Capital markets union: managing high expectations
March 2015 • Unlocking capital markets • by William Wright
By pulling down artificial barriers to the free flow of capital across borders in Europe, capital markets union could help unlock hundreds of billions of euros in additional investment to boost growth and job creation. But it is such a wide-ranging project that there is a danger it will fall short of the unrealistically high expectations that many people have set for it.
In particular, a huge amount of hope has been invested in the impact capital markets union will have on SME funding and the potential for developing securitisation and private placements (that may have been inadvertently raised by the recent green paper from the European Commission).
This paper is an attempt to manage down some of those expectations, by looking at what capital markets union is not…
(This article is a 10 point summary: you can download a more detailed 10 page version of the paper here)
1. It’s not an academic question
Capital markets union is not a theoretical concept: by breaking down the many barriers and obstacles across Europe that are holding back the free flow of capital across borders to where it can be most effectively invested, capital markets union could unlock hundreds of billions of euros a year to help fund growth and job creation. If European capital markets closed half of the current gap in depth with US markets, it would translate into an extra $500bn of funding for corporates a year.
2. It’s not about the finance industry
It’s about investors, companies, infrastructure and growth. Capital markets union can help bridge the wide but largely artificial gap between the world of finance and the real economy, and help financial markets refocus on their primary purpose of supporting investment and allocating capital. It should start from the perspective of investors and asset owners, and help to connect them as efficiently as possible to those projects and companies that need investment.
3. It’s not just about securitisation
Securitisation can play a potentially important role in helping finance a recovery in Europe, but it is not a silver bullet or a quick fix. The economics of securitisation will remain relatively unattractive until monetary policy normalises (and even then) overall volumes of securitisation – particularly the securitisation of SME loans – will remain a relatively small proportion of overall bank financing. In addition, there are other ways of freeing up bank balance sheets to encourage SME lending, such as the development of an institutional loan market and capital markets for mid-sized companies.
4. It’s not really about SMEs
We need to be realistic about what capital markets can do for SMEs. Even though SMEs account for two thirds of employment in Europe they account for just 3% of capital markets activity – a similar proportion to the US (using the official definition of an SME as a company having fewer than 250 employees). Capital markets favour scale and only a small proportion of small companies will ever be suitable to access capital markets directly. For example, annual volumes of IPOs smaller than $100m in Europe is equivalent to about two days of SME lending. The biggest boost to SME funding will be indirect, by unclogging bank balance sheets to free them up to lend more to SMEs.
5. It’s not all about private placements either (or SME stock markets, or mini-bonds, or crowdfunding)
There is plenty of scope for the European private placement market to grow, but even if it hits the very high expectations set for it, the market will at best be a few percent of overall funding. European companies already raise the same amount as US companies in this market – they just raise half of it in the US instead of over here. The same caution should apply to other growing sources of finance such as mini-bonds, direct lending or crowdfunding. Every little helps – particularly when it comes to funding SMEs and mid-sized companies, but let’s be realistic about the impact they can have.
6. It’s not about the next five years
Five years is a very long time in European politics. The European Commission hopes to have ‘created’ a capital markets union by 2019, but it is unlikely that it will be able to have done much more than lay the foundations for future work. Many of the big issues – such as tax and insolvency law or the patchwork of market infrastructure across Europe – will take decades to change, and even some of the easy low hanging fruit could take years to have an impact. The most important shift required for a successful capital markets union is cultural – and that is not going to happen overnight.
7. It’s definitely not about the City of London
Capital markets union is not about the City of London or a conspiracy by free market Anglo-Saxon economics to take over Europe. The range in the depth and development of capital markets between individual countries in Europe is far wider than the gap between Europe and the US, and it will be important to build a capital markets union that works as well for countries with nascent capital markets – such as the newer members of the EU – as for highly-developed market economies, such as the Netherlands or the UK. As the largest financial centre in Europe, London has an important role to play in setting an example. If London is seen to exploit its position, it will quickly kill off the project.
8. It’s not about tax and insolvency law
The diversity and complexity of different tax and insolvency law across Europe is a significant barrier to the creation of a genuine capital markets union –but addressing them head-on would go beyond the remit of the Commission and risk exhausting limited political capital on intractable legal wrangling with member states. Better to start laying the groundwork now but to focus immediate efforts on more practical and achievable projects.
9. It’s not about increasing savings
Europe doesn’t have a savings problem: it has an investment problem. Europe saves more of its income than the US but the majority sits in the bank earning a negative return (European bank deposits of €22 trillion are nearly three times the US) or under mattresses. One of the biggest challenges ahead is to encourage a shift from bank deposits to investments. A good start would be for the capital markets industry to think hard about how to make the industry simpler, more efficient, and more trustworthy.
10. It’s not about more regulation
The answers to more efficient and deeper capital markets are unlikely to be found in more regulation, particularly after the barrage of reform over the past five years. You cannot regulate a capital markets union into existence. Instead, policymakers and the industry should come together to identify the main inefficiencies and barriers to deeper capital markets in Europe and work out how to overcome or remove them – while retaining a strong focus on investor protection and market supervision. Too much focus on regulatory structures and policy debate could sap the energy from this valuable project.
Note: over the past few months New Financial has been running a series of workshops for market participants from across the industry to identify barriers and obstacles to deeper capital markets in Europe looking at equities, debt, market infrastructure and investing. We will be publishing a manifesto on ‘Unlocking capital markets’ in April.