In November 2014, the European Commission (EC) announced a flagship project to build a deeper and more integrated capital market among the EU28 countries – named Capital Markets Union (CMU). This blog takes a closer look at the motivation behind this project, its key elements and perhaps most importantly which financial institutions (FIs) stand to gain – and lose – from it.
Why a Capital Markets Union?
For much of the EU, the financial crisis of 2008 was followed by a growth crisis – output is pretty much flat, unemployment remains high, and investment is falling. Hence, boosting growth and creating jobs are top priorities for European policymakers with small and medium-sized enterprises (SMEs) as well as infrastructure projects having been identified as key conduits for achieving these goals.
Enabling SMEs and infrastructure projects to expand within the EU relies on widening their funding opportunities, which so far have been largely limited to bank lending.
Compared to the US, European firms’ funding structure relies mainly on bank lending – about 75% of total debt financing comes from banks, with even higher bank dependency in individual countries.
Such centricity on banks has proven detrimental to the broader economy as wave after wave of regulatory reform—including new capital requirements and increased risk-weightings—have tightened lending capacity significantly over the past few years. Therefore, creating new and reinforcing existing alternative channels of funding to SMEs and infrastructure projects lies at the heart of the CMU effort.
Alternative funding channels mainly center on the equity and corporate bond markets—which, again compared to the US, are clearly underdeveloped in the EU. Equity market capitalization among the EU 28 is only about half of that in the US, and financing through corporate bond markets is at a third of the US level.
Key Elements of the Capital Markets Union Effort
The above comparison between the EU and US capital markets must be understood against the backdrop of Europe’s lively diversity of currency, fiscal policy, tax rules, language and regulatory structures – all driving what is known as “home bias”¹.
A realistic key goal of the CMU, voiced by several stakeholders, would therefore be to increase the EU capital markets’ share of debt financing by 10 percentage points, from currently 25% to 35%. To achieve such a goal, a number of measures need to be taken, e g:
- Increasing Europe’s stock market capitalization from around 75% of GDP currently to 100% of GDP
- Doubling European issuance volumes of securitization and private placement by encouraging greater participation from non-bank investors
Framework for Action
Three pillars of the CMU have been suggested to start building a framework for action.
1. Supply Side
On the supply side, developing more efficient and liquid markets for financial instrument issuance including measures like
- Introducing high-quality SME securitizations in parallel to a review of the currently harsh capital requirements,
- Reviewing the prospectus directive for SMEs to reduce documentation demands
- Changing the tax regime for SME equity to remove the current bias towards debt.
2. Demand Side
On the demand side, harnessing long-term savings to drive investment, including measures like
- Re-calibrating the capital requirements framework for institutional investors to encourage long-term investment into Europe’s capital markets
- Harmonizing EU insolvency rules to facilitate SME restructurings (rather than forcing liquidation)
- Widening the product choice for investors
3. Capital Markets
Promoting an open, integrated capital markets infrastructure, including measures like
- Driving closer integration of clearing and settlement systems to reduce cost and facilitate cross-border investments
- Introducing a new securities law to clarify collateral ownership to provide safety and trust for cross-border investments
- Ensuring broad yet affordable access to real-time market data to improve transparency of SMEs and infrastructure projects
And the FI Winners Are…
It is not hard to guess that a successful implementation of the CMU would significantly strengthen the position of institutional investors, like insurance companies, pension funds and sovereign wealth funds – also referred to as non-bank financial institutions (NBFIs) – vis-à-vis banks.
Although NBFIs have traditionally turned to government bonds for returns, the current low-interest-rate environment has forced them to look energetically for other capital market opportunities to generate the returns needed to meet their long-term liabilities.
So far, Solvency II and other regulatory restrictions, external as well as internal, have kept NBFIs largely outside lucrative and long-term SME and infrastructure project funding – a situation the CMU could significantly change.
Winners normally face new challenges in their glory, and this case is no exception. Are insurance companies and pension funds properly equipped to control and deal with the risks of investing into SMEs or infrastructure projects?
Moreover, as insurance companies and pension funds establish a growing presence as investors/lenders to the SME and infrastructure sectors it is not unlikely that the “shadow banking” flag will be raised, followed by demands for stricter regulation of the NBFIs. Are they willing to undergo the same detailed scrutiny that banks already suffer on a daily basis?
Finally, what about our noble losers, the banks? If and when the CMU comes into play, banks seem very likely to face tougher competition from NBFIs – also outside of the SME and infrastructure project realm, hitting the banks’ remaining “sweet spots”. This is probably a realistic threat not only from local NBFIs, but also for those institutional investors venturing cross-border to a larger extent to find good investment opportunities.