The EU's role in our financial crisis
By Christopher Booker
Last Updated: 12:01am BST 05/10/2008

As the Western world's banking system teeters on the edge of collapse, one
crucial factor in this unprecedented crisis has gone almost entirely unnoticed -
although David Cameron made a veiled reference to it on Tuesday.

At the heart of this catastrophe lies a drastic change made last year to banking
regulations, which has led to the current freezing of the money markets. Without
it, most of the banks that have collapsed, such as Lehman Brothers, might have
survived.

Last December, a leading City economist, Professor Peter Spencer of Ernst &
Young's Item Club, warned that unless something was done urgently to modify the
new rules, the resulting paralysis of the banking system would "make 1929 look
like a walk in the park".

Last week, as his prediction seemed to be coming true, the US was moving to
change the rules. But in the EU they are enshrined in a directive which could
take months, or years, to unpick.

In 2004, partly in response to the Enron debacle, the world's leading economic
powers made an agreement known as Basel 2.

It proposed a drastic tightening of the so-called "fair value" or
"mark-to-market" rules, whereby banks and other financial institutions define
whether they are solvent and fit to continue trading. Brussels, which is fast
taking over regulation of our financial services, embodied this in two
directives, 2006/48 and 2006/49, known as the Capital Adequacy Directive.

Much of this lays down a complex "Risk Assessment Model", under which a bank at
the end of each day's trading must produce a statement of its assets to show
whether or not it is solvent. If not, the bank must declare this to the
regulatory authorities, such as Britain's Financial Services Authority (FSA),
and cease trading.

As informed observers pointed out at the time, this might not cause problems
when property and share values were rising but when markets fell the banks would
be put in a critical position.

Writing down their assets to the value they would fetch in a "fire sale",
without allowing for underlying value or future recovery, their asset base might
be so severely undervalued that it would be difficult for them to lend or
borrow, freezing those deals which are the banking system's lifeblood.

At worst, though technically solvent, they would have to close their doors.

Since the credit crunch began last year, this is precisely what has happened.
Another City economist, Professor Tim Congdon, warned in January that the
"scientific precision of the Basel rules" had been shown to be "hocus pocus",
explaining how this had already played a key part in the collapse of Northern
Rock. As a "solvent but illiquid bank", wrote Prof Congdon, Northern Rock's only
hope was to appeal for help to the Bank of England.

In former times, as the Bank's governor, Mervyn King, tried to explain to the
Treasury Select Committee in September 2007, he could have sorted it out behind
the scenes, in a rescue operation involving other banks - as had often been done
before.

But Mr King was hamstrung by EU legislation, such as its directives on takeovers
and "market abuse", as shown by Prof Congdon in a devastating pamphlet, Northern
Rock and the European Union (published by Global Vision). The EU's role makes
nonsense of the claim that Britain's financial regulation is a "tripartite"
system - Bank, Treasury and FSA.

In reality it is quadripartite, with Brussels the fourth and in many ways most
important player, as we saw when subsequent attempts to sort out the Northern
Rock shambles fell foul of EU competition and state-aid rules.

As Ron Sandler, Northern Rock's chairman, said when it was nationalised, "the
bank will have to operate according to rules set in Brussels". Because the EU's
competition commissioner, Neelie Kroes, failed to grasp the difference between a
loan and state aid, one of her first requirements was that the bank should sack
2,000 employees as evidence that it was being "restructured" .

Thus the EU has become the gigantic "elephant in the room" of our financial
services industry, on which a third of Britain's income depends. Nowhere is the
effect more damaging than in those directives implementing the Basel 2 agreement
(actively promoted by Britain at the time) that have reduced our banking and
lending system to paralysis.

When Mr Cameron admitted last week that a "new international regulation" which
"automatically downgrades the value of banks" was "making the financial crisis
worse than in previous downturns", he did not dare risk inflaming his party's
Eurosceptics by referring to the EU directly. He merely coyly suggested that
"our regulatory authorities" should get together with "the European regulators"
to "address this difficult issue".

He did not point out that, as the US Securities and Exchange Commission was
abandoning the new rules (supported by the bail-out bill before Congress), all
we have to look forward to is that Gordon Brown, after his "crisis summit" in
Paris yesterday, will air this "difficult issue" at the European Council on
October 15.

Even if they decide to follow the US lead, it would entail the tortuous
procedure of the Commission drafting a new directive, which could take more than
a year. Meanwhile Europe's banking system remains frozen, threatening no one
more than Britain - for reasons that none of our politicians dare explain.