How to harmonise capital markets and regulation across Europe.
We are familiar with the story: we went through a major financial crisis, combined with a global recession. On top of that, Europe had its sovereign debt crisis with yet another economic recession on the follow.
After the crisis of 2007-2008, financial stability was the key priority for the European Commission. In order to restore that stability, the resilience of banks needed to be strengthened and systemic risk in the markets needed to be contained, which had Brussels produce that famous "tsunami" of regulation.
Today, most of the work to make banks and markets stable again is done and the respective legislation has been or will soon be implemented. The next item on the European Commission's to-do list is now to create growth. Therefore, corporates need to grow their businesses, invest and expand.
Historically, corporates have been very much dependent on bank lending if they want to expand. However, on the back of capital and liquidity requirements imposed by bank regulation, some banks have found it more difficult to fulfil their role of traditional lender. Seeing their bank funding channels drying up, larger corporates turned to capital markets, but did not always meet favorable borrowing conditions and interested investors. For some of the smaller corporates, getting funding had become as good as impossible. A survey done by the ECB and the European Commission in 2014 on the access to finance of enterprises (SAFE) showed that 35% of SMEs did not get the full financing they asked their banks for in 2013.
Looking at the US, we notice that corporates get about three quarters of their funding directly from the capital markets, and rely only to a small extent on bank lending. In Europe the situation is the other way round. So Europe wondered if they could create a funding landscape that would resemble more the US situation. That would mean that those in need of financing would meet directly with those that have money to invest. It would reduce the dependency of the real economy on banks, which would again contribute to financial stability. However, what is needed in that case is a harmonised, well integrated capital market in Europe. And now that is exactly where there is need for action! And this is where comes in the initiative of the European Commission: build a Capital Markets Union. So in short, this is what CMU is about: it is a plan to create a single market for all 28 Member States of the European Union, where, on the one hand, funding choices for corporates will be diversified beyond bank lending and where, on the other hand, investment opportunities and the investor base will be broadened.
Let me also tell you what it is not about:
- it is not about banks: while these will still have to play an important role, the focus is really on corporates and investors and on markets facilitating the match between the two. Banks will not find themselves redundant in the future European financial market, but their role will gradually change.
- it is not about regulation: the European Commission will invite the industry to come up with market-lead solutions, best practices. Legislation will not always be the right answer and the European Commission only intends to install it if that seems the appropriate approach.
- it is not about creating a sort of "banking union", which is a pure financial stability concept that foresees risk mutualisation and supervision of banks. CMU does not look to set up any new supervisory institutions.
- it is not a single measure; call it rather a project, with the European Commission in the role of the project manager, setting objectives, priorities, short term and long term actions. As far as the timing of the project is concerned, the Capital Markets Union should see the light by 2019.
""(...) CMU it is a plan to create a single market for all 28 Member States of the European Union, (...)""
So what's the plan?"The Plan", which the European Commission published in October last year, sets 4 clear objectives: Support job creation and growth Connect financing effectively to investment projects across the EU Make the financial system more stable Deepen financial integration and increase competition. "The Plan" also defines 5 priority areas for action, with over 30 different initiatives for reviews, assessments, reports, initiatives and legislative proposals, all to be taken between now and sometime in 2018.
The first priority is to provide more funding choices for Europe's corporates and SMEs. Here we will see initiatives to support venture capital and innovative forms of financing, such as crowdfunding. The EU is also thinking about ways to provide necessary data on SMEs to investors, so that they can make well informed investment decisions.
Second, long term investment has to be promoted. An initiative here is to make sure that capital requirements for insurers are reviewed so that they see their investment needs more efficiently met. Measures will also be taken to promote investment in infrastructure projects.
Third, the range of investment choices both for retail and institutional investors has to broaden. In this area, we will see, amongst others, incentives to promote pensions savings and private placements.
The fourth priority is to enhance the capacity of the banks to step up lending. This may sound contradictory, as the idea of the CMU is to move away from traditional lending. However, for a lot of SMEs, banks will still remain the prime source of financing. So Europe wants to make sure that banks can offload more assets from their balance sheet so that they have extra space to lend. And lastly, the EU wants to dismantle barriers that would hamper cross-border investment across the Member States. This is quite an ambitious area, where certain tax issues will be tackled, and where we will see a certain harmonisation as far as national insolvency laws and securities laws are concerned. At the same time of the publication of "The
Plan", the European Commission issued a couple of legislative proposals and 3 consultations, as a matter of launching the short term actions right away and getting the train out of the station.
The European Commission takes immediate action in the field of securitisation. This may seem quite controversial as some will still consider this as the root of all evil. However, it is a critical tool to finance the economy and it sits high on the Commission's agenda. In order to kick start the securitisations market, the EU has come up with a legislative proposal, the purpose of which is twofold. First, it aims at reinstalling confidence. Therefore, a quality label is introduced: "Simple, Transparent and Standardised" securitisations. That means that any "STS" securitisation will comply with over 20 different standards, thus helping investors to better understand these products and ensuring quality. Second, it incentivizes banks to restart the activity again by giving these STS securitisations a better capital treatment, compared to other forms of securitisation. Next to that, the EU has issued a proposal to adjust Solvency II rules for insurers, so that they would have to deploy less capital when investing in long term infrastructure projects or in European Long Term Investment Funds (ELTIFs). Also note that the European Commission is looking into covered bonds.
"The effects of a CMU may be more pronounced for the corporate sectors of certain countries with relatively small capital markets."Currently there are 26 different covered bond frameworks in the EU, an area which could possibly benefit from a certain level of harmonisation. While the idea is not to create a single framework for Europe, the Commission would look to promote best practices, step up transparency and remove barriers that would hamper cross-border investments. We also saw a consultation venture capital and a call for evidence on the cumulative impact of financial legislation.
In the medium term, a review of the Prospectus Directive is on the cards. This is a logical move, given that the EU would like to attract many more corporates directly onto the capital markets to issue debt. Making prospectuses cheaper and less burdensome for smaller issuers on the one hand and more user friendly for investors on the other hand, would be a welcome help in that respect. Another initiative is a Green Paper (this is a first, general exchange of views between the EC and the industry to explore a certain topic) on Retail Financial Services. Here he European Commission is exploring ways to enhance competition and make sure that consumers have access to a broader range of services in order to get the best deal around, when it comes to mortgages, savings products, insurance, banks accounts etc.
In the long term, count 2017/2018, we can expect further steps to support SME growth markets and private placements, along with plans for a pan European Pension Fund. As already mentioned earlier, matters regarding withholding tax and insolvency law will get attention as well. All in all, CMU certainly has a fully packed and ambitious agenda.
"So all in all, the Capital Markets Union is an ambitious, yet challenging plan of the European Commission."Now what's in it for corporates, really? Potentially a lot. However, we appreciate that the road to a real CMU may be a far longer one. 2019 seems awfully close for some of the changes to happen. Rebalancing financial intermediation for example will most probably be a gradual, organic process that will go hand in hand with political interests, FinTech developments etc., rather than a major shift on a particular point in time.
Also, it will need a change in mindset and behavior by all stakeholders involved. The effects of a CMU may be more pronounced for the corporate sectors of certain countries with relatively small capital markets. For these countries, some of the initiatives could be particularly beneficial. Their domestic capital markets may currently not be able to cater for their large corporates, pushing them away to international markets. CMU could bring them back home and expand their markets.
The benefits of CMU will be different for the different types of companies. Start-ups will get special attention, as their innovation and entrepreneurial spirit are key to Europe's growth potential. At this moment startups can turn to crowdfunding, but this is only developing and there is already some investment by business angels. However, these funding channels remain small and local and will not always provide the necessary funding at critical moments in their expansion. The initiatives to step up venture capital for example may be particular beneficial in that respect. Small companies that are struggling to get bank funding, especially in those countries that have been hit the hardest by the crisis, may unlock more funding via securitisation. SMEs in particular could be positively impacted, as the intended side effect would be that securitisationt allows banks to step up the lending capacity, knowing that bank lending for this type of corporates may remain a very important source of funding. Next to that, the European Commission also wants to work closely together with the SME growth markets, a new market sub-category created under MiFID II to facilitate access to capital for SMEs, to ensure that the regulatory environment for these markets delivers the expected results.
Medium and large-sized companies, which may already have access to capital markets, should also feel the effects as CMU will support investors who wish to place larger amounts of capital in the market. The initiative to promote private placements, building on successful experiences such as the one in Germany and through supporting market-led initiatives such as the one by ICMA on the use of standardised documentation could be quite helpful. Tackling tax issues could come in helpful as well. What is important too is that the European Commission is also planning to review the functioning of the European corporate bond market and to see how market liquidity can be improved. A well-functioning secondary market will be crucial for the success of the primary debt markets.
So all in all, the Capital Markets Union is an ambitious, yet challenging plan of the European Commission. Ambitious because it intends to reengineer Europe's traditional funding channels. Challenging because of the wide range of issues that need to be tackled to get there and the tight deadline. The outcome should be that corporates meet with investors in an efficient market place, thus broadening the scope of options for both parties to contribute to economic growth.