Capital Market Union: Unlocking Funding for European Growth

Margaux Rensink, Laura de Beer

December 2017

The Capital Market Union (CMU) is an initiative from the European Commission aimed at mobilizing capital in Europe. It is a key element of the Investment Plan announced by the Jucker Commission in November 2014. In particular, it is aimed at developing non-bank lending, so called shadow-banking, and capital market financing. It intends to increase the role of institutional investors such as pension funds and life insurance companies and households (retail investors) in financing the real economy. Simultaneously, the CMU should reduce the role of traditional banks. Furthermore, the CMU is focused on economic integration by removing barriers and harmonizing the rules on the free movement of capital. This would give savers more investment choices and offers businesses a greater choice of funding at lower costs, irrespective of the country they are located in. [1]

The Capital Market Union (CMU) is based on a large number of assumptions. In the following paragraphs, we will discuss some of these assumptions and argue whether the CMU will have the desired effects.

The European Market is Heavily Reliant on Banks for Funding

Compared to other jurisdictions, Europe’s financial system is heavily reliant on banks for funding. This is one of the arguments of the European Commission for the implementation of the CMU in Europe. [2] Banks provide approximately 70% of European firms’ external financing, with the remainder provided by capital markets. On the contrary, in the US, banks provide approximately 20% of firm’s external financing and 80% is provided by capital markets. As a consequence, the banking sector in the European Union is significantly bigger than in the US; banks assets to nominal GDP (in percentages) in the European Union is above 3%, whereas in the US this is less than 1%. [3] This high level of bank-dependence has been challenged by the 2008 global financial crisis and the subsequent international regulatory responses: During the global financial crisis, smaller companies relying solely on banks for funding were hindered by the credit crunch (condition in which investment capital is difficult to obtain). Larger companies that had direct access to the capital market were not hit by the sudden credit crunch and performed better than smaller companies. [2] Following the financial crisis, the European Commission implemented Basel III requiring banks to hold more capital and liquidity when conducting their business. This should result in greater resilience at the individual bank level and reduce the risk of system wide shocks. [4] But, if increasing bank leverage becomes more costly because of regulation, ceteris paribus, bank loans will become more costly and less available. Creating a wide range of alternative financing sources through capital markets would improve the resilience and reliability of credit supply to the real economy and would protect the economy against setbacks in the banking sector. However, to ensure that capital markets function well, excesses and vulnerabilities that contributed to the global financial crisis need to be guarded against. [3]

Moreover, the bank centred financial system in the European Union is a reflection of the European corporate sector, which comprises many small and medium-sized enterprises (SMEs). In general, SMEs cannot issue directly on capital markets because insufficient information is available to investors to assess the performance and creditworthiness of a company. Therefore, SMEs rely heavily on banks to obtain funding. [3]

Shortage of Credit Supply to SMEs and Securitization

A second argument for the implementation of the CMU is an overall shortage of credit supply to SMEs in Europe. According to the European Commission, this problem could be mitigated through securitization. Securitization is the process through which an issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instrument to investors. Here, the financial assets comprise the loans to SMEs. However, the notion of overall shortage of credit supply by the European Commission contradicts the results of a survey on the access to finance of enterprises in the Euro area by the European Central Banks (ECB). [5] In the survey the find that the shortage of credit supply to SMEs is not an overall problem in Europe. Indeed, there is a shortage of credit supply in e.g. Greece, but there is no shortage in e.g. Germany or Finland. A large number of countries in the European Union even show a drop in demand of SME finance over the past few years. So, the survey conducted by the ECB shows that the lack of finance for SMEs differs strongly across Member States. Therefore, it is better to look at credit supply to SMEs from a local perspective. As mentioned before, it is difficult for international investors to assess the performance and creditworthiness of a SME. It is much easier for a local bank to obtain the necessary information and provide credit.

Securitization of loans to SMEs gives rise to another problem. Many SME loans are tailored financial constructs which need comprehensive monitoring. [6] The securitization of SME loans might be too complex and expensive because of the number of intermediaries that are part of the process and the necessity to offer an attractive return for investors. This raises the question whether securitization is suitable and sustainable.

Capital Market and European Integration

Another argument for the implementation of a CMU by the European Commission is European integration. According to the Treaty of Rome (1957), there should be free movement of capital in the European Union. As a consequence, capital market should be fully integrated. [2] When capital markets are fully integrated, assets with similar risk profiles are traded at the same price regardless of the country in which the asset is traded. Indeed, if there is free movement of capital, assets with similar risk profiles command the same expected return. So, a fully integrated capital market implies convergence in market risk and price. On the contrary, when markets are not fully integrated/segmented, assets with similar risk profiles can have different prices and hence different expected returns. [7] Integration through a fully integrated capital market will enhance European economic activity in the following ways: [7]

• More integration would increase competition between intermediaries. Because of this increased competition, margins of these intermediaries will narrow. This implies that the costs of finance will decrease for borrowers and increase returns for savers. Because returns increase for savers, they have an incentive to provide more finance. Likewise, because costs will decrease for borrowers, they might borrow more. As a consequence, a more efficient financial industry will raise the level of investment.

• More integrated and competitive financial markets can also contribute to growth through more efficient allocation of capital. Given that sophisticated intermediaries can distinguish between good and bad investment, funds will be allocated to the most profitable investments. Hence, the productivity of the overall economy will increase.

• A more integrated capital market will increase Europe’s economic resilience: First, improving diversification of funding will enhance risk taking across borders and allow capital markets to reduce the impact of a certain shock in one country. Second, efficient and diversified capital markets can have more cross-border banks that are large enough to operate internationally and diversify risk, but not too-big-to-fail.

On the other hand, the European integration through fully integrated capital markets also poses various risks: [7]

• An adverse economic shock in one country can lead to adverse economic shocks in other countries within the market and increase volatility.

• European integration could boost international capital markets. However, SMEs mainly operate locally and might not be able to access this international capital market.

Before the global financial crisis, the European Union showed increased levels of integration. However, during the financial crisis, foreign banks and investors retreated within their national borders. In other words, during times of stress banks and investors are subject to home bias which results in inefficient allocation of funds. So, in order to successfully implement a CMU, an effort should be made to mitigate home bias. [2,7]

Sufficient Stability – Focus on Growth

One of the striking assumptions supporting the implementation of a CMU in the European Union is based the urge to grow. Current regulation is focused on making individual banks more resilient which should result in an overall resilient European system. [8] So, the European Commission argues that the needed stability in the financial system has been accomplished and it is time for growth. As mentioned in the previous section, implementing a fully integrated capital market could result in foster growth through efficient allocation of capital. However, is the system stable enough?

Although each financial crisis is different, there are certain similarities in the period preceding the crisis in run-up of assets prices, in debt accumulation, in growth patterns, and in current account deficits. [9] One of the characteristics of the 2008 global financial crisis is the increased financial integration and interconnectedness. As mentioned in the previous section, a fully integrated capital market can have advantages and disadvantages/risks. One of the disadvantages of an integrated capital market is that an adverse economic shock in one country can lead to adverse economic shocks in other countries within the market. In other words, the interconnectedness of financial institutions and markets intensified the cross-border spillover of the financial crisis. [10] So, for a successful implementation of the CMU the European Commission should ensuring that banks and other institutions do not run into trouble at the same time. This could be achieved by e.g. reducing the possibility of by reducing the possibility of different financial institutions to invest in the same things and to reduce the number of contracts between financial institutions. The reduction of spillovers is a necessary condition for sustainable growth. By introducing the CMU before ensuring a great reduction in spillover risk may only lead to greater instability.

In conclusion, implementation of a Capital Market Union (CMU) in the European Union might have positive effects in that companies have more access to credit, capital market union fosters European integration and growth. However, there are certain aspects that should be addressed before turning to the implementation of the CMU:

• The bank centred financial system in the European Union is a reflection of the European corporate sector, which comprises many SMEs. In general, SMEs cannot issue directly on capital markets because insufficient information is available to investors to assess the performance and creditworthiness of a company. Therefore, SMEs rely heavily on banks to obtain funding. So, is a capital market based system suitable for Europe or should SMEs obtain financing through local banks?

• European integration has possible effects. However, during times of stress banks and investors are subject to home bias which results in inefficient allocation of funds. So, in order to successfully implement a CMU, an effort should be made to mitigate home bias.

• Excesses and vulnerabilities that contributed to the global financial crisis, such as spillovers, need to be guarded against.


References


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Margaux Rensink

MSc Finance at Vrije Universiteit Amsterdam

Laura de Beer

MSc Economics at Vrije Universiteit Amsterdam