes implement the work conducted by CEBS and the Basel Committee on Banking Supervision to develop sound principles for liquidity risk management…
This section, in particular, addresses exactly the current problems with "mark to market", not in respect of the actual system of calculating "fair value" but in the risk assessment model, and the way the accounting system is implemented.

Giving the lie to the claim that "the proposed measures will come into effect in about two year's time and will be way too late to have any impact on the current meltdown of the financial system," the press release itself notes that the proposed amendments are, in part, "a response to the recent recommendations of the G-7 Financial Stability Forum."

It further notes: "The European Council has expressed a strong sense of urgency emphasising that the measures should be adopted by April 2009."

The amendments have been sent out for consultation with a closing date of 15 October – an incredibly short period for such complex documents - totalling over 200 pages of highly technical detail and, with an adoption set for April 2009, this in EU terms, is moving at warp speed. The measure is clearly being fast-tracked through the system, to emerge in what is probably the shortest period that it can get through the labyrinthine procedures.

All the evidence is, therefore, of an emergency measure being rushed through at breakneck speed (in EU terms) to "address the shortcomings in the current regulatory framework" in "direct response to the financial turmoil."

Finally, the "impact assessment" puts to bed any lingering doubts anyone might have about the role of EU law in the implementation of the Basel II agreement. The history is all set out:

Financial markets are crucial to the functioning of modern economies. Their integration is critical for the efficient allocation of capital and for long-term economic performance. Enhancing the single market in financial services is a crucial part of the Lisbon Strategy for Growth and Jobs and essential for the EU's international competitiveness.

The Financial Services Action Plan 1999-2005 (FSAP) aimed at reinforcing the foundations for a strong financial market in the EU by pursuing three strategic objectives:

  • ensuring a Single Market for wholesale financial services;

  • open and secure retail markets and

  • state-of-the-art prudential rules and supervision.

  • Together with some other 40+ measures of the plan a review of the legislation governing the capital framework for credit institutions (banks) and investment firms was undertaken in order to align it with market developments and work of the G-10 Basle Committee on Banking Supervision (the Basle Committee).

    The then existing European legislation, the Consolidated Banking Directive 2000/12/EC and the Capital Adequacy Directive 93/6/EEC, was based on the Basel I Accord of 1988 and the Basel market risk amendment of 1996. To keep up with the developments in the market, the latter were updated with final proposals for the Basel II Framework in June 2004 and the Trading Book Review in July 2005.

    The "new" Basel agreement was reflected in the EU as a new capital requirements framework that was adopted in June 2006 as the Capital Requirements Directive (CRD); this comprises Directives 2006/48/EC and 2006/49/EC.
    Yet never once has the commission, any commission official, or the government of any member state – and especially Gordon Brown and his chancellor, Alistair Darling - ever openly admitted the depth of EU involvement in our financial regulatory system.

    Nor for that matter has leader of the opposition, David Cameron, given any clue of the presence of this "elephant in the room", despite many references to the Basel agreement, not least this one in March, where he correctly identified the problems associated with the agreement.

    Crucially though, not only has the commission failed openly to mention that there were "shortcomings in the current regulatory framework", neither has the British government. Nor has it acknowledged the rush attempts by the commission to rectify matters. It had that opportunity on 8 October, when shadow chancellor George Osborne brought up the issue of "mark to market" in Parliament - when he was obviously unaware that his concerns were being addressed by the commission, albeit with glacial speed.

    The point, of course, is that had the original Basel II agreement been implemented directly into the British legal code, rather than through the medium of EU Directives, the "urgent" changes so vitally needed to clear the logjam in the banking system could by now be in place in the UK.

    But, locked into the EU, we are trapped. Such is the complexity of the EU law-making process that, even despite the "strong sense of urgency" expressed by the European Council, it will be six months before the commission's proposals become EU law. It will then be some months more before the results can be transposed into British and other member state law.

    Furthermore, the process itself, which led to these amendments being sneaked out on 1 October this year, was actually set in train on 9 October last year. It was then that the finance ministers of the 27 member states met to review the previous summer's market turmoil following the US sub-prime mortgage crisis.

    The finance ministers then agreed on a "15-month road map" for "reviewing the bloc's financial rules" in order to avoid a repeat of that "market turmoil", a repeat they have singularly failed to prevent.

    That the new proposals have been rushed out, not fifteen but twelve months later demonstrates with utmost clarity the desperate urgency of the situation, But, from start to finish, it will still have been well over 20 months before the vital changes are in place.

    The tragedy is that we have suffered an entirely preventable financial meltdown, with the current legislation having magnified the effects of structural failures in the banking sector, turning a serious problem into a disaster.

    The very worst of it all, though – apart from the commission's refusal to come clean about its own failures – is that, if we still had a sovereign government, even at this late state we could take corrective action. As it is, we have eight or nine months to wait, by which time the additional damage will be incalculable.

  • Other posts on the financial crisis here.