The Capital Market and European Banking Union: do SME’s get left behind or taken in hand?

Nick Bootsma, Pepijn Meewis, Quinten Faijdherbe

December 2017

Europe is currently in the process of completing a Capital Market Union (CMU) before the end of 2019, and a European Banking Union. The CMU aims to make the financial system more flexible, more diversified, and increase access to finance throughout the whole market. On the other hand, the European Banking Union aims to improve and strengthen the supervision of EU banks. This banking union consist of thee pillars: the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and the currently under discussion European Deposit Insurance Scheme (EDIS) (European Commission, 2017). This blog solely focuses on the CMU and the SSM pillar of the Banking Union, since the CMU and the Single Supervisory Mechanism have relatively significant implications for the financial environment of European small and medium-sized enterprises (SME’s). The SSM aims to enhance the supervision of Europe's banking sector by conducting central supervisory of the ECB for 120 significant European banks. The remaining banks, which only account for 18% of banking assets in the euro area, are continued to be supervised by the national central bank.

Since over two-thirds of the European Market consists out of SME’s and SME’s are mainly bank-financed, the European economy and financial system is highly dependent on these firms. Therefore, originating a greatly impacting Capital Markets and European Banking union might have significant effects on the financial environment of SME’s, which in turn might impact the European financial system and economy. This undoubtedly calls for investigating whether the implications of such unions is either beneficial or detrimental to SME’s. Do SME’s get left behind or taken in hand by the initiation of these unions?

Cheaper Loans

SME’s can obtain access to cheaper loans due to improved financial integration as a result of the European Banking Union. SME’s represent a large proportion of over two-thirds of the European market (Goldman Sachs, 2015). Additionally, the financing structure of European SME’s consist for approximately 95% of bank loans (Demary, Hornik, & Watfe, 2016). The former and the latter combined constitute the significant dependence of the SME’s on banks and the bank-domination of the European financial sector. This dependence is partially due to the lack of information on SME’s, ultimately making investments in these firms riskier, which pushes away investors. Also, if Europe would experience an increase in larger firms, the domination of banks in the financial sector would be reduced.

One of the features of a financial sector is that it helps to smooth out temporary fluctuations in economic conditions (Praet, 2016). To elucidate, financial intermediaries can accommodate financing needs of both companies and households to different extents depending on economic conditions, which can help mitigating fluctuations in spending patterns, for instance. This responsiveness of financial intermediaries results in macroeconomic stabilization, ultimately resulting in more stable banks too. Financial integration enhances this feature of a financial sector, which reinforces stabilization of macroeconomic conditions.

The European Banking Union advocates and pivots around financial integration. In other words, this banking union enhances financial integration and therewith reinforces the macroeconomic stabilization. In Europe, as mentioned above, banks are the major financial intermediaries, the financing of SME’s is highly bank dependent and SME’s represent the majority of the European market. Therefore, the reinforced macroeconomic stability due to the European Banking Union is highly beneficial to SME’s. Additionally, macroeconomic stabilization due to enhanced financial integration causes the interest rates to decrease (Claeys, Moreno, & Suriñach, 2012). This entails that the European Banking Union will push down the interest rates through financial integration, making it cheaper for SME’s to take loans. As a result, more SME’s can afford to take up loans, which leads to an increase in production and economic growth in Europe as the SME’s represent the majority of the European market. In other words, financing becomes cheaper due to financial integration, increasing overall liquidity of European SME’s. In turn, this affects the whole European market due to the significant role of SME’s. Therefore, the European Banking Union

Increased Funding Liquidity

The Single Supervisory Mechanism (SSM) of the European Banking Union project, reduces the fragmentation in the European banking sector. This fragmentation is caused by significant differences in national supervision of central banks across countries. One of the cornerstones of the European Banking Union is the Single Supervisory Mechanism (SSM). The SSM aims to enhance and equalize the supervision of Europe's banking sector by conducting central supervision of the ECB for 120 significant European banks. The remaining banks, which only account for 18% of banking assets in the euro area, are continued to be supervised by the national central banks (European Commission, 2015).

This restructuring of supervision, with the aim of having the same degree of supervision for the 120 most significant banks in Europe, creates a level playing field for banks. To elucidate, banks now play by the same rules due to similar supervision, which results in increased trust between banks. Subsequently, increasing trust leads to a more flexible behavior with regards to lending out surplus liquidity by banks. Prior to the SSM, liquidity surpluses of banks in one country were not efficiently accessible for companies operating in another country. Sovereign reputation reinforced the difficulties for companies from underperforming countries to receive foreign loans, deteriorating the liquidity position of both banks and companies in certain European countries (Mersch, 2013). For instance, it would be more difficult for a Greek company to receive a loan from a German bank, than it would for a German company to receive a loan from a Greek bank.

The level playing field created by the SSM, as part of the European Banking Union, allows for this problem to be solved, since now cross-border banking is substantially easier. Consequently, companies are less dependent on sovereign reputation, and the banking structure is more efficient with enhanced capital allocations (Praet, 2016). This increased financing accessibility entails that the funding liquidity of European SME’s is increased. Therewith, the European Banking Union improves the funding liquidity position of European SME’s, which can subsequently have positive effects for the European economy.

Improved Financial Environment

The proposed Capital Markets Union (CMU) helps to reduce the information asymmetry, through which European SME’s can increase and diversify their financing sources, and therewith improve their funding liquidity position. Currently, SME’s in Europe are highly dependent on bank-financing (Figure 1).

Figure 1: Financing structure of European SME’s in percentages of debt capital

Private and institutional investors often lack the resources and information on SME’s to analyze the credit risk for SME’s in Europe (Norton Rose Fulbright, 2017). Banks are capable of doing this and have more information on SME’s, which is why SME’s are highly limited to bank loans rather than receiving funding through other option, such as securitization. The CMU aims to develop a common minimum set of standardized credit quality information on European firms, a high-quality securitization market and linking and helps to connect firms and investors from inside and outside the EU. Realizing these three aims will improve the environment for European SME’s significantly (Ciani, Russo, & Vacca, 2015). Namely, the standardized credit quality information system will help to reduce information asymmetry SME’s, which improves the access to finance. Secondly, the high-quality securitization market and connecting national and international firms and investors will result in an increase in the sources of finance for SME’s, which helps to diversify their sources of finance (improving their funding liquidity position) and ultimately reduce their dependence on banks. Therefore, the Capital Market Union will greatly benefit the financial environment for European SME’s.

Do SME’s get left behind, or taken in hand?

In conclusion, findings show that the initiation of the European Banking Union enhances and improves financial integration in Europe, causing interest rates to decline, which makes loans cheaper. Obviously, cheaper loans allow for more funding for SME’s in Europe. Additionally, the Single Supervisory Mechanism allows for cross-border banking. This improves the access to finance in Europe, removes sovereign reputation effects and improves the funding liquidity position of firms in Europe, including SME’s. As previously mentioned, the European market mainly consists out of SME’s, so this increasing in funding liquidity has a great impact within the European market. Lastly, the Capital Markets Union will help reducing information asymmetry, which is the main obstacle for SME’s when trying to obtain funding from a non-bank company. This reduces the SME dependence on banks. Furthermore, the CMU also aims to improve national and international funding accessibility, which reinforces the effect of improved access to finance, further strengthening the funding liquidity position of SME’s. Finally, the high-quality securitizations market that the CMU plans to bring about removes the bank dependence problem of SME’s. Namely, this process will allow for SME’s to find non-bank investors, through which SME’s will be able to diversify their financial position.

Notwithstanding the aforementioned benefits of both unions to SME’s, it is all not a given that these processes will have the effect to the extent that the SME’s would desire them to have. For instance, many SME’s in Europe are considered ‘micro firms’, consisting of only a couple of people, which could hamper reducing the information asymmetry problem. This could result in SME’s not being able to diversify their funding and will remain highly bank dependent. However, it is inevitably noticeable that initiation of the Capital Market and European Banking Union aim to reduce these problems. Although complete elimination might be unattainable in the short term, it provides good hope for the long term.

Despite the limitations that come with the implications of both the Capital Markets and European Banking Union on the SME’s in Europe, the changing dynamics in the European economy and financial system due to these unions seem to favor SME’s and significantly improve their financial environment. Already representing over two-thirds of the whole European market, SME’s are on the rise to become larger as they get taken in hand by the initiation of the Capital Markets and European Banking Union.


References

  • Ciani, D., Russo, P., & Vacca, V. (2015). Financing SMEs in Europe: Stylised Facts, Policies, Challenges. Istituto Affari Internazionali. Rome: Istituto Affari Internazionali.
  • Claeys, P., Moreno, R., & Suriñach, J. (2012). Debt, interest rates, and integration of financial markets. Economic Modelling, 48-59.
  • Demary, M., Hornik, J., & Watfe, G. (2016). SME Financing in the EU: Moving Beyond One-Size-Fits-All. Köln: Institut der deutschen Wirtschaft Köln.
  • Dombret, A., & Kenadjian, P. (2015). The European Capital Markets Union: A viable concept and a real goal? Berlin: Walter de Gruyter GmbH & Co KG.
  • European Commission. (2015). Building a Capital Markets Union. Green Paper. Brussels: European Commission.
  • European Commission. (2017, October 17). EC Europa. Retrieved December 2, 2017, from Single supervisory mechanism: https://ec.europa.eu/info/business-economyeuro/banking-and-finance/banking-union/single-supervisory-mechanism_en
  • Goldman Sachs. (2015). Unlocking Europe’s economic potential through financial markets.
  • Goldman Sachs Global Investment Research. The Goldman Sachs Group, Inc.
  • Knot, K. (2017). The European sovereign debt crisis, the monetary policy response and the way forward. Presentation Vrije Universiteit Amsterdam. Amsterdam: De Nederlandsche Bank.
  • Mersch, Y. (2013, November 13). SMEs, Banking Union, and securitisation – exploring the nexus. Retrieved December 2, 2017, from ECB Europe: https://www.ecb.europa.eu/press/key/date/2013/html/sp131113.en.html
  • Norton Rose Fulbright. (2017). SME finance. Retrieved December 2, 2017, from Norton Rose Fulbright: http://www.nortonrosefulbright.com/knowledge/technical-resources/capitalmarkets-union/getting-funding/sme-finance/
  • Praet, P. (2016, November 24). The importance of a genuine banking union for monetary policy. Retrieved December 2, 2017, from ECB Europe:https://www.ecb.europa.eu/press/key/date/2016/html/sp161124.en.html

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