At the end of September, the EU Commission released its action plan for establishing a Capital Markets Union. The release marked phase two of the plan to launch a single market for capital across the 28 member states of the EU. Among the key principles behind the plan is the establishment of funding sources for businesses similar to the model in the United States, where capital markets and venture capital are commonly used alongside bank loans. You can read our full story on the Capital Markets Union here.
Understanding the difference between financing for institutions in the EU and U.S. goes a long way in explaining the inspiration behind the project. To get a closer look at it, we spoke with William Wright of New Financial, a London-based think tank focusing on capital markets in Europe.
What are the main differences between the U.S. and European capital acquisition process.
The fundamental difference in corporate funding between the U.S. and Europe is that European companies rely far more heavily on bank lending. Overall, some 80 percent of corporate debt in Europe is in the form of bank lending, with just 20 percent coming from the corporate bond markets – almost the inverse of the U.S. Our research suggests that there is a shortfall in capacity of more than $1 trillion a year between what European companies raise in the capital markets and what they could potentially raise if capital markets were as developed as in the U.S.
Why is there such a heavy reliance on bank lending in Europe?
First, many companies and individuals in Europe have a cultural suspicion of risk-taking, entrepreneurialism and ‘Anglo-Saxon’ capital markets. This is also reflected in their savings habits: while Europeans save more than people in the U.S. far less of these savings are invested. Pension fund assets in Europe are just one third the size of the U.S. relative to GDP, and mutual funds are just over half as big.
Second, the structure of the European banking system, with a series of national champion banks traditionally operating within their own borders, allied with a strong local network of regional banks (and backed up by all of those deposits) has historically made bank lending the default option for most companies. A key difference with bank lending is that in the U.S. banks securitize or sell on many of their loans into the much more developed institutional loan market, whereas in Europe a far larger proportion of bank loans remain on bank balance sheets.
And third, alternative sources of funding such as capital markets have been fragmented across national borders and have only in the past few decades begun to catch up with the U.S. This is reflected in the significant gap in depth in most sectors of the capital markets.
What are the the differences is size between the U.S. and European bond and loan markets.
For higher growth and small companies, the gap is particularly acute. Issuance of high-yield bonds in Europe has been growing rapidly over the past few years but it is still only 35 percent the size of the U.S. market relative to GDP. The leveraged loan market is just one fifth the size of the U.S., and venture capital just one eighth as big. Almost perversely, the smallest companies in Europe that rely most of bank funding have the most unrealistic expectation of banks. The European Central Bank and its national counterparts report that too many small companies that need financing are unprepared for borrowing significant sums of money from their bank and expect banks to provide the sort of risk capital that should be provided by entrepreneurs themselves, angel investors or early stage venture capital firms.