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Brexit and Covid-19: Why Europe Needs a Capital Markets Union 

ARTICLES - 20 October 2020

Ursula Von der Leyen, President of the European Commission, gave a State of the European Union speech last month. Its focus was recovery: in health, economies and of societies in general, still largely in shock after the first wave of the Covid-19 pandemic. Since this speech, European institutions have been trying to secure an agreement for the next Union budget and its associated economic recovery plan, while in the background, Member States have been dealing with a second wave of infections. Brexit has also rumbled on, as the deadline for the end of the UK’s transition period approaches in December. All of this has provided ample distraction from a lesser commented-on element of President Von der Leyen’s speech: her call to "to make structural reforms in our economies and complete the Capital Markets Union and the Banking Union". A true, European Capital Markets Union is a critical piece of financial architecture which would be a long-term driver of growth, while also helping to fund and support other EU priorities, in climate change, innovation, digital, etc. While the post-pandemic economic downturn and Brexit may occupy policy space right now, in fact, both demonstrate the need for faster progress towards a Capital Markets Union. Indeed, a recent report on Responsible Capitalism by Institut Montaigne addressed the need for further action in this area. 

If we want a European alternative to Google, Apple, Facebook or Amazon, we need to be able to fund innovation – and banks aren’t typically a good way of doing this. 

The Capital Markets Union (CMU) is not a single directive or regulation. It is instead a series of measures that move towards an integrated, better functioning, pan-European capital market. One of its driving motivations is to increase the role of equity financing in the EU. Freedom of movement of capital is one of the famous four pillars which make up the EU Single Market (the others being goods, services and people). Yet, to date, the EU’s capital markets remain siloed within individual Member States, each being managed by a national regulator who either applies different rules, or applies the same rules differently. 

The result is a patchwork of regulations, leading to significant practical barriers to capital (investors) moving between Member States. Such barriers inhibit the role of equity in financing the real economy and in boosting household savings. 

At present, the EU is highly reliant on bank financing to fund the real economy – unlike countries such as the US, for example, where equity financing plays a greater role. There are some well-known problems with such a heavy reliance on the banking sector. Firstly, getting a bank loan can be difficult. It usually requires stable revenues and credit scores, and this can lock out start-ups, or companies looking to invest in riskier projects. This in turns acts as an inhibitor to innovation. If we want a European alternative to Google, Apple, Facebook or Amazon, we need to be able to fund innovation – and banks aren’t typically a good way of doing this. 

A second challenge with a heavy reliance on bank funding is that it is cyclical. In an economic downturn, a bank’s portfolio of loans becomes weaker as businesses start to default and this in turn forces the bank to reduce its lending, restricting access to credit and further exacerbating the downturn. During the European Sovereign Debt Crisis in 2011/2012, this created a link between domestic economies and the health of the banking sector which can, in a worst-case scenario, threaten the solvency of the State itself. In the aftermath of the Sovereign Debt Crisis there was action at a European level, through stress testing and new capital requirements. 

As a result, European banks may look healthier than they did in 2012, but the problem of non-performing loans hasn’t disappeared. It continues to drag down access to credit, notably in countries such as Italy. This problem will likely only increase as the longer-term economic fallout of the pandemic is felt. Indeed, in Germany, arguably one of the most resilient EU economies, the Bundesbank recently forecast that at least 6,000 companies will file for bankruptcy in the first quarter of 2021. In the same release, the Bundesbank called on banks to continue to provide access to credit, hinting at fear of the prospect of banks turning off the money taps.

EU Governments face the twin challenges of increasingly constrained public finances and demographic trends towards longer retirements with fewer workers supporting them.

In contrast, equity financing is not cyclical; investors typically do so on different timescales and some, such as pension funds, for example, will have much longer time horizons in mind – making them less prone to retraction during downturns. In principle, a well-functioning pan-European capital market could act as a shock absorber during times of economic stress. A range of investment horizons and risk appetites should enable finance to be allocated more efficiently, to innovation, but also to long-term projects in infrastructure or fighting climate change, for example. 

A further benefit to an increased role for equity financing would be the impact on pensions. EU Governments face the twin challenges of increasingly constrained public finances and demographic trends towards longer retirements with fewer workers supporting them. In fact, UN projections expect the EU’s median age to be close to 50 by 2030. This means pension adequacy will become an increasingly pressing issue. Households will likely have to supplement their public pensions, either through private pensions or other savings. Yet at present, most households save through their banks. In the era of quantitative easing and historically low interest rates, the returns on such savings are minimal. Private pensions or savings invested in the equity markets should offer a better return, but the challenge is making such investments accessible to retail investors. 

These benefits notwithstanding, there are important cultural differences to overcome in raising the profile of equity financing in Europe. There has to be a cultural shift to make business and retail investors more comfortable accessing and using such financing, over the perceived stability represented by banks. Equally, in moving towards equity markets, one has to accept less control. Market forces determine financing terms, whereas government policy (say, to provide subsidised loans to a given sector) can be more easily directed through the banking sector. 

Another challenge with equity financing is that it cannot be generated from nowhere - market size is very important. Efficient markets require a critical mass of liquidity and transactions as, in general, people only invest in an asset if they believe they will be able to resell it. Deeper, more liquid markets therefore bring lower costs. At present, the EU’s capital markets are siloed within Member States, fragmenting the potential market and increasing costs. Indeed, the current situation is compounded for smaller Member States, because they are reliant on a smaller pool of domestic investors. 

Given the compelling arguments for a greater role for equity markets, the question arises of why progress on better integration has been relatively slow. To date, the Commission’s approach has been to systematically identify, then remove the existing barriers to investment, be they barriers making it difficult for investor’s capital to find investment opportunities, or barriers that prevent businesses looking to raise funds from reaching investors. 

Negotiations on the future relationship between the EU and the UK have been underway for much of the year and, to date, appear to have yielded little progress.

Many of these challenges are well-known and indeed, a June 2020 report by a High-Level Form dedicated to accelerating the CMU project, identified 17 recommendations which would support better integration. The focus to date has therefore been on technical measures, such as simplifying and standardising the rules around investor prospectuses, for example. The difficulty that a true CMU would go beyond this, to include common corporate tax and insolvency policies, as well as harmonised supervision, all of which requires the political support of Member States. Up to now, however, such proposals have been met with resistance. 

For Member States, issues such as tax policy or other structural reforms come with huge social and political sensitivities. Differences on these issues alone are enough to highlight deep splits within the EU27; think Ireland’s lower corporate tax base; or France’s proposed digital tax; or residual resentment in Greece to troika-imposed structural reforms following its bailout. In truth, it has until recently been easier to avoid a further push on the CMU, because the opportunity cost of inaction was better hidden. Indeed, the EU could worry less about the costs of fragmentation elsewhere because these were compensated to some extent by one dominant financial centre lying within its borders. London, a financial centre of gravity with its aforesaid deep and liquid markets, did what all gravitational centres do: attracted greater and greater mass, in this case, more and more transactions, enabled by EU passporting. But Brexit blows the current status quo apart, because from 1 January 2021, the transition period will end and London, having already left the EU, will no longer sit within the Single Market. Passporting will no longer apply. 

While there are countries that rely on an extra-territory financial centre (Canada, for example), it is probably safe to assume that such reliance, which in turn implies a loss of control and concomitant ability to protect, would be unpalatable to the EU. What next? In principle, the EU either has to find a way of working with London, or it has to find a way of replacing it. In answering this question, the EU has to consider what it wants to achieve from its future relationship with the UK. 

Negotiations on the future relationship between the EU and the UK have been underway for much of the year and, to date, appear to have yielded little progress. While an agreement remains possible before the end of this year, what is almost certain is that it won’t touch on financial services. This seems ironic given how crucial a subject it is to both sides. For the UK, financial and intermediary services are its largest service export to the EU. Likewise, the EU is about to lose its major financial centre. In tacit acknowledgement of this, the Commission has just extended the right to use UK-based clearing houses for a further 18 months after the end of the transition period. This is in effect an admission that the EU doesn’t have equivalent provision amongst the EU27 at the moment.  

Early commentaries on the UK-EU FTA negotiations talked up the idea of ‘fish for finance’ whereby both sides, the EU being a demandeur on fish and the UK being a demandeur on finance, would find a mutually-agreed compromise. The reality has been different: the UK hasn’t asked and the EU hasn’t offered, and thus financial services haven’t been part of the discussion. From the UK perspective, it perhaps made tactical sense not to have included financial services as part of its asks. It probably didn’t feel the need to provide the EU another source of leverage, particularly given the prevailing sentiment that the City could survive the lack of passporting, at least in the short-to-medium term. In preparation for Brexit, firms have moved necessary staff to the EU, but have kept a large majority of their services based in London. 

Equally, even if the EU had unilaterally offered to maintain the passport in financial services, it would have, understandably, never have accepted doing so without equivalent regulatory oversight. This would have trampled over the UK’s red lines over sovereignty. Hence, de facto no deal. The two sides will instead rely on each other (or not) regulatory equivalence in the areas they deem fit. This blog post won’t be the first to say that equivalence doesn’t represent a solid foundation for cooperation on financial services. The granting of equivalence is ultimately a political decision and it can be unilaterally withdrawn at short notice, as indeed the EU did to the Swiss stock market in 2019. Equivalence also relies on regulatory alignment and it is possible that the UK and the EU diverge in the future – already there is discussion about differences in how and when the two will implement the next round of Basel III banking regulations. 

Pursuing this logic, with London outside the EU and with limited formal cooperation between the two, it must follow that the EU needs to replace London. This is why the CMU is important because, if the EU wants to be serious about developing critical mass, this demands a serious effort at better integrating its capital markets.There must be sufficient political will, at European Council level, to inject momentum into the process. 

While it is difficult to envisage great leaps in coordinated tax policy and the like, Member States could take a big step by accepting increased supervision of their local markets at a European level. 

The long-term benefit of greater regulatory convergence would be to facilitate the movement of capital between markets. 

Existing institutions, such as European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA), would need to be strengthened and this in turn would probably demand treaty change – so none of this is easy. But it would be a pathway to greater convergence.

The long-term benefit of greater regulatory convergence would be to facilitate the movement of capital between markets. This could enable a model not seeking to replicate London by building up an alternative financial centre (in Paris, or Frankfurt, for example), but instead moving towards a network of regional capital hubs, with capital moving more freely between them. If regulation and supervision were better converged, the distinction between different local markets would become less important and the combined effect would be one large, networked market, spread across different European hubs. This in turn would have the gravitational effect of attracting further mass, in terms of capital and transactions, as investors, domestic and foreign, are attracted to use EU markets. One would hope that increasing market mass would have a domino effect on the EU’s investment culture, as companies and investors are encouraged to participate by the positive issuances and investments that went before them. Likewise, maintaining home markets (under converged regulation) would be a route towards increasing local participation, as most new investors show a home-bias. This is an achievable model for the CMU, which could grow and support EU goals on climate change, innovation and digital. 

 

Copyright: Isabel INFANTES / AFP

 

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