Wednesday, April 08, 2015

The low-hanging fruit of European capital markets

The planned capital markets union in Europe faces many obstacles. Commissioner Hill was right to start with the lower-hanging fruit but it will not help the eurozone in the short term.

Europe’s economy is too dependent on bank finance. A greater reliance on capital markets would help to boost the region's economic growth and resilience in future financial crises. To this end, the European Commission is aiming to create a capital markets union (CMU) in an effort to lower Europe’s dependence on bank finance and encourage the integration and deepening of its capital markets. But there are plenty of obstacles. Jonathan Hill, the EU’s finance commissioner, is sensibly focusing on the lower hanging fruit. But even these ‘early action’ measures will take time to implement, and as such will not improve Europe’s short-term economic prospects.

Contrary to the US, banks provide the bulk of financing to businesses in Europe. To some extent, this reflects the fact that US firms are on average larger: almost 60 per cent of American employees work for firms with a staff of more than 250; the corresponding figure in Europe is just a third. Participants in capital markets are less willing to invest in smaller firms, because it is relatively more costly to acquire the information needed to determine the risks of lending to them. Banks, with their closer relationship to customers, usually possess that information. Europe's bank dependence also reflects underdeveloped capital markets in Europe.

One problem with bank lending is that it tends to be pro-cyclical, growing strongly during booms and contracting during busts, thus amplifying the business cycle. There are two reasons for this. First, a financial crisis leads to losses and reduces a bank’s capital. Since banks have to finance a share of their loan book with their own capital rather than with deposits or bonds, they need to rebuild their ‘capital ratio’, which often leads them to curtail lending. Second, regulation tends to tighten after crises: often regulators demand that banks finance a larger share of their loan books with their own capital, or change the amount of assets that banks need to hold to remain liquid. Such changes in regulation often lead to further cuts in lending.

To some extent, pro-cyclical regulation is inevitable, but it is more painful in a bank-based economy. Since the crisis, European firms have struggled to access funding because the region’s banks have reined in lending and capital markets were underdeveloped. Regulation was also tightened unduly, for example regarding securitisation. And monetary and fiscal policy failed to offset the negative impact of pro-cyclical bank lending on the economy. Some of these mistakes are being corrected: macroeconomic policies have become less contractionary; and regulation has been relaxed in areas where the post-crisis response went over the top, though arguably not enough.

A fully-fledged CMU would broaden the funding base for firms and infrastructure projects, making the European economy less bank-dependent and more robust. Larger and deeper capital markets would also help the European Central Bank (ECB) to conduct monetary policy: when a central bank lowers interest rates, there are two ways through which they can be transmitted to firms, via bank interest rates and via the cost of funding on capital markets. Moreover, the ECB would have a wider choice of assets (beyond government bonds) to buy in future ‘quantitative easing’ programmes.

However, a fully-fledged CMU requires politically and legally difficult measures like the harmonisation of insolvency, corporate and tax laws – which will take years to implement, if they are ever agreed at all. What is more, the reform momentum is currently strong and should not be spread too thinly over too many projects. The Commission is therefore right to set out three priorities for early action.

First, it wants to make it easier for firms based in one member-state to find investors in others. This requires that information about companies be easily accessible and in a form that analysts all around Europe understand. The prospectuses, the key documents that contain information about an asset such as a corporate bond, are costly to produce and need to be harmonised and simplified. Credit scores should also be made easily available and comparable across the EU.  The Commission is calling for a consultation on the existing prospectus directive and credit scores framework to start the reform process. It also wants to support the growth of the so-called private placement markets in which medium-sized companies can market bonds in volumes that would be too small for public offerings.

Second, the Commission aims to rebuild the European market for securitisation. Securitisation allows banks and financial markets to work together: banks have superior knowledge of local small and medium-sized enterprises (SMEs) and households, and can provide loans to financially sound borrowers; financial markets are eager financiers of such loans but only if they come in the right shapes and sizes. Securitisation allows banks to bundle loans together, and sell tranches to investors. Banks therefore have an incentive to extend more loans if they can sell bundles of them; participants in financial markets, including pension and insurance funds, can invest in SMEs and other assets that are too small to invest in individually; and the ECB has a large asset class that it can buy in its monetary policy operations.

Securitisation has an image problem as it is seen by many in Europe as a cause of the financial crisis. But just as Greek public finances were not the reason for the euro crisis, securitisation was not the reason for the 2008-9 crash: highly leveraged banks, overly complex securitisation, faulty risk models and a run on the refinancing markets of banks and shadow banks all worked together to create a perfect storm. Simple securitisation, on the other hand, was largely blameless. This is especially true in the EU, where the default rate of all ‘structured finance products’ was only 1.6 per cent between mid-2007 and mid-2014, compared to almost 20 per cent in the US. The key is to make the process of securitisation transparent and comparable across the EU. This is what the Commission aims to help achieve, and has started a consultation process on the issue.

The last ‘early action’ aims to boost long-term investments, especially the use of European long-term investment funds (ELTIFs). In essence, ELTIFs are a new regulatory class of funds which allow issuers to ‘lock up’ investors’ money for a long time, and market them across Europe. The aim is to make it easier for capital to flow across borders into long-term projects such as infrastructure. Here again, the Commission is consulting on how to support the use of these instruments.

These three measures are realistic first steps: they focus on relevant issues (access to funding, securitisation and long-term investment); and they cover areas where there is a role for the Commission to drive the process forward. Moreover, the Commission has a powerful ally in the ECB, especially on securitisation, and the support of the German and British governments. But even plucking the lower hanging fruit of the CMU will take time. For example, a new regulatory framework for securitisation could take two years until it is fully operational. The construction of the CMU is a long-term goal, not a solution to Europe’s immediate economic problems.

Christian Odendahl is chief economist at the Centre for European Reform.

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