Early in 2015, the EU Commission published a green paper on the idea of a Capital Markets Union (CMU) for all 28 member states of the European Union. The goal of the CMU is to expand capital access for businesses across Europe – especially mid-size and SME businesses; attract more financing from institutional and retail investors in the EU and beyond; and help create a more stable financial system overall. Seven months on, has this long-term project gotten off to a good start?
Half of European Union employees work at companies employing less than 50 people. That compares to just 28 percent in the U.S. Small and medium size business enterprises are a critical growth engine for the EU economy, yet these enterprises are often squeezed out of access to a capital markets system and cannot issue shares directly on publicly-traded securities markets, which leaves them reliant on bank lending.
The International Monetary Fund (IMF) forecasts gross domestic product growth at 1.8 percent in 2015 and 1.9 percent in 2017 for the Eurozone. While the European economy is growing, policymakers would like to see even stronger growth in Europe, and the proposed CMU is seen as a way to inject new capital investment, drive growth and spur job creation.
“Europe desperately needs to break the vicious circle of low growth, low investment and its over-reliance on funding from banks that have been paralyzed by the financial crisis,” says William Wright, founder and managing director at New Financial, a London-based think tank.
“Banks are shrinking and will continue to shrink in the future and are in no position to help the European economy borrow its way out of trouble,” he says.
The 2008-2009 global financial crisis and the challenges of slow growth in its aftermath have underscored the need to reform SME and mid-corporate access to financing and capital in Europe. Traditionally, European SMEs relied almost exclusively on bank financing, to a large extent in the form of relationship lending, says Dr. Katja Neugebauer, research associate at the Systemic Risk Centre at the London School of Economics. However, regulation since the financial crisis has required banks to shrink their balance sheets, which may impact SMEs the most.
“This inevitably leads to cuts in the amounts banks lend to firms, especially so for SMEs,” says Neugebauer.
Within the EU, SMEs account for 58 percent of value added, and 66 percent of all jobs, according to Neugebauer. “Therefore, neglecting the needs of SMEs means neglecting the needs of an integral part of the economy,” she says.
U.S. and European Capital Markets
Some economists say the reliance on bank lending in Europe is holding back its growth prospects. In the Euro area, banks provide 70 percent of external financial to non-financial corporations, according to the European Central Bank.
There are cultural differences and preferences relating to capital markets investment not only in business but at the individual level as well.
“Although most companies in Europe are financed by bank loans, companies in the U.S. prefer to go to capital markets, issuing equity and corporate bonds,” says Tomas Holinka, Prague-based economist at Moody’s Analytics. “Similarly, U.S. households hold their wealth in equities rather than in bank accounts. Before the burst of the internet bubble in 2000, almost two-thirds of U.S. households held shares, significantly more than in Europe.”
The United States bond market differs dramatically from Europe, in that there is no single bond market for the EU28 countries, or even the 19 Eurozone member states.
“The big issue for Europe’s capital markets is the lack of a Eurozone wide sovereign bond,” says William O’Grady, executive vice president at Confluence Investment Management. “One of the key factors that makes the U.S. capital markets work is the existence of Treasuries, which act as the base rate for nearly all credit transactions,” he says.
In the U.S., the existence of a credit risk free asset with a benchmark interest rate facilitates the creation and pricing of nearly all other fixed income products, O’Grady says. “In Europe, the closest one can get is Germany sovereigns, which is too small a market to base a large Eurozone-wide financial system. Until that issue is resolved, when Europe creates a Eurobond backed by the full faith and credit of the member nations, Europe’s capital markets will remain fragmented,” he says.
Creating a capital markets system across 28 nations is different than the capital markets system in the United States. But a Capital Markets Union is not about copying the U.S. model, says Wright. “There are plenty of structural and cultural reasons why capital markets in Europe are significantly less developed than in the U.S.,” he says. “A CMU needs to be ‘made in Europe’ and needs to reflect the fact that markets in Europe will never be as integrated or as harmonized as in the U.S.”
To that end, the European Commission, led by Jonathan Hill, EU Commissioner for Financial Services, embarked on a public consultation in February 2015 to get input from individuals and organizations about what building blocks for a CMU should include. The commission received over 700 responses.
“People want us to be ambitious for the Capital Markets Union, but they also want us to make quick progress where we can,” Hill told an audience in June. “For instance by creating a new market for simple, transparent and standardised securitisation products.”
The expectation is that development of a CMU will be beneficial and help stimulate business investment, growth and jobs for SMEs. But, expectations could be too high, warns Wright.
“There is a danger that policymakers invest too much hope in what a capital markets union can achieve for small and medium-sized businesses in Europe,” he says.
Wright highlights two key ways in which a CMU could boost the SME sector.
The first is greater access to venture capital, where EU activity is about one eighth the size of the U.S. market relative to GDP. That could free up significant investment in small high growth companies. Wright points out that if venture capital in Europe had been just half as developed as in the U.S. over the past five years, there would have been an extra $100 billion of investment in European companies. The second key point is that by simplifying access to public equity markets, a CMU could boost the small-cap and high growth IPO market, Wright says.
There are a variety of challenges to the creation of this ambitious project. One issue that may be overlooked is the demand side.
According to a bi-annual survey conducted by the ECB, access to finance was named as the most pressing problem by Euro Area SMEs over the last few years. However, in the latest report that was replaced by the problem of finding customers.
“Productivity has come down in many of the Euro area countries, especially in Italy, weakening the demand along the global value chain. Therefore, when discussing the financial side of the economy, the real side must not be overlooked,” says Dr. Neugebauer.
Another obstacle lies in cultural bias of the European investor. “Another issue is risk aversion and home bias of European savers,” says Neugebauer. “Compared to their American counterparts, they are much more likely to prefer low and safe returns from a bank, rather than the much higher but riskier ones from capital markets.”
Graham Bishop, an independent consultant who has served on several EU Commission finance advisory committees, o, hones in on the intricacies of creating deeper integration between the member states. “In the end, it comes back to the politics of an `ever closer union.’ Are the member states really willing to pool sovereignty over vital parts of their national economic life – such as harmonizing enough of company law, insolvency law, relevant parts of taxation and securities law – together with empowering a Union-level body to enforce it?,” says Bishop.
A Slow Start
“To put this in perspective, the free movement of capital in Europe was first mentioned in the Union’s founding Treaty of Rome in 1957, and the slow progress towards achieving it have been a policy headache on and off for decades,” says Wright.
There are many differences in culture, language, tax and legal systems across the 28 member states, which makes difficult the creation of a single capital market.
“The most important shift required for a successful capital markets union is a cultural shift – and that is not going to happen overnight,” Wright says.
This project, while still in its early stages, could have a significant and lasting impact on the Eurozone economy. Economists believe the creation of more unified capital markets could help Europe avoid another crisis in the future.
“Yes, it could help,” Wright says. “Financial crises are part and parcel of capitalism and are nothing new. What made the crisis in Europe so devastating – with a deeper and longer impact on the real economy than in the US – was that the over-extended banking system and transformed a financial crisis into an economic crisis.”
Hill, the EU commissioner, has stated that an action plan for implementing the CMU will be published in September, reflecting the consultation on the green paper with all interested parties across the EU, and with specific proposals to follow shortly thereafter. In his speech following the consultation in June, he acknowledged there will be a long road ahead.
“Ladies and gentlemen, we will be making a quick start, but we are going to have to keep the effort up, year-in, year-out.”