How Important Is an EU Capital Markets Union to MAPI Companies?
The Great Recession caused significant damage to the developed economies on both sides of the Atlantic. Yet whereas the American economy rebounded early if not very quickly, Europe’s recovery proceeded in fits and starts. Industrial output is fully recovered in the U.S. but is less than 60% recovered in the Eurozone. Such sluggish performance has spurred a search for answers.
Many analysts zeroed in on one area: how capital is allocated through a broad financial sector. A stylized fact, one that has been known for years but rarely noticed outside academia, suddenly emerged as a handy explanation. According to this theory, Europe was “overbanked” compared with the United States and even Japan. Excessive reliance on banks for credit was also blamed for the greater amount spent on bank bailouts in Europe than in the United States. As early as 2011-2012, a chorus of voices suddenly started to advocate for faster development of capital markets at the expense of bank-based intermediation.Examples include reports published by the IMF, Bruegel, and the Journal of Money, Credit and Banking.
The European Commission formally joined the fray and floated a green paper earlier this year. The document opens a policy discussion that is to culminate by 2019 in what the commission calls “the building blocks for a fully functioning Capital Markets Union” (CMU). The definition is imprecise and few admit to knowing what a CMU would be or where its boundaries would lie. In this paper I suggest a list of possible components of such a union and map out their importance to MAPI members operating in Europe. I also assess the chances that components will be in place by 2019 and whether they could materially enhance economic growth across the EU. It is an imperfect exercise that involves far more art than science. The views are subjective and may not reflect the conditions under which MAPI member companies operate.
On any number of yardsticks Europe’s financial intermediation relies more deeply on banks than is the case in the United States. Conversely, American business directly taps capital markets for a greater proportion of its financial needs than EU business does. For example, EU mutual funds hold about only 50% of the value of assets that their U.S. counterparts do. EU pension fund holdings are about 35% of the U.S. level and the respective shares for the EU equity markets are 60%, for the EU corporate bond markets 35%, and for the EU securitization market 20%.John Cunliffe, "Financial stability, the Single Market and Capital Markets Union" (speech, City of London Corporation and Open Europe conference, London, January 20, 2015). The stock of corporate bonds outstanding in Europe is €1.1 trillion compared with €6 trillion in the U.S.An agenda for capital markets union, Association for Financial Markets in Europe, November 2014, www.afme.eu/WorkArea/DownloadAsset.aspx?id=12155.
The commission is particularly concerned with poor access to finance by small and medium-sized companies (SMEs), noting in the green paper that SMEs in the U.S. receive five times more funding from capital markets than their EU counterparts. Relative to the EU, small companies in the United States receive twice the amount of overall funding normalized for size and the market size for private placement of bonds is three times bigger.
We can also observe stagnation in the development of securities markets over time. Figures 1 and 2 document the stock of outstanding bonds, both short term and long term, over the past dozen years (short term is defined as less than a year to maturity while long term is over one year). Debt securities of non-financial corporations are the only ones showing no significant growth in volume.
Figure 1 – Outstanding Amounts of Long-Term Debt Issued by Eurozone Residents
Note: Monetary financial institutions (MFIs) are banks subject to reserve requirements
Source(s): European Central Bank and MAPI Foundation
Figure 2 – Outstanding Amounts of Short-Term Debt Issued by Eurozone Residents
Note: Monetary financial institutions (MFIs) are banks subject to reserve requirements
Source(s): European Central Bank and MAPI Foundation
Devising a Capital Markets Union
The concept of a CMU is not new. Freedom of capital movement was first mentioned in the Treaty of Rome in 1957 and it was formally enshrined into law by the Single European Act of 1986. Nonetheless, capital accounts (cross-border flows of funds other than for payment of current transactions, such as exports) were restricted in most European economies until the Maastricht Treaty in 1992. Even this treaty left in place safeguards through which member states could limit cross-border investments when instability threatened their financial sectors. In an environment where capital was not free to move, the concept of a CMU always remained a slogan without substance.
The CMU proposed by the Commission does not offer quantitative guideposts or a legislative agenda. Nonetheless, the direction of change is clear to see. The share of debt financing through capital markets (as opposed to banks) ought to rise significantly alongside a higher ratio of stock market capitalization to GDP. Faster development of securitization, private placement, venture capital, and managed investing are also explicitly mentioned in the EC paper.
The broader CMU goals include a wider choice of investment vehicles, a greater share of cross-border investment flows, and greater sharing of risk across the EU. When all these elements are in place, shocks that hit the region asymmetrically could be pared down with greater ease as a result of a diversified pool of financial resources.
Table 1 lists suggested planks of a CMU, a ranking of their importance to MAPI member companies, the likelihood that the outcomes could be achieved by 2019, and an assessment of their impact on economic growth. The last point is noteworthy because the motivation behind many recent EU initiatives (a banking union, TTIP, the Juncker Plan) lay in bringing down high unemployment. Efficient allocation of resources drives productivity, which in turn spurs value creation, employment, and income. It is fair to say that many years from now the effectiveness of the CMU will be judged by the state of the economy at that point.
Table 1 – Components of a Capital Markets Union
Source(s): MAPI Foundation
Possible Priorities for a Capital Markets Union
A fully fledged banking union (including fully centralized supervision, resolution, and deposit insurance) would greatly support a capital markets union for obvious reasons. Yet a complete banking union is unlikely to be operational by 2019. For one, the opposition to setting up a common pool of deposit insurance runs deep in many countries, including Germany. The centralized supervision excludes a large number of financial institutions while the resolution regime relies heavily on bail-ins (losses suffered by creditors as opposed to public involvement). The importance of a banking union for MAPI members appears small. Large American companies that operate in Europe often draw on their own cash pools that span diverse jurisdictions and currencies. A far more imperative growth barrier to these companies is the lack of a common market. The often divergent norms and standards result in the expensive adaptation of products destined for different countries. Access to bank credit is not an explicit barrier to operations.
Consumer and investor protection has been on the EU agenda for some time. In 2008, the EU Commission adopted a Consumer Credit Directive that offers transparency and fair disclosure to those seeking credit. A slew of previous directives dealt with unfair terms, distance marketing, and unfair commercial practices, among other issues. These measures unify the initial approach to lending but do not offer unified and centralized conflict resolution. The ultimate liability continues to rest with national law enforcement. Investor protection laws make sense when there are pan-European investment products and pan-European investors to protect. MAPI members are unlikely to benefit from this approach because few consumers seek financial products in support of cross-border purchases of MAPI-sourced merchandise.
A home bias in demand for financial products is defined as a strong preference for financial products issued by residents. Examples include local bank accounts, credits drawn, and shares purchased through domestic intermediaries. At present, home bias is heavily entrenched on account of tax laws, securities regulations, and long-running traditions—all of which are national in character. Such bias is a drag on growth because capital does not flow freely from where it is abundant to where it is in high demand. A better allocation of capital would spur faster growth. It will take decades to narrow just the differences in national preferences. For example, Germans largely stick to local savings banks and opt for deposits while eschewing homeownership and share investing. Britons, on the other hand, embrace credit sourced from large banks and are open to investments in international mutual funds, often taking the currency risk along.
A home bias in supply describes a preference for borrowers to issue domestically. Sovereigns and large corporates borrow internationally but the scale remains small. Some institutions specialize in selected products such as credit cards, mortgages, and derivatives but rarely venture outside their home jurisdiction. This has to do with the uncertainty of legal protection and possible cross-border liability. As with demand, the home bias in supply is a drag on economic growth. MAPI members would welcome a greater ability for their European subsidiaries to borrow internationally as opposed to tapping only national markets. Yet such a change appears remote without laws authorizing the standard acceptance of products across the entire EU. A unified enforcement of contracts is also a prerequisite.
Varying levels of statutory corporate income tax rates stymie the cross-border allocation of capital. They also encourage tax arbitrage and locating headquarters for tax rather than operational purposes. A few jurisdictions, notably Ireland, Switzerland, Luxembourg, and the UK, benefit disproportionately. The narrowing of tax rate differentials would benefit MAPI members by streamlining their location policies. At the same time, it is unlikely that such clarity in tax policies could be achieved by the 2019 deadline proposed by the commission. A separate barrier to investment stems from the prevalence of withholding taxes on dividends when shares are purchased and sold across borders.
Platforms for clearing transactions vary widely across the continent. One barrier is the cost of transferring ownership across borders, which is not insignificant. The involvement of multiple brokers (necessary when separate laws govern transactions) also adds to costs and time. The ECB is fully engaged in creating centralized clearing platforms and there is a substantial chance that the EU will have functional and widely used multilateral trading facilities (called “alternative trading systems” in the U.S.) by 2019. This should benefit MAPI members, who would see their funding costs fall.
Securitization involves combining the debt of multiple borrowers (e.g., credit card debt, mortgages, and loans) and using cash flows from repayments to collateralize new securities, such as bonds and collateralized debt obligations. This financial innovation lies at the heart of easy access to mortgage loans in the United States. When banks are able to sell their loans, they free up capital to fund new assets. The EU lags behind the U.S. in the volume of securitized loans purchased and repackaged. Its laws demand high capital ratios and this discourages securitization. The continent lacks unified standards of disclosure but the ECB appears keen to support a pan-European approach to reviving this important source of funding.
Credit scores are a fact of life in the United States but this is not the case in every European country. The UK most resembles the U.S. system but France doesn’t keep credit scores at all. A significant hindrance to the development of a pan-European capital market (deposits, investments, and credit accessible across borders) is the lack of a unified system of assessing credit risk. Credit scores, if they exist, do not travel across borders. On the corporate side, the central bank is developing an analytical credit dataset called AnaCredit. It would enable comparisons of European corporate credits according to a single set of guidelines. While its debut is slated for 2017, I have tagged its 2019 deadline as only probable. There is still open debate about the limits of privacy in several jurisdictions and this alone could delay the project.
It is not clear that alternative finance will form a substantive part of the capital markets union but it merits mention. Peer-to-peer lending is already taking place in Europe and elsewhere, including through cash-pooling and entrustment loans, for example. It is possible that this type of intermediation will blossom without much regulatory attention, at least for a while. The impact on MAPI members of a formal development of this segment appears small because large companies already have ample access to funding, including through existing alternative finance channels.
Consumers win when companies compete vigorously. This simple adage does not yet reflect the reality of cross-border competition in retail financial services. New technologies relating to mobile and electronic platforms and standardized financial products can break barriers to entry and raise competition. Yet progress has been slow. An example of a standardized product is a mutual fund authorized in a single jurisdiction but automatically sanctioned across the EU. These funds are called UCITS (undertakings for collective investment in transferable securities) and were created by a series of EU directives. It is unlikely that many other financial products will become standardized by 2019 given that it took more than a decade for the EC to agree on UCITS. Heightened competition is vital for economic growth and MAPI members operating in Europe would benefit from it.
Common accounting standards will help unify capital markets in Europe. While the EU has adopted the International Financial Reporting Standards (IFRS) for consolidated financial statements of securities traded publicly, the effective adoption rate across member states varies. The EU lacks the centralized office of a chief accountant, which in the U.S. advocates for accounting rules. Proposals to endow such a position have been madeNicolas Véron and Guntram Wolff, Capital Markets Union: a vision for the long term, Bruegel, April 2015, www.bruegel.org/publications/publication-detail/publication/878-capital-markets-union-a-vision-for-the-long-term. but it is unclear if they will be followed up on. Accounting is closely linked to taxes but corporate income taxation remains a closely guarded national responsibility. Common accounting standards would be of paramount importance to MAPI companies that generally do not list in Europe but often consolidate within the EU.
The commission’s report singles out covered bonds and corporate bonds as prime candidates for standardization. This makes sense since both types of securities are highly developed yet trade heavily on national markets. Mentioned elsewhere in the report are ELTIFs (European long-term investment funds) and privately placed securities. Standardization will be difficult to achieve in the short term because many instruments derive from local jurisprudence. Changing borrower/debtor rights and regulations has proven difficult in the past.
Regulating intermediaries in capital markets is the rough equivalent of the banking union’s supervision. As with banks, financial stability is essential in this respect. In 2011, the EU set up the European Securities and Markets Authority (ESMA). Along with its insurance and banking sister equivalents, ESMA mediates among national supervisors but is not an equivalent of the U.S. Securities and Exchange Commission. It has input into national and EU legislative proposals to regulate markets but aside from involvement in regulating rating agencies, its track record has been scant thus far. It is unlikely that much effective supervisory power will shift from national regulators to this Paris-headquartered agency in the short term.
Cross-border resolution touches upon bankruptcy, insolvency, and settlement. National differences persist, hampering harmonization and making it problematic to restructure a company facing difficulties, particularly when assets are dispersed in various jurisdictions. It is quicker and simpler to liquidate, sometimes prematurely, leading to substantial social costs. Given these factors, the harmonization of cross-border resolution will be a long-term project. MAPI member companies have a stake in an efficient and quick pan-European resolution regime.
Europe’s capital markets will not be truly unified without a single legal rulebook. Securities laws draw on differing legal traditions across Europe, however. In this sense, perhaps the greatest value of ESMA will lie not so much in current supervision but in forward-looking lawmaking. To the extent that any future legislative proposal across any EU state is harmonized according to a common rulebook, a single body of securities laws will eventually emerge.
Differences in business culture and languages are rarely mentioned in discussions of European integration. Indeed, they are not considered a priori barriers to trade, investment, or even movement of labor. What is missing in the EU is the unifying fabric of common business practices and law. These attributes have made successful monetary and fiscal unions out of highly decentralized and multilingual federations, such as Canada and Switzerland. Diversity should not deter the EU from integrating where conditions are propitious, for example in foreign, security, and energy fields. Nonetheless, progress toward harmonizing taxation, banking products, and rules on mergers and acquisitions will be slow. National champions are called such because “national” refers to a sub-entity rather than the entity of the EU. This centrifugal force is strong and has not been offset by a parallel pan-European ethos. What this means is that like-for-like, the economic potential of an entity called the EU is bound to be smaller than that of the U.S.
A CMU, even in its idealized final state, cannot compare with a unified capital market like that of the United States. For one, U.S. fiscal federalism doesn’t have a European counterpart. Also, the more robust monetary environment in the United States provides far greater stability to capital markets than would be the case under an approximate CMU. These observations must be spelled out prior to assessing the CMU proposal because the U.S. is not a comparator in this exercise. Rather, it is sufficiently important to just judge the timeline and possible impact of a CMU.
The impact of a CMU on MAPI member companies’ operations in Europe will probably be modest. MAPI companies are large and they already benefit from worldwide access to funding. The retail investment side of a CMU does not concern them, while the entire legal and regulatory framework touches expressly upon financial institutions.
The probability of success must be judged as low. As Jon Cunliffe of the Bank of England has said, if a banking union were a sprint, then a capital markets union will be a marathon. Capital and banking still evoke national currencies whose living memory is fresh and they are enshrined very much in national laws and customs. Loosening such ties might take decades judging by the time it took to liberalize capital accounts or the pains the EU is going through with harmonizing taxation. Of the 17 planks in Table 1, 11 stand a negligible chance of being in place by the 2019 target date and 5 seem probable.
The immediate boost to growth from a swift implementation of all planks is judged as substantial but not overwhelmingly so. This is because changes in behavior, institutions, and various economic multipliers will take time to translate into greater efficiency. To paraphrase a former French president, we ought to “give time some time.”
Perhaps the greatest success of a CMU would lie not so much in striving for the largest number of deadlines in the least amount of time but rather in going for a realistic agenda that stands a realistic chance of delivering enhanced efficiency. It is the measurable quality that matters here and not the quantity.
The author would like to thank Katarina Minarikova, a graduate student at the University of Economics in Bratislava, for research assistance.