The European Capital Markets Union: A viable concept and a real goal? 9783110444643, 9783110443806

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Andreas Dombret and Patrick S. Kenadjian (Eds.) The European Capital Markets Union ILFS

Institute for Law and Finance Series

Edited by Theodor Baums Andreas Cahn

Volume 17

The European Capital Markets Union A viable concept and a real goal? Edited by Andreas Dombret Patrick S. Kenadjian

ISBN 978-3-11-044380-6 e-ISBN (PDF) 978-3-11-044464-3 e-ISBN (EPUB) 978-3-11-043632-7 Library of Congress Cataloging-in-Publication Data A CIP catalog record for this book has been applied for at the Library of Congress. Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available on the Internet at http://dnb.dnb.de. © 2015 Walter de Gruyter GmbH, Berlin/Boston Cover illustration: Medioimages/Photodisc Printing and binding: Hubert & Co. GmbH & Co. KG, Göttingen ♾ Printed on acid-free paper Printed in Germany www.degruyter.com

Table of Contents Andreas Dombret and Patrick Kenadjian Introduction 1 Benoît Cœuré Capital Markets Union in Europe: an ambitious but essential objective

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Christian Ossig Capital Markets Union: Process and Priorities – A financial industry perspective 11 Dirk Schoenmaker From Banking Union to Capital Markets Union

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Dr Andreas Dombret What can capital markets deliver? – A central banker’s view

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Anshu Jain What can the capital markets deliver? A market participant’s view Andrew Bosomworth From Capital Markets Confederation to Capital Markets Union Philipp Hildebrand Capital Markets Union – Who Will Invest?

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Alexandra Hachmeister European Capital Markets Union: Strengthening Capital Markets to foster 67 growth Wim Mijs Banks set for pivotal role in new growth ecosystem Cyrus Ardalan A Vision for Capital Markets Union

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Sir Jon Cunliffe What has to change?

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Patrick Kenadjian The European Capital Markets Union: how viable a goal?

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About the Contributors Cyrus Ardalan Cyrus Ardalan is a Vice Chairman of Barclays and Head of EU and UK Government Relations. Previously he was a Vice Chairman of Barclays’ Investment Bank where he has had a variety of roles, including Head of Public Sector EEMEA, Head of Investment Banking, Middle East, Africa and Emerging Europe, and Head of Investment Banking for Continental Europe. Mr. Ardalan joined Barclays in 2000 from BNP Paribas where he held a number of senior positions between 1990 and 2000 in London and New York. These included the Global Head of Bonds, Global Head of Fixed Income Marketing and President and CEO of Paribas broker dealer in the US. Prior to this Mr. Ardalan was a Managing Director at Chemical Bank. He joined Chemical Bank from the World Bank where he spent 12 years in a variety of roles including Division Chief of Treasury Operations. Mr. Ardalan is currently Chairman of the Board of the International Capital Markets Association (ICMA) and Chairman of the British Banking Association Strategy Group. He is also an Honorary Adviser to the National Association of Financial Market Institutional Investors (NAFMII) in China, and a Member of the Board of the International Finance Facility for Immunisation (IFFIm). He has previously served as a member of the board of the Dubai International Financial Centre (Dubai’s onshore banking facility) and on the Federal Reserve of New York Foreign Exchange Committee. Mr Ardalan is a graduate of University College London and Balliol College University of Oxford. He is a member of the Campaign Committees of both institutions. He has published a number of articles including co-authoring a book on the principals of workers self management in Yugoslavia.

Andrew Bosomworth Mr. Bosomworth is a managing director in the Munich office and head of PIMCO portfolio management in Germany. Prior to joining PIMCO in 2001, he worked at the European Central Bank, Merrill Lynch and at New Zealand’s Debt Management Office. He has 21 years of investment experience and holds a master’s degree in economics from the University of Canterbury, New Zealand. He also graduated from the Advanced Studies Program in International Policy Research at the Kiel Institute in Germany.

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About the Contributors

Benoît Cœuré Benoît Cœuré is a member of the Executive Board of the European Central Bank and the Chairman of the Bank for International Settlements’ Committee on Payments and Market Infrastructures. Prior to joining the ECB, he served in various policy positions at the French Treasury. He was the CEO of the French debt management office, Agence France Trésor, then France’s Assistant Secretary for Multilateral Affairs, Trade and Development, co-president of the Paris Club and G8 and G20 finance sous-sherpa for France, and finally Deputy-Director General and Chief Economist of the French Treasury. Mr Cœuré is a graduate of École polytechnique in Paris. He holds an advanced degree in statistics and economic policy and a B.A. in Japanese. He has taught international economics and economic policy at École polytechnique and at Sciences Po in Paris, and authored articles and books on economic policy, the international monetary system and the economics of European integration, including most recently: “Economic Policy: Theory and Practice” (Oxford University Press, 2010).

Sir Jon Cunliffe Sir Jon Cunliffe became Deputy Governor for Financial Stability of the Bank of England on 1 November 2013. Jon is a member of the Bank’s Financial Policy and Monetary Policy Committees, the Bank’s Court of Directors and the Prudential Regulation Authority Board. He has specific responsibility within the Bank for the supervision and oversight of Financial Market Infrastructures, for Resolution and for the provision of Emergency Liquidity Assistance. He is a member of the G20 Financial Stability Board Steering Committee, the Bank for International Settlements’ Board of Directors and the European Systemic Risk Board. Before joining the Bank, Jon was the UK Permanent Representative to the European Union, effective from 9 January 2012. From July 2007 to December 2011, he was the Prime Minister’s Advisor on Europe and Global Issues and the UK Sherpa for the G8 and G20 and the Cabinet Office Permanent Secretary responsible for EU coordination. Between 2002 and 2007, Jon was Second Permanent Secretary at HM Treasury, Managing Director of the Macroeconomic and International Finance Directorate. He was responsible for UK macroeconomic policy, international and EU policy and financial services and the Government’s representative at the meetings of the Bank’s Monetary Policy Committee. Between 1990 and 2002, Jon held various posts at HM Treasury, including Managing Director for Financial Regulation and posts on EU and international

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finance. He led the Treasury’s work on operational independence of the Bank of England; European Monetary Union; and the international financial system. Prior to that Jon held a number of posts at the Department of Transport and the Environment. Jon was appointed a Companion of the Order of the Bath in the New Year Honours 2001, and made a Knight Bachelor in the New Year Honours 2010. He has a Master of Arts in English Language and Literature from the University of Manchester and spent some time as a Lecturer on English Literature at the University of Western Ontario, Canada.

Dr Andreas Dombret Professor Dr Andreas Dombret was born on 16 January 1960 in the USA to German parents. He studied business management at the Westfälische Wilhelms University in Münster and was awarded his PhD by the Friedrich-Alexander University in Erlangen-Nuremberg. From 1987 to 1991, he worked at Deutsche Bank’s Head Office in Frankfurt as a manager with the power of procuration. From 1992 to 2002, he worked at JP Morgan in Frankfurt and London, from 1999 as a Managing Director. From 2002 to 2005, he was the Co-Head of Rothschild Germany located in Frankfurt and London, before serving Bank of America as Vice Chairman for Europe and Head for Germany, Austria and Switzerland between 2005 and 2009. He was awarded an honorary professorship from the European Business School in Oestrich-Winkel in 2009. Since May 2010, he has been a member of the Executive Board of the Deutsche Bundesbank with currently responsibility for Banking and Financial Supervision, Risk Control and the Bundesbank’s Representatives Offices abroad. He is also the Bundesbank’s Deputy for the G7, the G20 and the IMF. Andreas Dombret is a Member of the SSM’s Supervisory Board, the Basel Committee on Banking Supervision and the Bank for International Settlements (Board of Directors).

Alexandra Hachmeister Alexandra Hachmeister (born in 1975) is Chief Regulatory Officer of Deutsche Börse AG. Ms Hachmeister joined Deutsche Börse AG in 1999. Since then she served in various positions and departments including Market Design Functionality, Systems Business Development and Boards & Committees. Prior to becoming Chief Regulatory Officer she managed the Group’s Corporate Office. In her role as Head of Regulatory Strategy and Deputy Head of Global Public Affairs she

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is responsible for the development, implementation and communication of the Group’s global regulatory strategy and positioning. Ms Hachmeister is member of the Group of Economic Advisors to ESMA (European Securities and Markets Authority) and the working groups ‘Role of Financial Services in Society’ (World Economic Forum) and ‘Financial Transaction Tax’ (German Exchange Experts Commission). She chairs the Board of Examiners ‘Certified Board of Director’ of Deutsche Börse Capital Markets Academy. Ms Hachmeister studied business in Germany, France and the US, earning a Ph.D. in market microstructure from European Business School. She is married with two sons.

Philipp Hildebrand Philipp Hildebrand is Vice Chairman of BlackRock, a member of the firm’s Global Executive Committee, and Chairman of Multi-Asset Strategies (MAS). Philipp also sits on the International Advisory Board of Oxford University’s Blavatnik School of Government. Until January 2012, he served as Chairman of the Governing Board of the Swiss National Bank (SNB). In that capacity, he was a Director of the Bank for International Settlements (BIS), the Swiss Governor of the International Monetary Fund (IMF) and a member of the Financial Stability Board (FSB). Previously, Mr. Hildebrand served as Chief Investment Officer of a Swiss private bank and as a partner of Moore Capital Management in London. Between 2006 and 2009, he served as a member of the Strategic Committee of the French Debt Management Office. Mr. Hildebrand is a member of the Group of Thirty and an Honorary Fellow of Lincoln College, Oxford. Mr. Hildebrand earned a BA from the University of Toronto, an MA from the Graduate Institute of International Studies in Geneva, and a DPhil from the University of Oxford.

Anshu Jain Anshu Jain became Co-Chief Executive Officer of Deutsche Bank in 2012, having first joined in 1995 to build the Bank’s nascent markets business. He was subsequently appointed head of Global Markets and later head of the Corporate & Investment Bank. In these roles he led first the integration of fixed income and equities, then of sales and trading and corporate finance, and finally a further alignment of investment banking and transaction banking, which achieved both efficiencies and improved delivery to clients. As Co-Chief Executive Officer, Anshu and his colleagues are spearheading Strategy 2015+, a comprehensive transformation programme in pursuit of Deutsche Bank’s aspiration to be the leading client centric global universal bank.

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Anshu advises governments and industry bodies around the world. He led Deutsche Bank’s team advising the UK Treasury on financial stability. He sits on the Board of Directors of the Institute of International Finance, is a member of the Financial Services Forum and he also serves on the International Advisory Panel of the Monetary Authority of Singapore, which he advises on industry, market and macroeconomic issues. He is Chairman of the Board of Trustees of the Alfred Herrhausen Society. In 2014, he was awarded an honorary doctorate by TERI University in New Delhi, one of the leading research institutions for sustainable development and an Honorary Fellowship from London Business School. In 2012, The Economic Times of India named him Global Indian of the Year. In 2010, he received a Lifetime Achievement Award from Risk magazine. Anshu is a wildlife conservationist, supporting wildlife charities in India and Southern Africa.

Patrick Kenadjian Patrick S. Kenadjian is currently an Adjunct Professor at the Goethe University in Frankfurt am Main, Germany, where he teaches courses on the financial crisis and financial reform and comparative public mergers and acquisitions at the Institute for Law and Finance. He speaks frequently on topics related to financial reform, including too big to fail, the architecture of financial supervision and the new regulatory environment in the US and the EU. Mr. Kenadjian is also Senior Counsel at Davis Polk & Wardwell, LLP in their London office. He was a partner of the firm from 1994 to 2010, during which time he opened the firm’s Tokyo and Frankfurt offices in 1987 and 1991, respectively and spent over 25 years in their European and Asian offices. His practice includes cross-border securities offerings, especially for financial institutions, mergers and acquisitions, privatizations and international investments and joint ventures, as well as general corporate advice, with an emphasis on representing European clients. He has been active in securities transactions for issuers in Asia and Europe, particularly on initial public offerings and privatizations in Germany, Austria, Italy and Switzerland. He has represented bidders and targets in cross-border acquisitions throughout Europe, in particular in France, Germany, Italy, Switzerland, the United Kingdom and the United States. Mr. Kenadjian has also represented European and Asian issuers in U.S. debt private placements. He speaks French, German and Italian.

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About the Contributors

Wim Mijs Wim Mijs started as Chief Executive of European Banking Federation in September 2014. He started his career teaching at the faculty of Law of the University of Leiden (the Netherlands) until 1990 and worked at the Permanent Court of Arbitration at the Peace Palace in The Hague until 1993. He then joined ABN AMRO in Amsterdam before moving to Brussels to head the ABN AMRO EU Liaison Office. Mr Mijs moved back to The Hague in 2003 where he became the Head of Government Affairs for ABN AMRO. From 2001 to 2007 he was Chair of the Financial Markets Committee of the European Banking Federation, and was appointed Chief Executive of the Dutch Banking Association in 2007. He holds a Law degree from the University of Leiden.

Christian Ossig Christian Ossig has been working for large international investment banks for almost two decades and is currently a Policy Advisor on capital markets and financial regulation at the Institute of International Finance (IIF) in Washington DC. He has been a Managing Director and Board Member at Bank of America and at The Royal Bank of Scotland in Frankfurt, heading the German, Swiss and Austrian Financial Institutions and Public Sector businesses. Before this he worked as M&A and restructuring expert, equally focussing on Financial Institutions, at NM Rothschild and JPMorgan in London. At Goethe University in Frankfurt he has been lecturing on International Banking and International Financial Systems. He studied business and economics at the European Partnership of Business Schools in both Germany and France, at the College of Europe in Belgium and at Cambridge University in the UK.

Dirk Schoenmaker Dirk Schoenmaker is dean of the Duisenberg school of finance. He is also a professor of Finance, Banking and Insurance at the VU University Amsterdam and a member of the Advisory Scientific Committee of the European Systemic Risk Board at the ECB. He is a renowned expert in the areas of (inter)national banking, financial supervision and stability, and European financial integration. He is author of ‘Governance of International Banking: The Financial Trilemma’ (Oxford University Press) and co-author of the textbook ‘Financial Markets and Institutions: A European Perspective’ (Cambridge University Press). He earned his PhD in economics at the London School of Economics.

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Before joining the Duisenberg school in 2009, he had served at the Ministry of Finance in the Netherlands. He was a member of the European Banking Committee as well as the Financial Services Committee of the European Union. In the 1990s he served at the Bank of England and was a Visiting Scholar at the IMF, OECD and the European Commission.

Andreas Dombret and Patrick Kenadjian

Introduction

On February 18, 2015, the European Commission published its Green Paper on Building a Capital Markets Union, presenting its views of the goals and challenges of building such a union, thus launching a public consultation on the priority actions needed to put in place by 2019 the building blocks for an integrated, well regulated, transparent and liquid Capital Markets Union for all 28 Member States. On March 18, 2015, the Institute for Law and Finance at the Johann Wolfgang Goethe University in Frankfurt am Main held a full-day symposium which brought together leading representatives of the public and private sectors to deliver the first high level response to the questions posed by the Commission’s Green Paper. These responses are collected in this volume. The background of the project is well known. From a macro point of view, only 20 to 30 % of financing in Europe comes from the capital markets, with 70 to 80 % being provided by the banking sector. The experience of the US where the capital markets provide 70 to 80 % of the financing shows there is room for increasing that percentage. In the aftermath of the financial crisis of 2008/9, the ability of banks to provide financing has been restricted, as it always is after a balance sheet crisis. It has also been argued that this effect has been exacerbated in this case by changes in regulation requiring banks to hold more capital. The more rapid recovery of the US economy has been in part attributed to the ability of the capital markets to step in where the banks are limited. Whether this was coincidence or causation, this has contributed to the impetus to address problems which have long been known on a micro level, some of them going back as far as the Giovannini Reports in the early years of this century. In the Green Paper the Commission asks us in effect three questions. Do we agree with its goals for the Capital Markets Union? Which parts of the project can be carried out by the private sector alone and which will require public sector intervention in the form of regulatory or legislative changes? Do we agree with their proposed prioritization of reform in three stages, going after the low-hanging fruit, then medium- and long-term changes and what they have put in these three baskets? A consensus emerged easily on the desirability of the project and the wisdom of a phased approach, although a question was raised as to whether this consensus is due to the fact that at this point no one knows exactly what it will include or, in the words of one public sector participant, how ambitious it

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will be. In fact, several speakers warned that while a phased approach was tactically desirable, it could bring with it the danger of not being ambitious enough, of going after the low-hanging fruit and being satisfied with those first steps. Several speakers also cautioned about focusing the project too closely on specific products such as securitization or infrastructure investment, or on a specific goal, that of helping small and medium-sized enterprises (SMEs) to gain broader access to the capital markets. Focusing on specific products could result in losing sight of the overall goals of the project, while focusing on SMEs could lead to the project being prematurely judged a failure if cultural and macro economic factors turn out to set limits to the appetite of SMEs for capital markets products. Several representatives of the private sector noted that many of the initiatives and goals of the project could be hampered by other regulatory and supervisory initiatives currently being pursued, ranging from the introduction of a securities trading transaction tax to the increased capital requirements for trading assets and the new leverage ratios for financial institutions. There was a broad consensus that the project should not be viewed as an attempt to substitute the capital markets for bank lending, but rather as providing a supplement to bank lending, which would diversify sources of funding to the European economy and make the financial system more resilient and less subject to shocks. A single source of funding, like any monoculture, will make the system vulnerable to shocks, while several sources will make the system more stable. Frankfurt, April 2015

Benoît Cœuré

Capital Markets Union in Europe: an ambitious but essential objective Strengthening growth and employment is a top priority for Europe. And there is an increasing consensus that further integration and development of European capital markets are key elements in achieving this goal. The European Commission is therefore planning to lend its support to the creation of a true single market for capital – the Capital Markets Union (CMU). It has issued a green paper on the subject to encourage discussion. Indeed, it is time that Europe made progress in this area. In general, European capital markets are less developed than those in other major jurisdictions. The difference is particularly striking when we compare the European Union (EU) with the United States (US). In Europe, savings are concentrated in the banking sector, businesses rely heavily on bank lending and capital markets lack depth. In terms of value, European equity amounts to about 60 % of its US counterpart and corporate bonds to around 35 %. Both the bank-based financing system in continental Europe and the more market-based system in the US are the result of economic, historical and political developments. Traditionally, small and medium-sized enterprises (SMEs) in Europe rely mainly on bank loans for their funding. As a result, the importance of banks for funding the economy can partly be explained by the importance of SMEs for economic activity, which is more pronounced than in other jurisdictions. Partly as a result of this, the legal infrastructure needed for a market-based financing system remained incomplete, while the banking sector developed more strongly. Another element is the uneven development of funded pension systems in Europe, in contrast to the US. Yet another element has been the different regulatory approach followed on the two continents. As an example, the restrictions on banks’ activities under the Glass-Steagall Act of 1933 certainly helped to stimulate the development of alternative ways of financing the economy, while in Europe banks reinforced their position as the main providers of funding. This is important to bear in mind when reflecting on how to achieve the Capital Markets Union in Europe: the way in which financial markets integrate (or not) will also be affected by the underlying regulatory and legislative framework, and Europe will have to find its own way, different from that of the US but also different from its – Europe’s –recent past.

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Both systems (bank-based or market-based) have their costs and benefits. However, as Europe’s economy depends mainly on bank lending, the deleveraging of banks induced by the crisis has proved to be a drag on the recovery. In the last two decades, European financial markets have started to become more market- oriented, and more integrated in terms of cross-border holdings of financial instruments. However, the crisis undermined this trend.

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In the early years of this century, the euro area experienced significant convergence in respect of asset prices, but then was hit by a sudden fragmentation of its financial markets when the crisis erupted. In fact, the crisis revealed that the integration had been partly driven by debt-based wholesale banking flows which were prone to sudden reversals in the face of shocks. Today, capital markets are starting to show some signs of de-fragmentation as illustrated by the FINTEC index, designed and published by the ECB¹. This is a welcome process, but it is no guarantee of deep and resilient financial integration.

So when promoting financial integration in Europe through the Capital Markets Union, we need to go beyond quantitative convergence – we should seek to promote qualitative integration. True financial integration implies a single market for capital supported by an adequate regulatory and legislative framework. And indeed, establishing the Capital Markets Union is a logical step in the ongoing construction of the European Union.

 See the ECB’s Financial Integration in Europe report, April .

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Capital Markets Union is needed to complete the Single Market Integrating capital markets is essential for the creation of a true EU-28 Single Market. In this regard, CMU should seek to increase the effectiveness of capital markets, in other words their ability to allocate resources and match supply of funding with demand. This will require a diversification of the sources of financing for the economy. At the same time, CMU should improve the efficiency of capital markets by enhancing competition among financial institutions and within the market. This would ultimately help to reduce the costs of financial intermediation, and benefit consumers and investors. Finally, CMU should seek to increase the size of capital markets by removing cross-border frictions – hence allowing credit and capital to flow freely throughout the market. Even the bestperforming national markets in the EU lack critical mass, leading to a smaller investor base, low economies of scale and fewer financial instruments to choose from.

Capital Markets Union is essential to Economic and Monetary Union Turning to the euro area, I would argue that a genuine capital markets union is in fact essential for the good functioning of a monetary union. Financial markets in the euro area have not seemed to provide much cross-border risk-sharing as the low levels of cross-border investment flows illustrate. This means that a negative economic shock has the greatest impact at home. CMU should ensure that financial markets are integrated in such a way as to help companies and households cushion local shocks. To achieve this, we should aim to have sizeable cross-border holdings of debt and equity and direct cross-border exposures from banks in one jurisdiction to firms and households in another. In addition, deep and well-diversified capital markets would enhance the functioning of our monetary policy, which is today constrained by the large reliance of the economy on bank financing. Of course, increased diversification and more risk-sharing would benefit the Single Market as a whole. This is even more the case in a monetary union.

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Capital Markets Union complements Banking Union In addition, CMU will complement Banking Union. By fostering diversification and enhancing the allocation of cross-border capital, CMU will help to attain two of the core objectives of Banking Union: breaking the bank-sovereign nexus by enhancing cross-border risk-sharing; and complementing the Single Resolution Fund as a private insurance against banking crises. In parallel, CMU should aim to ensure that funding is allocated efficiently and regardless of location. Companies or individuals looking for funding in Europe should get access to this funding on the basis of their own merits, not their location. In addition, Banking Union and the regulatory agenda addressing the “too big to fail” issue should encourage banks to reach an optimal size relative to the European market – that is, large enough to operate across borders and diversify risks, but small enough to be resolved with the resources of the Single Resolution Fund. Here, developing a European market for banking mergers and acquisitions could help to foster consolidation within the sector, achieve efficiency gains and disconnect local banks from local vested interests. Consolidation within the market could also contribute to restoring banks’ profitability, thereby putting them in a better position to finance the economy. Having a single European banking supervisor could also help to promote cross-border lending. At the same time, an ambitious implementation of the CMU agenda would foster financial integration and facilitate banking supervision, as the Capital Markets Union would help to overcome market fragmentation along national lines, which in turn would also make cross-border supervision of banks easier.

How do we get there? There are various hurdles and barriers to be surmounted on the way to a full capital markets union which would bring about all the benefits mentioned above. Many are known and could be overcome in the short run. However, a lot more work is needed to create the framework conditions for capital markets to develop throughout Europe. Barriers vary in size and difficulty. To overcome them, we will also need various measures, with different degrees of ambition. One measure could be to foster individual market segments. Developing certain market segments, or allowing these markets to operate in a more crossborder way could be the first step towards diversifying capital markets in Europe.

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Benoît Cœuré

A number of initiatives are ongoing or have been identified by the Commission for early action in this regard. These include measures to support the development of certain market segments such as securitisation and EU covered bonds or private placement. Initiatives can also be undertaken to foster transparency in certain markets with a view to reducing information asymmetries between originators and investors, and enabling investors to perform the necessary due diligence. Such initiatives can be publicly supported but they should be market-led. This would be particularly important for SME loans and would help investors to develop their own credit models and risk metrics. Finally, there is the option of providing public risk enhancement for the development of certain markets where there is an obvious market failure. This has to be evaluated against the risk of market distortions, but don’t let us fool ourselves: the European securitisation market will probably never be as deep and liquid as in the US, given the significantly different amount of public sponsoring. However, promoting certain market segments and fostering transparency will not be sufficient to create a full CMU, and will itself require legislative action. As an example, a well-functioning securitisation market could be one of the key pillars for CMU in the short term. For this to happen, legislative action is needed to ensure an appropriate treatment of high-quality securitisation throughout the EU, in order to promote securitisation as an alternative funding tool and as a credit risk transfer tool. Therefore, a second, more ambitious measure will be to take legislative action in order to foster CMU. Let me give two examples: the regulatory framework applying to market infrastructures – a key element of capital markets – is being put into place. A further step in this direction will be the legislative proposal which the Commission is preparing on a European framework for the recovery and resolution of clearing houses, based on work done by the Committee on Payments and Market Infrastructures, the International Organization of Securities Commissions and the Financial Stability Board. Another example relates to the integration of European corporate bond and equities markets, which is still being hindered by a lack of harmonisation in key areas. One area is legislation relating to rights granted by the ownership of securities, which currently prevents investors from being able to assess the investment risk in another jurisdiction on the same basis. A key step forward here would be the Securities Law Directive. Taken together, legislative initiatives should be geared towards the creation of a single rulebook for capital markets in Europe. This would promote true financial integration by ensuring that all market participants are subject to the same set of rules, are treated equally and have equal access to that market. In general – and even if this takes time – we should not shy away from difficult is-

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sues, such as pushing forward in the fields of insolvency, corporate and tax laws as well as accounting standards, all of which play a key role in the cross-border functioning of capital markets. As long as there are barriers in these areas, financial integration, which forms the basis of CMU, will not be fully achieved. Alternatively, if action cannot be taken at EU level in the short term, a clear commitment by Member States to take steps to lower barriers and harmonise national legislation would represent significant progress. A third measure will be to establish an efficient monitoring framework ensuring the common application of rules throughout the market, in addition to a sound legal and regulatory framework. A single rulebook by itself will probably not be sufficient to ensure that the same conditions prevail throughout the whole of the EU. So there is a case for ensuring at EU level the effective implementation and consistent enforcement of the rules and standards that we develop for CMU. As Europe’s financial structure evolves over time, the steady state of the supervisory framework should be assessed and improved to match the needs arising from the development of CMU. In the meantime, CMU has to cater for enhanced supervisory convergence.

Conclusion The Commission’s CMU initiative is very welcome. The Capital Markets Union will in any case play a useful role in improving the allocation of capital throughout Europe and in diversifying sources of financing. However, it remains to be seen how ambitious Europe wants to be in developing a genuine capital markets union – and therefore to reap its benefits. While some low-hanging fruit should be quickly picked, I believe that we need to be bold in our objectives and give ourselves the tools to turn CMU into a reality rather than allow it to languish in the realm of wishful thinking. To quote Nelson Mandela: “It is not where you start but how high you aim that matters for success”. And the tools that we choose will shape the framework in which capital markets develop. To achieve genuine financial integration – in other words, to ensure that all market participants are subject to the same set of rules, are treated equally and have equal access to that market – will require action in a range of fields which are not always directly linked to capital markets.

Christian Ossig

Capital Markets Union: Process and Priorities – A financial industry perspective Key messages –

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The new European flagship project found in the Capital Markets Union (CMU) is a highly welcome and overdue initiative. Strengthening capital markets as a source of economic financing to complement bank lending, may promote jobs and foster economic growth throughout Europe. In its Green Paper, the European Commission has proposed a broad array of possible reform areas that target issuers, investors and intermediaries. As an important first step, this array must be narrowed down to a specific list of attainable priorities while appropriately sequencing short- and long-term measures Visible welcome momentum for CMU as a high level priority for Europe has been created. In order to sustain and augment this momentum, the Commission should focus on a number of low hanging fruits that may be easily addressed. The following reform areas have attractive potential for short-term gains: – Greater standardisation to promote a stable, deeper and less fragmented European corporate bond market. This will provide issuers with better funding options, while giving investors a broader range of more liquid investment opportunities – Development of a European private placements market to channel funding directly from issuers to medium sized firms – As financing patterns are not only shaped by borrowers but also by savers: Strengthening minimum and consistent standards for investment advice and comparability between investment products is necessary to channel household savings into capital markets more effectively Realising the full benefits of rebalancing financial intermediation in capital markets will involve profound structural change. This requires time. The following reform areas offer great potential but their success requires steadfast perseverance: – Improving the availability of capital market funding for small and medium-sized enterprises (SMEs) – Developing a European risk capital market for high growth companies, when bank funding is often inaccessible

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Implementing proposals to rebuild securitisation markets and help freeup banks’ balance sheets for new lending – Implementing existing proposals to remove impediments to long-term private infrastructure investments Many of the measures proposed in the context of the CMU both deepen and integrate financial markets with each process reinforcing one another. Removing obstacles to a single financial market unlocks scale effects and increases competition and risk diversification. For issuers, this means improved access to lower cost funding and expanded options for households to save and invest CMU is also concerned with the issue of attracting more international investment into the EU. The alignment of its standards with relevant global standards will thus be crucial to its success

Acknowledgements and disclaimer The author would like to thank the colleagues from the IIF, Hung Tran and Jessica Stallings, for their input and useful discussions, and Khadija Mahmood for excellent research assistance. The views expressed herein should be attributed to the author and not to the IIF. This Note represents the view of the author and does not necessarily represent IIF views or IIF policy recommendations.

1. Overview: Financial intermediation and CMU The February 2015 release of the Green Paper on Building a Capital Markets Union (CMU) marked the launch of a new flagship project of the European Commission. The principal objectives of the Commission’s initiative are (i) to strengthen capital markets as a source of financing for the economy in order to (ii) promote jobs and growth in Europe and (iii) to remove barriers towards a true single capital market for all 28 Member States.

Banks dominate financial intermediation in Europe In contrast to the US, banks are the principal mechanism for financial intermediation in the EU (Chart 1). Relative to GDP, bank loans to non-financial corporations in the EU are twice as high as in the United States, and this gap has widened since the on-set of the financial crisis. In contrast, financial intermediation through capital markets in Europe remains underdeveloped; while the amount of debt securities issued by government and financial institutions are comparable to the US, the share of public equity markets in the US is twice as high and the share of corporate bonds is three times as high as in the EU (Chart 2). Access to capital markets differs greatly among EU member states. In terms of bond and

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equity issuance, the UK capital market structure is roughly comparable to the US, while in Italy and Germany equity and bonds play a much smaller role. It does not come as a surprise that the financing pattern of non-financial corporations in the EU reflects the dominance of bank loans in Europe, rather than the issuance of securities (Chart 3). This greater dependence on bank lending makes the aggregate European economy more vulnerable when bank lending decreases, as it did throughout the financial crisis.¹ Chart 1: Bank lending to non-financial corporations  RI *'3 

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Source: ESRB Advisory Committee

Chart 2: Capital market structure SHUFHQWDJH RI *'3   )LQDQFLDO LQVWLWXWLRQV GHEW VHFXULWLHV *RYHUQPHQW GHEW VHFXULWLHV  &RUSRUDWH GHEW VHFXULWLHV  3XEOLF (TXLW\      

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 European Commission (), Green Paper – Building a Capital Markets Union, February.

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Christian Ossig

Chart 3: Composition of non-financial corporations’ liabilities SHUFHQWDJH           

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Source: OECD

Structuring the approach towards building CMU CMU does not seek to replace banking as the principal source of financing. Its objective is to complement bank based financing with stronger, market based intermediation. To achieve this, the European Commission has proposed a broad range of possible reform areas in its Green Paper (Figure 1). The Green Paper can therefore be viewed as a map of possible policy areas to address in the concept’s construction rather than as a strict blueprint for establishing a European CMU. The policy initiatives proposed by the Commission in the Green Paper can be grouped into three main areas: (i) improving access to capital markets, particularly equity and bond funding for SMEs, growth companies and long-term financing needs (e. g. infrastructure), (ii) increasing and diversifying investment opportunities for both retail and institutional investors, and (iii) enhancing the link between investors and investment opportunities through improved financial intermediation processes. The third area includes both improvements to financial market infrastructure and the institutional framework, as well as changes to the broader market and legal environment. An important first step will be to reduce this broad scope to a focused list of attainable priorities, and appropriately sequence short- and longer-term measures.

Capital Markets Union: Process and Priorities – A financial industry perspective

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Figure 1: Green Paper – Schematic overview of proposed reform areas

Note: * The Commission’s “Priorities for early action” and highlighted in red

It should be noted that the manners by which corporates fund themselves and households save change slowly over time. Financial intermediation patterns are part of a complex ecosystem driven by underlying forces that go far beyond

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Christian Ossig

the scope of CMU. These include the extent of home ownership, national pension systems or even legal traditions and regimes. This means that long-term structural change will be necessary in many areas to realise the full potential benefits of CMU. CMU also provides, however, an opportunity to pluck some low-hanging fruits and thereby cause a short-term impact. This paper suggests and focuses on three short-term priorities for early action. The publication of the Green Paper marked the beginning of a consultation period and an invitation to stakeholders to participate in the debate. The feedback should help in developing an action plan to be finalised and released during the second half of 2015. The building blocks for a fully functioning CMU are expected to be in place by 2019.

CMU and Banking Union – conceptually different but working in complement with one another CMU differs in several aspects from the other EU flagship project, Banking Union, whose two main initiatives, the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM) are currently being implemented. Indeed, the similarity of the two terms (along with the term Monetary Union) suggests a potentially misleading analogy. The primary objective of Banking Union is to centralise a banking policy framework while providing supervision and resolution on a European level. Banking Union is thus focused on creating a new institutional framework and not on developing banking in the EU. The primary objective of CMU is to strengthen capital markets as a source of financing; the creation of new institutions is thus not at the project’s core.² However, as CMU progresses, the process might reveal that institutional changes, e. g. revised and expanded authorities of the European Securities and Markets Authority (ESMA), might be necessary to achieve these objectives. Furthermore, unlike Banking Union, CMU is not subject to crisis management considerations or limited to financial markets but rather part of the broader long-term EU agenda of structural reform designed to promote jobs and foster economic growth. Finally, while Banking Union centres on the Eurozone (although non Eurozone members

 EU Commissioner Hill pointed out in a debate at the Brookings Institution in Washington DC in February that the three European Supervisory Authorities (ESAs) for banks, securities and markets, as well as insurance and occupational pensions are indeed in place. Focussing on creating additional institutions at this stage would work against achieving the objectives of CMU. The concern that proposals for institutional change might hinder progression of the overall CMU project has been raised in particular in the UK.

Capital Markets Union: Process and Priorities – A financial industry perspective

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have the option to join), CMU extends to the entire EU. Thus, CMU continues a long history of promoting the Single European Market idea that started with the Treaty of Rome’s declaration in support of the free movement of capital in 1957. Despite the conceptual differences, CMU and Banking Union should be seen as complementing one another. Efficient and diversified capital markets will help weaken the sovereign-banking nexus, which is one of the key objectives of Banking Union. CMU will also help reduce the home bias in European capital markets. Furthermore, CMU should support the process of preserving international banks that are large enough to operate across borders and diversify risk, but banks that are small enough to be resolvable.³

2. Short-term priorities to sustain and increase current momentum The Commission’s Green Paper distinguishes between “priorities for early action” on the one hand and further “measures to develop and integrate capital markets” on the other. This approach of identifying priorities, which may yield early benefits, is welcome. The focus on short-term achievable progress is essential to sustaining and augmenting the visible momentum for CMU as a high level priority for Europe. As CMU progresses this momentum will be vital to tackling the many complex and technical challenges ahead. Most priorities (“quick wins”) proposed by the Commission relate to initiatives to improve access to finance directed to SMEs (Figure 1). Given the importance of SMEs and growth companies in contributing to job creation and economic growth, policymakers’ focus on supporting SMEs and growth companies is well-placed and instrumental in generating broader momentum for the CMU project. Banks however may well remain the principal source of external financing for SMEs for some time. The Commission should therefore adjust the scope of the short-term priorities and put stronger emphasis on reform measures that will impact financing for medium and large firms and saving behaviour of households.

 Coeuré (), What is the goal of the Capital Markets Union, Presentation at the ILF conference, March.

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Christian Ossig

Greater standardisation to deepen corporate bond markets A stable, well-integrated, deep and liquid bond market plays a key role in providing issuers with funding options and investors with a broad range of investment opportunities. Currently, corporate bond issuance as a percent of GDP in the US is four times larger than in the EU (Chart 4). This is despite the increase in European corporate bond issuances in the wake of the financial crisis. The growth in bond issuance in crisis situations is not surprising given its lower volatility than bank lending as a funding instrument in times of financial distress.⁴ Chart 4: Market for corporate debt securities '( )5  RI *'3 ,7 8.  (8 86                       

Source: ECMI

Corporate bond markets in Europe are fragmented across thousands of bonds of varying maturities that are frequently issued opportunistically when financing needs arise. This fragmentation, combined with bilateral, over-the-counter trading practices leading to complexities, inefficiencies, low price transparency and ultimately higher costs for investors is discouraging corporations from tapping the bond market. Furthermore, concerns about the decrease in secondary bond market liquidity have become increasingly apparent.⁵ Highly favourable market conditions with low interest rates and low volatility are covering up numerous underlying structural weaknesses in the corporate bond market, many of which are rooted in the liquidity shift from the sell-side to the buy-side. A change  Giesecke et al. (), Macroeconomic effects of corporate default crisis: A long-term perspective, February.  IIF (), The Illusion of Liquidity, Capital Markets Monitor, October, or Morgan Stanley & Oliver Wyman (), Liquidity Conundrum: Shifting risks, what it means, March.

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19

in market environment might expose these issues and lead to even lower liquidity along with sharp price deteriorations. Such financial stability considerations should make fixed income market reform an even higher priority. Greater standardisation of corporate debt issuances in Europe would help to address these concerns. Corresponding measures could include i.a. a full disclosure-based primary issuance regime across the EU, standardised short deadlines for bond prospectus registration and recognition of English as an alternative working language, whereby all documentation would be made available in English. Furthermore, well-functioning bond markets rely on investors and issuers and a free and transparent flow of information to assist them in making investment decisions. Similar to how credit rating agencies contribute to well-functioning capital markets, the regulatory framework should support an efficient, transparent and competitive credit ratings market. Given the size of the corporate bond market, any successful improvements in this field are likely to have a particular impact in providing financing for corporates.

Developing a European private placements market Private placement markets channel funding directly from institutional investors such as insurers and pension funds to primarily medium sized companies. Within Europe, only Germany, with the corporate Schuldschein market, operates a private placement segment of significant size. Markets for this instrument in France and the UK are emerging successfully, albeit from a low base. A truly European private placement market does not yet exist. European issuers thus often issue private placements on the much larger US market, despite the foreign exchange rate risk. Until recently the volume of private placement issued by European corporations in the US market regularly exceeded the amount those corporation issued in European markets (Chart 5). The data also shows that private placement markets have been growing markedly since the financial crisis, which illustrates the stability of this funding instrument.

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Christian Ossig

Chart 5: Private placements by European issuers (XURSHDQ 33 &RUSRUDWH 6FKXOGVFKHLQ 8633

OKV EQ ¼        











Source: S&P

Private placements provide long-term financing primarily to unrated medium sized issuers. To investors, predominantly insurance companies and pension funds, they offer an additional source of risk diversification. The instrument is typically tailored, unlisted, unsecured and offered privately to a limited group of institutional investors. As a consequence, investors typically purchase private placements with a “buy-to-hold” view. Given the success of private placements in markets with sufficient liquidity and depth, such as Germany and the US, a certain degree of Europe-wide standardisation should help to overcome fragmentation, attract investors, increase market depth and liquidity and kick-start transactions in member states, where the respective market segment does not yet exist. This is especially the case in small EU member states, where limited domestic liquidity pools prevent private placement markets of efficient size from emerging. Industry bodies have already established market guides for best practices, principles and standardised documentation so as to promote the development of a European private placement market.⁶ Any such common set of rules should include agreements on key economic and legal terminology and transaction conditions, common due diligence standards, disclosures and monitoring regulations and covenants. Policy makers could encourage the adoption of standardised documentation and increase liquidity of private placements by adopting 144a-like exemptions for transactions. Measures to address differences in national solvency laws and in-

 For example, ICMA (), Pan-European corporate private placement market guide, February.

Capital Markets Union: Process and Priorities – A financial industry perspective

21

formation on credit worthiness of medium sized borrowers are equally important areas for reform in this regard.

Measures to boost effective household and thereby institutional investment Financial intermediation patterns are, of course, not only shaped by borrower/ issuer behaviour but also by saver/ investor behaviour. In Europe, bank deposits account for 40 % of savers’ financial wealth. Consequently, bank-led financial intermediation plays a greater role. Given the fact that currently the bank lending channel in Europe is at least partially impaired, a large proportion of savings are not being intermediated effectively into the real economy. Conversely, in the US, savers invest 70 % of their financial wealth in shares and pension funds (Chart 6). As a result direct financial intermediation via capital markets dominates the landscape. The level of total financial wealth in the EU and the US also differs. At ca. €40,000, the average level of EU household net financial wealth is roughly one third of the average household net financial wealth in the US.⁷ Driven not only by the composition but also the smaller size of households’ financial assets, the European Fund management industry falls short of their US counterparts (Chart 7). Chart 6: Composition of household financial assets  RI ILQDQFLDO DVVHWV            '( )5 ,7

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 Figure for Europe refers to EU, before the  enlargement.

22

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Chart 7: Total assets of pension funds and insurance companies SHUFHQWDJH RI *'3  

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Source: ECMI

Increasing the pool of European savings to be put to use via capital markets is therefore a central challenge for CMU. On the one hand, this will require measures to incentivise households to reallocate their financial wealth differently. Transparency and providing retail investors with access to meaningful investment advice is key in this regard. On the other hand, measures are needed to reduce fragmentation and dismantle barriers preventing the asset management industry from offering their products and services throughout the entire European market. This could include a European passport for investment firms, which would allow them to operate throughout the EU and partake in a wider array of activities, as well as the introduction of a simplified prospectus to assist in the cross border marketing of UCITS or the harmonisation of regulatory requirements and marketing rules across EU Member States.

3. Longer-term objectives that require profound structural change Improving the availability of funding for SMEs One frequently hears that SMEs are the engine of the European economy, accounting for over 99 % of European companies and over 65 % of private sector employment. SMEs contributed over 55 % of value added and created 85 % of all new jobs between 2002 and 2010 in the EU (Chart 8). European SMEs rely largely on bank lending, with capital market funding playing only a minor role (Chart 9).

Capital Markets Union: Process and Priorities – A financial industry perspective

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Chart 8: Role of SMEs in the European economy 0LFUR 6PDOO 0HGLXPVL]HG

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Source: Deutsche Bank Research

Chart 9: Sources of external SME financing in Europe  RI (8 60(V 'HEW VHFXULWLHV (TXLW\ 2WKHU ILQDQFLQJ )DFWRULQJ 2WKHU ORDQ 7UDGH FUHGLW *UDQWVVXEVLGL]HG ORDQ %DQN ORDQ 5HWDLQHG HDUQLQJV /HDVLQJ %DQN GUDIWFUHGLW OLQH 





Source: SAFE 

Many SMEs have been particularly vulnerable given their domestic focus, lack of scale, and dependence on bank lending in the wake of the economic and financial crisis. Bank lending to SMEs has contracted and access to financing proven difficult, particularly in the periphery countries of the EU. Whilst the recent data shows that the decline in bank lending to SMEs seems to have bottomed out, signs of an outright recovery are modest (Chart 10). Increased banking regulation combined with market conditions have affected banks’ ability to shoulder credit risk because of their need to strengthen capital bases, de-risk loan portfolios, and rebuild profitability. The data also shows that rather than it being a uniform pan-European challenge, the divergence of the periphery from the core remains

24

Christian Ossig

particularly pronounced (Chart 11). Beyond geographic divergences in lending rates in the EU, the lending spread between small and large loans has been increasing consistently during and after the financial crisis, which is reflecting the challenging operating environment for the banking industry at large (Chart 12). Chart 10: Bank lending to SMEs in Europe (85 ELOOLRQV       























Source: ECB

Chart 11: New bank loans to SMEs PRQWK FXPXODWLYH IORZV HQG   ,UHODQG  

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Capital Markets Union: Process and Priorities – A financial industry perspective

25

Chart 12: Spread between euro area lending rates  SHU DQQXP 

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Source: ECB

In order to improve the availability of funding for SMEs the Commission should introduce a range of measures in order to overcome information problems relating to SME lending. These measures include greater standardisation of credit information for assessing creditworthiness, as differences in national laws hinder the collection and sharing of information, particularly across borders. Such measures should go hand in hand with the proposed simplified disclosure and prospectus requirements for securities listings and the introduction of a common high quality accounting standard for SMEs listed on alternative exchanges. The IIF work stream on SME financing impediments details a range of recommendations on how to improve funding access for SMEs.⁸ While the broad range of initiatives to improve the availability of capital markets funding for SMEs is highly promising, SMEs’ diversity, limited availability of credit information, monitoring costs and the fixed-cost nature of sourcing imply that relationship lending through banks will continue to be key. Chart 13 illustrates that in the US, banks are also the main channel for external finance. This highlights the risk that CMU might be oversold based on the aid that it can provide to SMEs, whereby CMU would then be primarily judged based on its short-term success in aiding SMEs. This could lead to disappointment and make additional progress in other CMU reform areas more challenging.⁹

 IIF (), Restoring Financing and Growth to Europe’s SMEs, October, and IIF (), Addressing SME Financing Impediments in Europe: A Review of Recent Initiatives, January.  The Brooking Institution (), Capital Markets Union in Europe: Initial Impressions, February.

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Christian Ossig

Chart 13: Sources of SME financing in the US  UHSRUWLQJ DV SULPDU\ VRXUFH RI IXQGLQJ %XVLQHVV (DUQLQJV 3HUVRQDO6SRXVDO 6DYLQJV &UHGLW &DUGV /LQH RI &UHGLW

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Source: FRBNY Small Credit Survey, May  and August 

Developing a European market for risk capital In terms of job creation, the young, rapidly growing firms have shown themselves as the driving forces. According to the OECD about half of new jobs are created by young high growth firms.¹⁰ Moreover, job creation by rapidly growing firms takes place throughout the business cycle, including during financial crises. Especially for high growth companies where bank finance is often inaccessible or insufficient, capital market based funding sources play an important role. In the US, venture capital funds frequently provide funding to firms at an early stage of their financial growth cycle. In Europe, markets for such risk capital remain relatively underdeveloped and national fragmentation prevents the development of sufficiently large pools of potential risk capital. As a percentage of GDP, venture capital investments in Europe are only a quarter or less the size of VC investment in the US (Chart 14). During the financial crisis, VC and PE investments declined further from their already comparatively low levels (Chart 15). Weak and volatile primary equity market activity in Europe, as illustrated by number and deal volumes of IPOs, reflects the lack of exit opportunities for investors, which is another obstacle for the expansion of VC and PE funding (Chart 16).

 OECD (), The Dynamics of Employment Growth: New Evidence from  Countries, OECD Science, Technology and Industry Policy Papers, March.

Capital Markets Union: Process and Priorities – A financial industry perspective

Chart 14: Venture capital investments SHUFHQW *'3   /DWHU VWDJH



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Chart 15: VC and PE investment in the EU ¼ ELOOLRQ           

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28

Christian Ossig

Chart 16: European IPO market OKV (85 EQ  UKV FRXQW

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The Commission’s Green Paper proposes a number of measures aimed at promoting VC and PE funding and enhancing exit opportunities for investors. These include changes to the Regulations on European Venture Capital (EuVECA) and European Social Entrepreneur Funds (EuSEF) which were introduced in 2013 to promote the provision of risk capital in the form of equity participations or loans to start-ups and social businesses. Measures to encourage a strong and vibrant VC industry in Europe are welcome and overdue. Given the mixed track record in Europe of direct public investment into high growth companies, either in the form of public VCs or through co-investments of public funds, caution must be exercised with respect to significant direct public investment in the VC market. Initiatives focusing on setting good framework conditions, in which private VC and PE markets can develop, should have priority. The promotion of crowd funding, including peer-to-peer (P2P) lending and equity-based crowdfunding are other promising policy areas in the field. The UK currently accounts for 75 % of crowd funding activity in Europe. Other European markets are much less developed (Chart 17). P2P business crowd funding is responsible for the largest volume and is more developed in the Netherlands and Spain than in France or Germany, where the focus is rather on P2P consumer crowd funding.

Capital Markets Union: Process and Priorities – A financial industry perspective

29

Chart 17: Crowd funding in Europe 2WKHU 33 EXVLQHVV 7RWDO

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Building sustainable securitisation International comparison shows that European issuance of securitised assets lags behind the US, despite the two economies being roughly the same size. Notwithstanding the sharp increase in European securitisations before the financial crisis, even at its peak the European securitisation market was markedly smaller than the US market, with just over USD 3 trillion outstanding in Europe vs. four times that amount in the US (Chart 18 and Chart 19). Since the crisis, securitisation issuance in Europe has declined significantly, with the majority of issuances retained by banks for use in central banks’ liquidity operations. One important factor that explains the differences between the two markets is the existence of a mortgage backed securities market in the US, benefiting from an implicit guarantee from government sponsored entities. The implicit benefit is that US banks’ balance sheets are in turn less burdened, particularly by real estate lending.

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Christian Ossig

Chart 18: European securitisation outstanding 86' ELOOLRQV

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Chart 19: US securitisation outstanding 86' ELOOLRQV  

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Securitisations are an effective indirect form of market-based finance in that they combine banks and markets so as to extend credit via the securitisation markets. In cases of genuine risk transfer, securitisation offers an indirect way of channelling market based funds to borrowers by freeing up banks’ balance sheets to provide new lending. The establishment of sustainable securitisation markets is one of the Commissions’ five priorities for early action. This recognition of the positive effects of securitisations found in the Green Paper coincides with a discus-

Capital Markets Union: Process and Priorities – A financial industry perspective

31

sion launched in February 2015 by the Commission regarding “An EU framework for simple, transparent and standardised securitisation”. This consultation has been preceded by two further prominent EU policymaker initiatives to promote securitisation markets in the last twelve months.¹¹ In its responses to the consultations, the financial services industry has consistently voiced its support and provided detailed steps to revive the securitisations markets through a regime of simple, transparent and comparable securitisations.¹² There is broad agreement that reviving simple, transparent and comparable securitisation by creating a consistent and streamlined regulatory framework for issuers and recalibrating Solvency II risk weightings for securitisations on the investors’ side would put European banks in a position to lend more money. It should be noted however that securitisations of SME loans, which are frequently supported by publicly funded guarantees, account only for a small proportion of the securitisation market both in Europe and in the US. In addition, recent European securitisations of SME loans, which are particularly strong in Italy and Spain, serve mainly to create eligible assets for collateral operations with the ECB. They are frequently retained on banks’ balance sheets and therefore do not create new lending capacity (Chart 20).

 The release of the “EBA Discussion Paper on simple standard and transparent securitisations” published by the European Banking Authority in October  stated that “a well functioning and prudentially sound securitisation market in the EU will contribute to strengthening the resilience of the European financial system by providing an alternative funding channel to the real economy and enhanced risk-sharing.” The paper by the EBA was preceded by the discussion paper on “The case for a better functioning securitisation market in the European Union” issued by the Bank of England and the European Central Bank in May , which contained similar sentiments.  IIF (), Joint Associations response on criteria for identifying simple, transparent and comparable securitisations, February, or the IIF (), CAIM Comments on ECB-Bank of England Securitization Paper, July.

32

Christian Ossig

Chart 20: European SME securitisation issuance (85 EQ

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Sources: AFME, Bruegel ()

Boosting long term investments In November 2014, the European Commission President Jean-Claude Juncker announced an ambitious infrastructure investment programme known as the “EU Infrastructure Investment Plan.” It aims at unlocking public and private investments of at least € 315 billion in the “real economy” over the next three years. Industry estimates of global infrastructure investment needs dwarf these targets set by the Commission (Chart 21). Estimates for future global infrastructure financing needs are in the range of USD 50 – 70trn through 2030. This underlines why the European Commission has also identified boosting long-term investment as a CMU priority for early actions.

Capital Markets Union: Process and Priorities – A financial industry perspective

33

Chart 21: Global infrastructure demand in investment by 2030 86' WUQ FRQVWDQW  GROODUV       

Source: McKinsey Global Institute ()

Current regulatory proposals for banks require high capital charges for longerterm assets such as infrastructure. Moreover, the European banking sector currently finds itself in a deleveraging mode, thereby creating the right incentives and capital market solutions to attract long-term private investors. This means that the infrastructure investment funding gap must be closed. The financial services industry has been vocal in recommending specific measure to address existing impediments to long-term investments while moving private-public partnerships forward with the goal of supporting the establishment of infrastructure as a capital market asset class.¹³ Key action points should include improved information-sharing and disclosure as part of developing a more efficient and liquid market, more conducive policy frameworks to reduce the policy uncertainty experienced by private investors and a reform of the regulatory framework with respect to infrastructure investment. These might include a review of relevant risk-weighting of regulatory capital charges, as notably articulated under Solvency 2, and the potential interaction of such charges with other regulatory measures and initiatives. The data available also indicates that strong capital market intermediation is better able to provide stable infrastructure financing than pure bank based financial intermediation. Infrastructure volatility in more bank based financial

 IIF/ SwissRe (), Infrastructure Investing. It Matters, February, and IIF (), Top  Impediments to Long-Term Infrastructure Financing and Investment, June.

34

Christian Ossig

systems is higher than in more capital market based regimes (Chart 22).¹⁴ Thus, enhancing capital market solutions would not only help close the funding gap but also benefit infrastructure investments with an associated decrease in investment volatility. Chart 22: Infrastructure investment volatility and financial market index [ ILQ PNW LQGH[ DEV FKJ \ LQYHVWPHQW YRO DEV FKJ  1RUZD\

 

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 Infrastructure investment volatility is defined as the standard deviation of the investment share in non-residential structure divided by its mean value in a defined period. See also IIF/ SwissRe ().

Capital Markets Union: Process and Priorities – A financial industry perspective

35

References Bank of England (2015), A European Capital Markets Union: Implications for growth and stability, Bank of England Financial Stability Paper No. 33, February. Bank of England & ECB (2014), The case for a better functioning securitisation market in the European Union, May. Blackrock (2015), The European Capital Markets Union: An Investor Perspective’, February. Coeuré, Benoit (2015), What is the goal of the Capital Markets Union, Presentation at the ILF conference, March. Deutsche Bank Research (2015), Mittelstandsfinanzierung im Euroraum: Neue Lösungen für ein altes Problem, January. EBA (2014), Discussion Paper on simple standard and transparent securitisations, October. European Commission (2015), Green Paper – Building a Capital Markets Union, February. European Commission (2015), Initial reflections on the obstacles to the development of deep and integrated EU capital markets, Staff Working Document, February. Giesecke et al. (2014), Macroeconomic effects of corporate default crisis: A long-term perspective, JFE, February. Hill, Jonathan (2015), The transatlantic relationship in financial services: a force for positive change, Speech at the Brookings Institution in Washington DC, February. ICMA (2015), Pan-European corporate private placement market guide, February. IIF (2013), Restoring Financing and Growth to Europe’s SMEs, October. IIF (2014), CAIM Comments on ECB-Bank of England Securitization Paper, July. IIF (2014), The Illusion of Liquidity, Capital Markets Monitor, October. IIF (2014), Top 10 Impediments to Long-Term Infrastructure Financing and Investment, June. IIF (2015), Addressing SME Financing Impediments in Europe: A Review of Recent Initiatives, January. IIF (2015), Joint Associations response on criteria for identifying simple, transparent and comparable securitiations, February. IIF/ SwissRe (2014), Infrastructure Investing. It Matters, February. Morgan Stanley & Oliver Wyman (2015), Liquidity Conundrum: Shifting risks, what it means, March. The Brooking Institution (2015), Capital Markets Union in Europe: Initial Impressions, February. OECD (2014), The Dynamics of Employment Growth: New Evidence from 18 Countries, OECD Science, Technology and Industry Policy Papers, March. Véron, Nicolas (2014), Defining Europe’s Capital Markets Union, December. Véron, Nicolas & Wolff, Guntram,(2015), Capital Markets Union: A vision for the long-term, April.

Dirk Schoenmaker

From Banking Union to Capital Markets Union 1. Introduction After the successful start of the Banking Union at 4 November 2014, the question has been raised whether we should also establish a Capital Markets Union. In this paper, we rephrase the question slightly: should we move from Banking Union to Capital Markets Union? There are concerns that Europe is overbanked (Pagano et al, 2015; Langfield and Pagano, 2015). If banks deleverage and thus reduce the provision of credit to the private sector, other channels are needed for financing firms and households. That is one of the drivers of Capital Markets Union. Moreover, market financing (e. g. corporate bonds) was more stable during the recent financial crisis than bank financing (e. g. bank loans). This driver comes from the supply side: firms issuing corporate bonds to replace bank loans. Another driver comes from the demand side. Employees are preparing for old age by setting aside part of their current income as pension savings. They can do it collectively through pension funds (a type of large institutional investor) or privately through private pension savings schemes managed by a professional asset manager (another type of institutional investor). Demographics, in the form of ageing, are amplifying this pension savings trend (De Haan et al, 2015). Part of consumer savings is thus moving from deposits at banks to claims managed by institutional investors, which typically invest in securities traded on capital markets. The increasing share of institutional investors increases the demand for marketable instruments, such as equity and debt securities. In particular, life insurance companies and pension funds invest in (long-term) bonds to match the maturity of their liabilities. While government bonds used to be the main asset class, life insurers and pension funds are increasingly looking for other bond classes, such as corporate bonds, to diversify their risk and to increase yield in the current low interest rate environment. While some of the drivers seem cyclical, the underlying patterns are of a more structural nature. This paper discusses how the corporate bond market segment can be deepened as part of the broader Capital Markets Union project.

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Dirk Schoenmaker

2. Is Europe overbanked? The view on banking has been changing over time. In the 1980s, the Wirtschaftswunder of Germany and Japan was partly assigned to the strength of their large banks. It was argued that the ‘Hausbanks’ were a stable source of finance for the flourishing industry. Figure 1 shows that that bank financing was increasing rapidly up to 1990, both in Europe and Japan. The theoretical argument was that financial systems with a higher degree of relationship-based lending could be expected to give greater weight to the long-term gains from maintaining an existing relationship with a borrower. Providing financing to ride out temporary downturns may not only be in the interest of the borrower, but also of the lender. The capital buffer of the bank (as lender) then absorbs part of the losses caused by the downturn. Allen and Gale (2000), for example, argue that a bank-based system is better able to provide inter-temporal smoothing of investment (and thereby the wider economy) than a market-based system. Figure 1. Total bank assets to GDP: Europe, US and Japan

Source: Langfield and Pagano ()

From Banking Union to Capital Markets Union

39

Then the asset bubble burst in the early 1990s in Japan leading to the lost decade(s) of growth. Also Germany got into economic problems, after unification of the West and the East. Banking nevertheless kept on increasing in Europe, but not so in Japan or the US. In the recent financial crisis, banks appeared not to be the stable source of financing to firms. As banks experienced large losses, their capital base eroded. Given the lack of capital, banks almost stopped lending to firms, leading to a credit crunch. Figure 2 shows that both in the Europe and the US banks deleveraged during the crisis. The net financing became negative, as the amount of amortised loans exceeded new loans. At the same time, net corporate bond financing (labelled debt securities in Figure 2) was more stable and remained positive throughout the crisis. Figure 2. Non-financial firms’ financing in loans and debt securities

Note: The figures plot the year-on-year change in non-financial corporations’ outstanding external liabilities (broken down as loans and debt securities) divided by nominal GDP. Source: Langfield and Pagano ()

Using an extensive data set on corporate bond defaults in the US from 1866 to 2010, Giesecke et al (2014) study the macroeconomic effects of bond market crises and contrast them with those resulting from banking crises. The US has experienced many severe corporate default crises in which 20 to 50 per cent of all corporate bonds defaulted. Giesecke et al (2014) find that corporate default crises have far fewer real effects than do banking crises. These results provide empirical support for current theories that emphasise the unique role that banks and the credit and collateral channels play in amplifying macroeconomic shocks. Capital constrained banks are reducing lending after a banking crisis. This credit channel effect is amplified by the reduced value of collateral, such as the value of houses as collateral for mortgages and SME loans. By contrast, corporate bond financing is less volatile. Moreover, Giesecke et al (2014) find a substitute effect: after a corporate default crisis, there is an increase in bank lending.

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So, views on banking have been changing over time. More recently, Pagano et al (2014) and Langfield and Pagano (2015) raise the question whether Europe is overbanked. Figure 1 highlights the prominent role of banking in Europe (up to 4 times GDP) compared to a more modest role in Japan and the US. In the aftermath of the recent financial crisis, European banks are slowly deleveraging. At the same time, capital markets are less developed in Europe. Figure 3 indicates stark differences in public equity markets (138 per cent of GDP in the US vs 65 per cent in the EU) and corporate bonds (41 per cent versus 13 per cent). Banks are thus overdeveloped and capital markets underdeveloped in Europe. An emerging view in the banking versus markets debate is that a healthy mix of bank-based and market-based financing provides the optimal financial structure for the economy. Banks and markets play complementary roles in the financial system. Langfield and Pagano (2015) calculate the bank-market ratio for Europe, the US and Japan. The bank-market ratio is defined as bank assets divided by stock and bond market capitalisation. Figure 4 shows that the bank-market ratio is high for Europe, while Japan takes an intermediate position. US has the lowest ratio. Moreover, the bank-market ratio is more or less stable over the 1990 – 2010 period for the US and Japan, but has increased to 4 in Europe in the run-up to the financial crisis. The bank-market ratio was thus higher in Europe, and kept on increasing. A more detailed examination of Figure 4 indicates that the difference is in bank assets, which are higher in Europe than in the US and Japan. The opposite is true for markets. On stocks the US is higher, and even more so on bonds. Figure 3. Capital markets structure: EU versus US (end 2013)

Source: Lannoo ()

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Figure 4. Financial structure since 1990 in Europe, Japan and the US

Note: The bank-market ratio is defined as the ratio of total bank assets to stock and private bond market capitalisation. Source: Langfield and Pagano ()

3. Role institutional investors: pension funds Over the last decades, the intermediation of financial assets has gradually shifted from banks towards institutional investors, such as pension funds, insurance

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companies, and mutual funds. In this process of re-intermediation, the assets of institutional investors of the EU-15 countries tripled from 49 per cent of GDP in 1990 to 165 per cent in 2012 (De Haan et al, 2015). Figure 5 shows that the role of institutional investors is rising faster in Europe and slowly approaching that of the US. The shift from banks towards institutional investors can also be illustrated by the financial intermediation ratio. Table 6 illustrates the bank and institutional intermediation ratio from 1970 to 2010 for the G-10 countries. It shows that the US and Japan have already experienced a 30 per cent shift from banking to institutional investment, while the large European countries have only shifted a mere 12 per cent. This suggests that a further shift may be expected in Europe. Figure 5. Total institutional investors assets to GDP: EU-15 and US

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Table 1 Bank and institutional intermediation ratios (in % of intermediated claims), 1970 – 2010

France Germany Italy United Kingdom

Bank Institutional Bank Institutional Bank Institutional Bank Institutional

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

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

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       

       

       

       

       

-  -  -   -

From Banking Union to Capital Markets Union

43



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EU

Bank Institutional

 

 

 

 

 

- 

Canada

Bank Institutional Bank Institutional Bank Institutional

     

     

     

     

     

-  -  - 

Bank Institutional

 

 

 

 

 

- 

Japan United States G

Notes: The intermediation ratio measures the share of the financial claims of banks and institutional investors as a percentage of total intermediated claims. The sum of bank and institutional ratios add up to 100. Source: De Haan, Oosterloo and Schoenmaker (2015)

A major driver towards further institutional investment is demographics. Figure 6 indicates that ageing is rising fast in Japan and Europe, and less so in the US due to immigration from Latin America. The dependency ratio is defined as the number of retired persons aged 65 or higher divided by the number of persons of working aged 20 to 64. While the ratio already differed in 2011 with 29 per cent in the US and 37 per cent in Europe, the gap widens towards 2050 with 54 per cent and 76 per cent respectively. Appreciating that governments will not be able to provide the current levels of health care and pensions (so-called first pillar pensions) with an ageing population in the future, employees have started to provide for their own pensions by saving through pension funds or private pension schemes (so-called second and third pillar pensions). Figure 6 shows that the need for pension savings is in particular pressing for Europe and Japan. Savings through pension funds (collective funds) and private schemes (mutual funds) is thus expected to rise further over the next decades in Europe. As these institutional investors prefer to invest in marketable assets, their demand for debt and equity securities will increase.

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Dirk Schoenmaker

Figure 6. Dependency ratio (65+ as percentage of population aged 20 – 64), 2011 – 2050.

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The rise of pension savings in Europe will lead to a broadening and deepening of European capital markets. For illustration purposes, we highlight three major trends. A first trend is the shift from government bonds to corporate bonds. A second trend is the move to formal pension funds or schemes. A third trend is the move from defined benefit to defined contribution schemes. On the first, pension funds as well as life insurers invest to a large extent in fixed income securities (bonds) to match the duration of their long-term liabilities. Government bonds are a large asset class. With the rising risk on government bonds and declining returns (due to quantitative easing), life insurers and pension funds are increasingly looking for other bond classes, such as corporate bonds, to diversify their risk and to increase return. It should be noted that the model of guaranteed returns by life insurers and pension funds is coming under pressure in the current low interest rate environment. They will move to more flexible products, where a larger part of the risk is shared with the consumer. This will speed up the third trend discussed below. On the second, some countries have already fully funded pensions schemes (De Haan et al, 2015). Examples are Denmark (pension assets are 34 per cent of GDP), Ireland (40 per cent), Netherlands (168 per cent) and the United Kingdom (92 per cent). By contrast, some major countries have almost no separate pension funds. Germany, for example, has only 6 per cent of GDP in separated pension assets. Most pension claims are book reserves on the company’s balance sheet. That is very risky for employees (as future pensioners) and former employees (as pensioners). If the company is defaulting, or getting into major difficul-

From Banking Union to Capital Markets Union

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ties, pension claims may be downsized or completely wiped out.¹ While a guarantee scheme may provide some compensation, the most viable alternative is to transfer pension claims to a separate fund. That would imply a major shift in corporate finance. In the case of book reserves, the company is partly self-financed through its pension liabilities. Moving its pension liabilities to a separate pension fund means that the company has to find outside finance in capital markets (or with banks). Moreover, these new pension funds need to buy assets. On the third trend, defined benefit schemes are risky for employers. As defined benefit schemes link pension payouts to the average (or final) salary of employees, there may be a shortfall if investments are not sufficient or not sufficiently growing to meet future pension commitments. Employers typically have to make up this shortfall. These potential pension liabilities were more or less hidden in the past. But transparency shows the real size of the problem. International Financial Reporting Standards (IFRS) require companies to show potential pension liabilities on the balance sheet. Company CFOs are wary of this large and fluctuating liability in their balance sheet. Schoenmaker and Sassen (2011) observe a trend towards converting defined benefit pensions into defined contribution schemes, where the investment risk is born by (former) employees. Companies are even prepared to pay a large ‘dowry’ to their pension scheme upon conversion to get rid of these uncertain liabilities.

4. Deepen capital markets: corporate bonds The previous sections show that both supply and demand factors are driving an increase in equity and debt securities. The Capital Markets Union should facilitate this increase in market financing. We focus on deepening the corporate bond market, as corporate bonds are a major component of the increased demand and supply. Langfield and Pagano (2015) also suggest deepening the market for corporate bonds and asset backed securities in response to the structural decline of banking. The transformation of the government bond market in the Eurozone after the start of Economic and Monetary Union (EMU) is instructive for the corporate bond market. EMU created a large euro-based government bond market, with different issuers (i. e. countries). To reduce their funding costs, governments mod-

 The same risk is present when a company’s pension fund invests in the company itself. That happened in the case of Enron. Prudential regulations typically restrict the investment in the own company.

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ernised their debt agencies. The challenge for debt agencies (at least prior to the euro sovereign crisis) was, and still is, to match the yield on the Bund, which is the benchmark bond in the Eurozone. Governments have reduced the number of bond issues in order to increase the size (and thus the liquidity) of these bond issues, which are issued in various tranches. Next, secondary trading in government bonds moved to centralised electronic facilities, such as MTS. The result of these innovations is a deep and liquid market for euro government bonds. The current trading of corporate bonds in Europe is still fragmented with multiple small issues and a decentralised dealer network. Bond markets are inherently less deep than equity markets. Subsequently issued equities by a company turn into one (or a few) listed equity, as they have the same maturity (i. e. infinite). By contrast, bonds have a finite life. Issuing bonds with different maturities further fragments the market. Large corporates can follow the example of Eurozone countries by issuing fewer, albeit larger, bond series, and thus increase the liquidity of each series. Similarly, bonds of small companies can be pooled. Next, corporate bond trading can be further standardised. Another innovation would be the move to a centralised platform for trading and clearing. That would improve the infrastructure for bond trading.

5. Conclusions The move from banking lending to capital markets may improve macroeconomic stability, as markets appeared a more stable force of funding for firms than banks during the recent financial crisis. On the supply side, we observe a broader trend of precautionary retail savings moving from bank deposits to institutional investment (pensions, insurance and mutual funds). This trend translates in a major change in the pattern of corporate finance, whereby firms replace bank loans by corporate bonds. On the demand side, we observe an institutional investors preference for corporate bonds (and equities). These trends are not just a cyclical response to current bank deleveraging, but are of a structural nature. We suggest that the Capital Markets Union project takes up this challenge. Key components are standardising corporate bond trading and moving trading and clearing to centralised electronic platforms. The Capital Markets Union could thus reinforce the positive spiral of bond markets initiated by Economic and Monetary Union (Pagano and Von Thadden, 2008).

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References Allen, F. and D. Gale (2000), Comparing Financial Systems, MIT Press, Cambridge (MA). De Haan, J., Oosterloo, S. and Schoenmaker, D. (2015), Financial Markets and Institutions: A European Perspective, Third edition, Cambridge University Press, Cambridge. Giesecke, K., F.A. Longstaff, S. Schaefer, and I.A. Strebulaev, I. A. (2014), ‘Macroeconomic effects of corporate default crisis: a long-term perspective’, Journal of Financial Economics, 111, 297 – 310. Langfield, S. and M. Pagano (2015), ‘Bank bias in Europe: Effects on systemic risk and growth’, Economic Policy, forthcoming. Lannoo, K. (2015), ‘Which Union for Europe’s Capital Markets?’, ECMI Policy Brief No. 22, Brussels. Pagano, M., S. Langfield, V. Acharya, A. Boot, M. Brunnermeier, C. Buch, M. Hellwig, A. Sapir and I. van den Burg (2014). ‘Is Europe overbanked?’, Report no.4 of the European Systemic Risk Board’s Advisory Scientific Committee, Frankfurt. Pagano, M. and E. Von Thadden (2008), ‘The European Bond Markets under EMU’, in: X. Freixas, P. Hartmann, and C. Mayer (eds.), Handbook of European Financial Markets and Institutions, Oxford University Press, Oxford, p. 488 – 518. Schoenmaker, D. and H. Sassen (2011), Het pensioenfonds als financiële instelling (The pension fund as financial institution), in: R. Maatman, R. Bauer, D. Busch en L. Verburg (eds), Onderneming en pensioen (Company and pension), Kluwer, Deventer, p. 281 – 300.

Dr Andreas Dombret

What can capital markets deliver? – A central banker’s view 1 Introduction Ladies and gentlemen Thank you very much for inviting me to speak at this year’s ILF conference. The topics of this conference are very well chosen, and I am therefore grateful for the opportunity to speak at today’s event and to share my thoughts on the European capital markets union. But let’s begin by taking a step back. As some of you will know, I spent ten years of my life working for JP Morgan. The legend goes that one day, old John Pierpont Morgan was approached by a young man who asked about the secret of the stock market. John Pierpont Morgan looked at the young man and replied: “it fluctuates”. In my view, that is an important thing to know about the inner nature of capital markets, but it is certainly not all there is to know. My short intervention today will therefore address a different question: what can capital markets deliver? Given the current discussions about a European capital markets union, it seems that we expect quite a lot from capital markets. Let’s take a closer look and discuss whether these expectations are justified.

2 Diversification – strengthening capital markets In essence, the European capital markets union has two objectives. The first objective is to increase the share of capital markets in the funding mix of the real economy. The second objective is to integrate capital markets more closely across borders. Some people relate the first objective to the question of whether a capital markets-based financial system is superior to a bank-based financial system. Well, to sum up the empirical evidence: it is impossible to tell.

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There is certainly some evidence indicating that capital markets-based financing might increase pro-cyclicality.¹1 Nevertheless, the recent crisis shed light on these issues from another angle. A system in which the real economy relies on a single source of funding will most certainly run into trouble when that source dries up – regardless of whether it is bank funding or capital market funding. Therefore, it is not a question of “either/or”. The objective of the European capital markets union is not to abandon bank-based funding but to supplement it with capital markets-based funding. And in Europe above all places there is ample room to do so. The European stock market is only 60 % the size of the US stock market when measured in relation to GDP. Likewise, the European market for venture capital is 20 % the size of the US market, and for securitisation the percentage is even lower.² In the end, it comes down to the uncontested argument of diversification. Increasing the share of capital markets will improve and broaden access to funding particularly for small and medium-sized enterprises. At the same time, it will improve the matching of investors to financial risk, thereby increasing the efficiency of the financial system. As a result, the financial system will be able to better support sustainable economic growth.

3 Integration – forming a single capital market The second objective of the European capital markets union is to improve the integration of capital markets in the entire European Union. What is it that integrated capital markets can deliver? One of the main arguments is that they can improve private risk sharing. The technical question is: to what degree does a shock to the economy affect consumption? Empirical studies for the United States show that integrated capital markets cushion around 40 % of the cyclical fluctuations among the US federal states. A share of around 25 % is smoothed via the credit markets, while fiscal policy cushions 10 – 20 % of shocks. Altogether, around 80 % of a given economic shock is

 Adrian/Shin (), Liquidity and Leverage. In: Journal of Financial Intermediation, Vol  (), pp  – . Leroy (), Credit Procyclicality and Financial Structure in the EU”. Available at SSRN: http://ssrn.com/abstract= or http://dx.doi.org/./ ssrn..  Bank of England (), A European Capital Markets Union: Implications for Growth and Stability. Financial Stability Paper No , February .

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absorbed before it can affect consumption.³ Studies for Canada yield similar results.⁴ In Europe, the picture looks different. Here, it is mainly credit markets that cushion economic shocks – and they are not very effective in doing so. Altogether, only around 40 % of a given shock is absorbed before it can affect consumption.⁵ Increasing the share of capital markets and integrating them across borders would therefore help improve risk sharing in Europe and reduce the volatility of consumption.

4 How to get there Increasing the share of capital markets in the funding mix of the real economy can contribute to economic growth. At the same time, integrating capital markets across borders can help improve private risk sharing within Europe. The Bundesbank therefore believes that the European capital markets union is a goal worth pursuing. But how do we get there? The argument for a capital markets union is straightforward, while its implementation is much less so. The capital markets union is a complex undertaking that touches upon many different areas. Consequently, the European Commission’s green paper on this subject⁶ includes a wide variety of suggestions and steps to be taken. With regard to the objective of increasing the share of capital markets, we should focus on equity markets. Against this backdrop, let me emphasise the issue of taxes. Currently, tax treatment still favours debt financing over equity financing. Removing this bias in taxation would encourage companies to strengthen their equity base and thus turn more towards equity capital markets in their search for sources of funds. In terms of the objective of integrating capital markets across Europe, there are some areas where standardisation could give us some early gains. The market for high-quality securitisation is one of these areas. So far, a number of policy initiatives have been launched to restart European securitiza-

 Asdrubali/Sørensen/Yosha (), “Channels of Interstate Risk Sharing: US  – ”, Quarterly Journal of Economics, (),  – .  Balli/Kalemli-Ozcan/Sorensen (), Risk Sharing Through Capital Gains. In: Canadian Journal of Economics, Vol (), pp  – .  Afonso/Furceri (), Business Cycle Synchronization and Insurance Mechanisms in the EU. ECB Working Paper No , December .  European Commission (), Building a Capital Markets Union – Green Paper.

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tion markets, including an initiative by the European Commission to develop a framework for simple, transparent and standardised securitisation. Other areas for early action include private placements, crowd-funding or the harmonisation of prospectuses. With a view to the long-run, it might also be beneficial to further the development of funded pensions in order to enlarge and deepen European capital markets. Another long-term objective could be to harmonise insolvency laws across Europe. In any case, we should not exclusively focus on the institutional and legal framework in our efforts to create a European capital markets union. There might also be soft factors at play, such as cultural preferences for certain forms of funding or the level of financial education. We also should address these issues in order to achieve our objective.

5 Conclusion Ultimately, the path towards a European capital markets union will be long and arduous. There will certainly be resistance, and there will be difficulties. Therefore, we should remain realistic about what can be achieved. Nevertheless, we embarked on the path of financial integration by adopting a single currency in 1999. And we must not stop there but deepen integration in order to make the European monetary union work. In November 2014, we took a major step by establishing a single European mechanism for banking supervision; now, we should consider taking another key step by forming a European capital markets union – one that not only includes the euro area but extends to the entire European Union. I would therefore like to conclude with a quote that is attributed to Robert Kennedy, although he allegedly borrowed it from his brother John F Kennedy, who – according to his advisor Ted Sorensen – borrowed it from someone else. In any case, the quote goes like this: “Some see things as they are and say ‘why’. Others dream of things that never were and say ‘why not?’”. With regard to the European capital markets union, I suggest we should join the latter group. Thank you for your attention.

Anshu Jain

What can the capital markets deliver? A market participant’s view Is European Capital Markets Union a viable concept? Certainly. Harmonisation of Europe’s Capital Markets is potentially a highly important and positive step. Nonetheless, it is vital to consider not only whether such a step is viable, but also, how Europe can reap the full benefits of such a move. To answer that question, we need to consider the dynamics of Europe’s capital markets as they stand today, in the context of wider challenges faced by Europe’s economy.

The capital markets and Europe’s growth imperative The short answer is: developing Europe’s capital markets is critical to spur the growth which Europe’s economy so urgently needs. We are living in a threespeed world and Europe is falling behind. Over the next 5 years, until the end of 2019, the world’s emerging nations will grow by around 30 % – that is, more than three times as fast as the Eurozone, which is forecast to grow at 8 % over the same period. The United States economy is forecast to grow around 15 % – not as fast as leading emerging market economies, but double the speed of Europe. Since the crisis, Europe’s recovery has not been strong enough, and structurally weak growth in the Eurozone has significant consequences. Most notably, it keeps unemployment from falling – particularly, and tragically, among Europe’s younger generation. In some peripheral Eurozone economies, youth unemployment stands at historically high levels of between 30 and 50 %. The implication is clear: stimulating growth is our overriding priority. To enable that growth, robust, diverse and well-balanced sources of financing will play a crucial role. Let’s first consider where we stand today. Currently, business in the Eurozone remains highly dependent on bank lending. Today, banks provide more than 70 % of debt for European firms. However, bank lending to the private sector in the Eurozone has decreased substantially since the crisis. Partly as a result of bank-dependent business funding, access to financing for Europe’s businesses today is highly uneven. Crucially, this problem is felt most acutely in precisely those areas where financing is most needed: in Europe’s peripheral economies, and in our small and medium-sized enterprises or SMEs.

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Economies in the Eurozone’s periphery are worse-hit than core nations. Lending remains 29 % below its peak in the periphery; by contrast, in core countries, it has fully recovered. 17 % of Spanish SMEs and 14 % of Italian SMEs, cite access to finance as their most pressing problem. This compares to only 9 % in Germany. Additionally, SMEs are harder-hit than large corporations. In the Eurozone, loans smaller than EUR 1 million, which are most common for SMEs, carry an average interest rate of 3 %. In this environment of record-low interest rates, this is the lowest level on record, but it is almost double the average interest rate of 1.63 % for loans above EUR 1 million. Furthermore, the gap is getting wider: interest rate ‘spreads’ between European large-caps and SMEs have widened by almost half, or 47 % since 2008. Experience tells us that economies which are dependent on bank financing have a harder time recovering from recessions than more capitalmarkets-driven economies like the US, particularly when the preceding economic downturn is accompanied by a banking crisis. To return to a path of sustainable growth, companies in the Eurozone, especially SMEs, need access to financing. However, in the post-crisis world, it is unlikely that the financing needs of Europe’s economic recovery can be met by bank financing alone. On the contrary, traditional bank lending will likely remain constrained as banks continue to repair their balance sheets and meet the demands of new regulation on capital adequacy. The implication is clear: in order to overcome potential financing constraints, Europe’s economy needs to reduce its traditional dependence on bank financing and deepen its capital markets. To assess the prospects for this development, we need first to ask: where do Europe’s capital markets stand today?

Europe’s capital markets: significant scope for development Today, capital markets in Europe are underdeveloped, especially in comparison to the US – even allowing for the fact that the Eurozone economy, at around $12.9 trillion, is smaller than that of the US ($16.8 trillion). Europe’s capital markets are considerably smaller than their US counterparts. Eurozone equity market capitalisation, at around $ 7.5 trillion, is a third the size of US equity markets at. $22.3 trillion. The Eurozone debt market, at around $22.5 trillion, is smaller by a third than the US at $37 trillion. The Eurozone market for asset backed securities, or ABS, excluding mortgage-backed securities, was already small compared

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to the US and has shrunk significantly since the crisis. Today, at $646 billion, it is barely half the size of the $1.3 trillion US market. There are several reasons for the difference. In the case of securitization markets, structural factors play a role. The US market for mortgage-backed securities, or MBS, dwarfs its European equivalent, primarily because an implicit ‘government guarantee’ via Fannie Mae and Freddie Mac creates conditions for a securitization market which now covers some $9 trillion in assets and accounts for around 90 % of all US securitization (Source: SIFMA). By contrast, in Europe, mortgages remain on bank balance sheets to a far greater extent. In addition, the US asset-backed securities market enjoys far greater availability of underlying assets eligible for securitization, such as student loans and automobile loans. This segment is virtually non-existent in Europe, compounded by regulatory constraints on demand in a key investor segment – insurers, who have reduced ABS holdings. In equity markets, cultural and historical differences partly explain the gap between the Eurozone and the US. Europe does not have an equity culture comparable to the US, partly because, as America industrialised, its banking system remained relatively small as capital markets expanded. That difference is important to this day. In 2014, US companies excluding financial institutions raised around $150 billion in IPOs and additional offerings – nearly double the amount raised by their Eurozone counterparts. Furthermore, whilst European stocks are up around 15 % this year, market participants are in large measure institutions and foreign investors – so a substantial proportion of the wealth created by market performance does not flow through to Europe’s retail savers and investors.

Potential areas of focus In other words; significant scope exists to develop and deepen Europe’s capital markets. In considering how we can achieve this, I believe several tools are available to us. Let me focus on two areas which are particularly important in the short term: strengthening the securitization market and access to capital markets for SMEs. Turning first to securitization; we have just discussed how the size of Europe’s ABS market remains significantly below its potential. Developing this market would help make the corporate loan market more liquid, spread risks more widely across investors and provide a vehicle for the ECB to support corporate lending. Policy makers could do much to overcome structural hurdles to the growth of this market – for example, by reducing lower capital charges for se-

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curitization. Here, differences are significant. AAA senior securitization, for example, carries a risk weight of 11 % and AAA mezzanine securitization a risk weight of 63 %; this compares to risk weights for covered bonds of just 4 % and for corporate bonds of 5 %. In this regard, US banks, and thus issuers, enjoy competitive advantages: US banks benefit from lower risk weightings for securitization and are precluded by Dodd-Frank from using external rating agencies, and thus use a less onerous ‘Simplified Supervisory Formula Approach’. By contrast, European credit rating agency requirements make it more expensive to issue structured finance assets. We have other tools at our disposal. Identifying high-level principles of ‘qualifying securitization’ would add investor confidence and increase liquidity. In addition, harmonised of accounting treatments would undoubtedly contribute. In Europe, differences across jurisdictions still exist, whereas US banks reporting under Generally Agreed Accounting Principles (GAAP) are more incentivised to issue securitization due to the potential for offbalance sheet treatment of certain structured finance instruments. We must also confront a second, crucial challenge: widening capital market access for Europe’s SMEs. SMEs are a critical sector of the European economy. They account for 58 % of EU GDP and 67 % of employment. At the same time, they are hit much harder than large corporations from the retreat in bank lending and face more difficult access to the capital markets. Several measures would help improving capital market access for SMEs. One such is to lower a key barrier: the cost of market access. This cost is still relatively high – driven in part by the need to provide investors with adequate information. SMEs vary widely in their business prospects and risks, particularly when compared across countries and transparency for investors is thus an important step. In addition, more can be done to promote equity financing by SMEs. SMEs have traditionally shown a strong preference for debt over equity, even though high debt ratios may put off lenders. Promoting a culture of equity involvement could be a step in the right direction – for example, via the development of private placement markets or more support for venture capital. In this context, let us now consider the question of Capital Markets Union.

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Capital Markets Union: an important step forward While the concept for the Capital Markets Union is still being developed, it is certainly a step in the right direction. The Green Paper currently under review outlines a number of positive steps. The focus topics included at this stage are the right ones, especially deepening EU capital markets and supporting SME growth and long term finance. These are critical to our efforts to set Europe back on the path to growth. Very importantly, Capital Markets Union is potentially of particular benefit for Germany. Improving access to funding for SMEs is good news for the Mittelstand which, as we all know, forms the ‘backbone’ of the German economy. Regulatory stability, deeper capital markets and encouraging seamless cross-border business, lending and borrowing will benefit an export-oriented economy like Germany. However, as we have seen, it is imperative that we see Capital Markets Union as part of a wider effort to deepen Europe’s capital markets. Additional measures, such as those we have discussed, are vital – for example, the harmonisation of rules to make securitization less onerous in terms of risk-weightings for banks operating under strict capital discipline. In addition, it’s important to recognise the role of the banking sector in enabling the development of deeper European capital markets. The banking sector remains a vital transmission mechanism – not only as providers of credit to SMEs, but also as intermediaries providing essential market-making and capital market liquidity. Finally, we must recognise that time is of the essence – particularly as economies in other parts of the world are already expanding faster than Europe. It is now vital that we prioritise the most pressing topics and find practical solutions quickly.

In conclusion Europe urgently needs to find the path to a sustainable growth. This growth will depend critically on robust and well-diversified sources of funding. We cannot afford a long, drawn-out process or solutions that are impractical to implement. Harmonisation of Europe’s capital markets is certainly important and right; but our overriding goal must be wider: to accelerate the development of deep, liquid, transparent, well-regulated and well-diversified capital markets in Europe.That is in the interest both of Europe’s businesses, and Europe’s savers and investors. It

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is also in the interests of millions of young people across Europe who need and deserve prospects for their future.

Andrew Bosomworth

From Capital Markets Confederation to Capital Markets Union Capital markets union (CMU) is a new term but it is not a new concept in Europe. CMU describes an existing evolution of European financial market integration that started many decades ago yet probably still has many more ahead of it before a “true” or “full” union is established. The benefits of CMU can be summed up as removing supply impediments to access to capital, defined broadly here as both savings and financial securities, i. e. making the process of matching savings with investment more efficient. In theory the CMU already exists. Article 63 of the Treaty on the Functioning of the European Union (TFEU) allows for the free movement of capital across intra-union borders. And 19 member states share a currency union. In practice, however, we do not observe the extent of integration of European capital markets as we do in other CMUs with deeper federal structures, such as the United States. Europe has instead what I call a capital markets confederation. The question becomes are we content with the confederation structure or do we want to develop it further? And if we want to develop it further do we want to achieve the type of features we observe in the United States with deep, liquid markets and no intra-state cross-border impediments to the movement of capital? Assuming we want to achieve the latter then I see five prerequisites needed to realize it: 1) Harmonization of the regulatory treatment of the financial sector (banking, insurance, asset management, pension funds), including taxation and capital standards. 2) Harmonization of bankruptcy laws and wind-down and recovery procedures. 3) Evolution of common financial infrastructure such as clearing houses for security and payment settlements. 4) Evolution of common deposit insurance. 5) Introduction of a common credit, and regulatory, risk-free asset. A lot of progress toward realizing CMU can be achieved via steps one, two and three, which do not require TFEU changes. Concerning the regulatory treatment of capital, so long as regulators at the national level where implementation occurs, even those who are members of a

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single college or mechanism of supervisors, use different definitions of what constitutes risk-free and risky assets, then impediments to the cross-border movement of capital will continue to occur. Without such harmonization we will experience geographical compartments of assets backing liabilities in the same national jurisdiction rather than consolidated at the holding company level. If the national regulator in country X, for example, defines its government’s bonds as risk-free for capital reserve purposes but the bonds of government Y as risky, then it will inhibit the flow of savings from country X to country Y. This may well be justified according to credit metrics. The crux of the issue is that Europe’s companies and savers are increasingly active across borders within the Single Market while our governments are predominantly geared toward national jurisdictions. I would like to highlight the importance of financial market infrastructure for a properly functioning CMU. Without the “pipes and plumbing” as it is colloquially referred to CMU will not realize its full potential. Let me give you an example concerning the settlement systems. Each day we sweep all cash balances in our accounts away from the custodian bank into overnight maturity repo, e. g. we lend cash overnight against borrowing securities for same-day settle (denoted T0 settle for trade day plus zero). Standard securities settlement in Europe has now been shortened to two days (T2). In order to settle T0 we must complete all transactions and ticket entry by about 9:30 – 10:00am Central European Time. Anything later than that risks settlement failure. This is possible but our bank counter-parties essentially provide the service as an exception in the knowledge that our middle and back office processes work efficiently. Our colleagues in the United States perform the same operations but they have three settlement windows within the same day for T0 settle. T0 settlement is not the defining feature of a CMU but it is hopefully an example of the different stages of development between the European and American financial systems. I would like to finish with an observation on portfolio composition that may give a practical insight into what the benefits of a full CMU could mean for Europe. We have two broad books of business that can be described as a set of portfolios in the United States using the dollar as base currency, and a set of portfolios in Europe using the euro as base currency. We can calculate the percentage share of euro assets issued by entities in Europe that are held in dollar portfolios; and the percentage share of dollar assets issued by entities in the United States that are held in euro portfolios. Typically these non-base currency holdings are currency hedged back to the base currency, so the motivation for choosing the securities is not to gain foreign currency

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exposure but has to do with the characteristics of the bonds. Currency exposure is a separate decision that is usually implemented via currency forwards. What we observe is that on average our euro portfolios hold a larger percentage share of dollar assets than the percentage share of euro assets that are held in dollar portfolios. Where the euro portfolios hold dollar assets they are typically corporate bonds, mortgage backed and asset backed securities. Where the dollar portfolios hold euro assets they are typically government bonds and corporate bonds. While this is partly a reflection of the different net international investment positions of the two regions, it also reflects that the dollar market offers more liquidity, depth and choice to investors than the euro market. If we consider it desirable to increase European companies’ access to capital markets and decrease their reliance on bank loan funding, then there certainly is more to do to complete the CMU.

Philipp Hildebrand

Capital Markets Union – Who Will Invest? I. Getting the perspective right I do not usually accept speaking engagements where I am asked to present the industry view. But in this case the question is genuinely one of public interest and one that has been conspicuously missing from initial reflections. It is nice and well to debate the goals and desirable features and reform needs of a capital markets union—in a nutshell offering a more efficient and sounder plumbing to the financing of the EU’s economy, notably its predominantly small and medium size businesses. But this objective can only really be achieved if the resulting framework appeals to those with funding to invest— not just to those with funding needs. So it is very welcome that this conference has a session dedicated to the investor perspective. In these introductory remarks I would like to give an overview of what investors want but also raise a few questions about where they will come from, questions that have been equally absent from the public debate I have seen so far. I will conclude with two words of caution.

II. What do investors want? For investors, there is an emerging consensus that the following ingredients are needed and, for now, lacking: – Simplicity: amazingly given when the so-called single market started, it is still not possible for financial services firms to “passport” their services across member states’ borders as freely as banks, let alone car manufacturers, do, and investing capital across borders is a major headache. Likewise, it is far too complex for a retail investor to shop around across borders for the best investment product. – Transparency: investors need to know what they invest in; right now disclosure requirements, credit registries and credit ratings are nowhere near where they should be to give confidence to invest in all but the top tier of European corporates. That is a huge hindrance. – Adequate incentives: the key investments that the CMU initiative purports to promote—such as long-term investments, notably in infrastructure, securitizations– are penalized compared to other investment products (e. g., tax re-

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gime, risk weights). In some cases, to jump start the market, some form of government support might be worth considering, e. g., for venture capital. Liquidity: not absolutely all investors want that, but most do. And in Europe most market segments are simply too small to provide it. On top of that, a number of countries are considering a financial transactions tax which, by discouraging transactions, would by definition further reduce existing liquidity.

This brings us to the elephant in the room of cross-border securities. Only with such securities can European capital markets reach a size and scale comparable to the US, providing adequate liquidity and risk diversification. Indeed without such securities one might challenge whether there is a capital markets union at all. A very encouraging first step to deal with the thorny issue of cross-border investment, especially in the area of private capital, was taken with the European Long Term Investment Funds (ELTIFs)—which are not perfect but have the merit of allowing a fund based in one member state to access investment opportunities across the entire single market. Developing the concept of a true investment or asset passport for both ELTIFs and other funds on the same model should be facilitated. To go further and have genuine cross-border securities, two difficulties come to mind however, both quite challenging. – One is the need for a minimum degree of harmonization of underlying legal regimes, notably insolvency regimes across countries; without this, pooling securities across borders would be like pooling apples and oranges, a result that makes a very unattractive investment product. – The other is the creation of cross border “risk free” benchmarks off which to price the rest of the market. Indeed without such a step to prime the crossborder securities market it is somewhat doubtful whether it can emerge at all. The question though is will there be any time soon sufficient political appetite for such a step? This seems doubtful, sadly.

III. Where Will Investors Come From? One issue in need of clarification is the following: Is the goal of CMU to bring new investors to the table from outside the EU, or to prompt existing ones to reallocate their savings from the banking system to the capital markets? And can we be sure this reallocation is pareto-optimal? A case can be made that there is scope to bring new investors/investments to the table: the EU as a whole runs a sizable current account surplus, meaning it

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exports its savings to the rest of the world, to the tune of nearly €300 billion per year. By definition, these exported savings reflect a lack of sufficient attractive investment opportunities within the EU. In part this has been because of difficulties in the real economy. But in part also, arguably, because of inadequate financial market “plumbing”. Thus, if CMU facilitates the creation of new and attractive EU investment products, more financing could indeed be available and this would benefit the EU economy. But this current account surplus likely has a large cyclical component. So in steady state, what CMU would accomplish is a reallocation of existing “investments”. Would that necessarily improve economic efficiency? Let’s consider separately institutional and retail investors. – Institutional investors are heavily invested in government paper, which gives them the liquidity, and safety characteristics many need. If they suddenly switch a large chunk of their holdings to private sector securities, the cost of government borrowing will go up, assuming constant supply. Perhaps now is a good time for such a switch: supply is in fact shrinking, and demand from banks has increased owing to post global financial crisis regulations. ECB QE will be an additional source of demand for the next two years. This is therefore a good time to implement this shift without disruption. – Retail investors/households keep over half of their savings on average in cash in bank deposits. On the one hand these can be seen as idle, inefficient investments that will create difficulties down the road as households realize they have insufficient savings to smooth consumption through their retirement. On the other hand, they constitute funding for banks that allows them to lend. To the extent the creation of CMU is a response to fears of credit contraction, or insufficient credit growth, as European banks delever under the effect of post crisis regulations, competing for their deposit base may not have the intended effect. One would need to study whether £1000 in a bank account generate more or less SME funding than £1000 in an ETF. The answer is not completely obvious.

IV. Two words of caution Speaking from the perspective of a financial market participant, it is heartening to see the recent enthusiasm for the capital markets union. But two caveats are in order: – First, the financial institutions that are at the heart of the capital markets union are largely the same institutions as the so-called “shadow banks” that continue to be eyed with great suspicion and in the line of fire of various

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recent and ongoing regulatory reviews. There is no question that markets need to be regulated. The key is to do that without hindering their development. I understand Lord Hill has promised to launch a review of the impact on jobs and growth of the multitude of financial market regulations that have popped up since the crisis and that is exactly the right approach. Second, as in everything, one should be mindful not to overpromise. CMU has been hailed, amongst others, as a way to bring more financing to SMEs. But here too the comparison with the US is instructive. Despite capital markets playing a hugely bigger role in financing the US economy than in the EU, SMEs have almost no access to them, just like in Europe. What capital markets finance a lot more in the US than in the EU is mortgages and medium to large enterprises. And that frees up space on banks’ balance sheets to lend to those small businesses that do not have an alternative.

In sum, the CMU is a welcome and overdue initiative. One needs to be mindful as it unfolds to keep in mind all the relevant perspectives—the demand and the supply sides, the forest and the trees.

Alexandra Hachmeister

European Capital Markets Union: Strengthening Capital Markets to foster growth Restoring European competitiveness with joint efforts On 18th February 2015, the European Commission published its Green Paper “Building a Capital Markets Union”. Along with its paper, the Commission opened the consultation phase, inviting all interested parties to contribute to the conceptual framing of a future Capital Markets Union. Deutsche Börse Group welcomes the Commission’s initiative. The aim of integrating European financial markets has long been in the focus of policy makers; with the Customs Union, the Monetary Union and, most recently, the Banking Union. A Capital Markets Union can be seen as the next step on the way to fully integrate European financial markets in all 28 Member States. Europe has gone through a severe financial and economic crisis in recent years, with much of the region still struggling to make meaningful head way on reducing unemployment and stimulating economic growth. A shift in political priorities from years of crisis solving towards sustainable growth and job creation is therefore decisive. The concept of a Capital Markets Union should provide part of the solution, with its main objective to enhance the efficient allocation of capital throughout the EU by developing non-bank sources of funding. A strong economy needs strong capital markets to finance its growth. This is especially problematic for small-and medium sized enterprises (SMEs) in Europe, which rely heavily on bank funding. Enhancing capital market financing will allow for companies of all sizes to benefit from alternative methods of funding. Ideally, bank and non-bank funding exist in parallel. With regard to a broader picture, Deutsche Börse Group proposes following six core principles at the heart of achieving the objectives of a functioning Capital Markets Union:

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1. Revive investor trust in financial markets Since the global financial crisis in 2008, trust in financial markets has dramatically decreased. The loss of trust combined with a lack of properly understanding the complexities of the financial system have also led to a decline of confidence in capital markets. It takes convincing initiatives to restore the trust of investors and spur the demand for new sources of funding. Through communication and education the informed investor will be more willing to invest into European companies; and the informed company will be capable of better choosing its right source of funding.

2. Improving access to non-bank funding sources Compared to Asia and the U.S., Europe still has a lot of room to foster non-bank financing. For example, while in the U.S. only 30 percent of general funding is covered by bank loans and 70 percent via capital markets, exactly the opposite is true for the European Union. In order to bridge the gap that emerged as traditional sources of bank funding have become increasingly constrained, non-bank funding provides alternatives through equity and debt funding. A well functioning Capital Markets Union would provide investors and companies with choices, market infrastructures, in this regard, play an important role. There is not just one method through which to increase access to funding i. e. for SMEs in Europe. Fostering a stable, positive environment and incentivising companies through attractive and diverse funding options is essential.

3. Promote financial stability Reducing risk in the system is an indispensable condition for growth and employment. A lack in financial stability translates into economic instability as has been demonstrated during the financial crisis. In order to mitigate systemic risk and create well functioning markets, safety and integrity must be ensured. In recent years, regulators have clearly understood and strengthened the vital role of market infrastructures: exchanges, central counterparties (CCPs) and central securities depositories (CSDs) in achieving this objective via permanent market supervision, efficient post-trade processes and collateral management. An important aim of the Capital Markets Union should thus be to realise the G20

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goals and to continue implementing and truly applying the European regulations (e. g. Emir,CSDR).

4. Increase transparency Ensuring transparency for investors as well as supervisors is an essential prerequisite for increasing financial stability, as increased transparency in terms of execution, both pre- and post-trade, improves the quality of price discovery and reduces investment risk. The Capital Markets Union should look to improve upon existing initiatives, ensuring transparency for functioning price discovery mechanisms, while keeping in mind that different data users, like retail investors, institutional investors or regulators, have different transparency needs.

5. Foster harmonisation and remove barriers Harmonising different rules and standards within the European Union is a fundamental effort in order to eliminate costly barriers and reduce complexity for investors and companies. Significant fragmentation still exists in the public domain, for instance in securities law, insolvency law, accounting standards for SMEs as well as tax procedures. Initiatives in this area, building on the single rulebook as a harmonised regulatory framework, will increase the attractiveness of European financial markets and returns on investment, thereby stimulating growth. The Capital Markets Union can serve as an efficient vehicle to dismantle some of the cross-border barriers that still prevent the development of truly integrated European markets.

6. Shape the supporting regulatory and supervisory environment Last but not least, shaping the supporting regulatory and supervisory framework, not only within the European Union but worldwide, is vital to create an environment in which the proposed initiatives for growth can fully prosper. A Capital Markets Union represents an ambitious joint vision for policymakers as well as industry and societal stakeholders to integrate and further deepen European financial markets. Spurring the dialog between the different parties is an indispensable part of turning ideas into concrete actions that can flourish.

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Deutsche Börse Group therefore highly appreciated the Conference of the Institute for Law and Finance of the Goethe University in Frankfurt to have offered a platform that brought together the various views on the initiative, with the common aim to revive Europe’s competitiveness.

Wim Mijs

Banks set for pivotal role in new growth ecosystem Intro: The free flow of capital is one of the fundamental principles on which the European Union was built. The creation of a Capital Markets Union – more than fifty years after the signing of the Treaty of Rome – aspires to turn this vision into reality. Europe’s banking sector – traditionally the main source of lending for Europe’s entrepreneurs large and small – is ready to contribute to the success of CMU, says Wim Mijs, Chief Executive of the European Banking Federation. A new ecosystem for growth is emerging in Europe and banks are set to play a pivotal role in this new financial environment. A strong and stable banking sector can support the creation of more efficient and more dynamic capital markets. The March publication of the green paper “Building a Capital Markets Union” marks the beginning of a major initiative by the European Commission to integrate capital markets in the EU. The objective of this Capital Markets Union (CMU) is to make European capital markets more efficient, competitive and diverse, and thus also more resilient to possible shocks. Broader, deeper and more efficient capital markets are seen as a good basis for funding a dynamic and innovative economy in the EU. Reshaping the structure of capital markets in the EU to achieve a Capital Markets Union is therefore one of the most important tasks of the new European Commission. The ultimate objective of CMU is to find alternatives to fund investments and boost economic growth, to help companies create jobs and, ultimately, to create more prosperity. The European Banking Federation (EBF) fully supports the goal of unlocking the latent investment potential in Europe’s capital markets. However before concretely discussing the views in the banking sector on CMU let us make sure that we do not lose sight of the bigger picture. The nature of the European economy is such that banks are a crucial and important factor. This will not change even when alternative sources of funding become readily available and when markets will play a bigger role. And let us also not forget that banking finance is innovating and taking up new opportunities. When we talk about alternative sources of finance, we tend to limit ourselves to responding to the role of capital markets. Many banks in Europe however are modernising their lending channels so that SMEs can access finance in more flexible and more cost-effective ways.

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It’s a fact that approximately two-thirds of all funding in Europe continues to be based on a preference for banks. In our part of the world there is a strong historic and cultural preference for going-to-the-bank instead of the market. Bank funding often is less complex than having to go to markets – and therefore also cheaper. That’s very different from the United States, where the economy depends largely on financial markets for funding. It is important that we do not ignore these cultural differences. Capital Markets Union may have been inspired by the fact that the bank transmission system in Europe in recent years has not managed to deliver fully what was expected. We take great comfort in comments¹ that Commissioner Jonathan Hill made in March, when he said Capital Markets Union is not about displacing banks, but about complementing the role of banks. Still, Capital Markets Union is important as a project that can help address fragmentation in Europe’s financial services markets and that can encourage renewed integration. Our sector strongly feels financial integration is tremendously important for the EU economy. The European Banking Federation, ever since it was created in 1960, works hard to contribute to that integration. However, reality requires all of us to admit that despite all the efforts of the European Union, the financial services markets in Europe remain deeply fragmented. European Central Bank data shows that fragmentation in Europe’s financial markets has even increased again during the years that followed the financial crisis. Just to given one example: the share of cross-border debt securities in the euro area was only 16 % in 2013, compared to 30 % at the beginning of 2008. One of the good things about Capital Markets Union is that it provides a clear and fresh focus on removing obstacles and on removing barriers to growth. We also very much welcome the focus of the new European Commission on growth and jobs, and also on better regulation.

Regulatory uncertainty as a barrier to growth Turning Capital Markets Union into a success also requires all of us to acknowledge and define some of the factors that could prevent it from delivering on its potential. Regulatory uncertainty is one of them. The European Commission’s green paper makes clear that CMU has a broad scope, with the prospect of various different measures for the short, medium and

 http://europa.eu/rapid/press-release_SPEECH- – _en.htm.

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long term horizons. That means we can expect many different measures. The drawback of this broad scope also is that it creates uncertainty. The financial services industry – banks as well as investors and markets – needs certainty on the limits of regulation. After the avalanche of new rules that was introduced in recent years, it is becoming difficult for our industry to keep up with the continuous flow of new regulations. We see another risk in one of the key success factors for Capital Markets Union: the willingness of national governments to embrace change. If fragmentation is to be addressed properly, national securities laws need to be further harmonized. But how will it for example be possible to reconcile home repossession laws in Italy with those in Sweden. In Italy it can take five years, while in Sweden a home can repossessed in merely six months. Differences such as these will not make it easy to securitize mortgages at a European level. The success of CMU will depend to a significant extent on how the EU handles the proposal to break up banks and the financial transaction tax. If we are not careful, these plans will harm liquidity and weigh down capital markets. Banking Structural Reform should not be introduced without carefully considering the unintended consequences. This risks a scenario where the EU goes full throttle – with the hand brake on. With that in mind, Europe’s banking sector would welcome a regulatory pause. That could give more time to make sure that we correctly implement the existing regulatory framework, with MiFID II, MiFIR, the Single Rule Book and BRRD. These new regulations should not be allowed to complicate CMU.

Key objectives: efficient demand, easier risk allocation, appropriate balance We believe that CMU should achieve three objectives in order to bring about a more integrated market: 1. It should increase the efficiency of the capital market by bringing investment opportunities for savers and investors more into line with the demand for capital. This can be achieved by broadening the availability of diverse corporate finance options and by expanding the range of investments open to savers and investors. 2. It should make risk allocation easier by improving cross-border investment opportunities. This would help to better absorb the effects of economic shocks on individual Member States.

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It should ensure that the capital market and the banking sector each contribute an appropriate share to funding the economy. This could make the economy more resilient to economic shocks.

The CMU project requires joint efforts to be successful. The EBF also stresses that efforts should be carried out by all actors in the European economy, including banks and Member State governments. A fundamental prerequisite for the success of CMU are economic reforms which help to restore confidence in the capital markets. Above all in the countries hit by crisis, such reforms are a sine qua non for improving the international competitiveness of their domestic economy. Only then will new regulation have a chance of creating a broader, deeper and more efficient capital market. Without restoring investor confidence both in the stability of the capital markets and in sound economic and fiscal policy, all measures to establish CMU – whatever its precise design – will be in vain.

Ten priority points to consider In preparing its official position that will be submitted to the European Commission, the EBF has identified a list of ten key priorities for establishment of the CMU: 1. Ensure a level playing-field between markets and between EU and non-EU actors 2. A “one-size-fits-all” approach will not work 3. Complete the Single Rulebook 4. Do no harm to existing markets 5. Emphasise importance of liquidity and market-making 6. Revise rules for Securitisation 7. Review the Prospectus Directive 8. Remove existing tax barriers 9. Promote tax transparency for cross-border shareholders 10. Improve financial education and SME knowledge

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Key points 1. Ensure a level playing-field The Commission must ensure a level-playing field for all actors in financial markets, and there should be equal terms for all market participants. To ensure an effective Single Market it is necessary to align regulation to ensure that it does not act to prevent cross-border activity or to distort competition. Alternative channels of funding to bank intermediation will be essential to create a CMU, however these channels must be appropriately regulated. Socalled “Shadow Banking” activities should not benefit from less onerous or even preferential regulatory treatment, and should be subject to the principle of “same risks, same rules”.

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2. A “one-size-fits-all” approach will not work Proportionality must be a key principle of the Commission in developing the CMU. A one-size-fits-all approach will not take into account the different risks of different activities and business models within EU capital markets. The Commission must take into account the different cultural, economic and legal frameworks in EU jurisdictions, and disproportionate measures could lead to serious unintended consequences and further fragmentation of capital markets.

3. Complete the Single Rulebook The implementation and completion of a true Single Rulebook would help to remove uncertainty for investing in capital markets. The Single Rulebook must be complemented by close convergence of supervisory practices that must be effectively and consistently enforced across all Member States. This will help to create a Single Market for capital for all 28 Member States and would help to remove barriers to cross-border investment within the EU. Member States must avoid “gold-plating” legislation, which would disturb the single market. Member States should not be competing on legislation, but instead should be competing on business-friendliness and reliable environments to attract investment.

4. Do no harm to existing markets Policy-makers need to avoid introducing any measures that are likely to have a negative impact on capital flows and investment. This would hinder the overall objective of the CMU. The Commission must in particular avoid unintended consequences on capital structures which could risk further fragmentation in financial markets. A good example of this is the implementation of MiFID II and MiFIR, which if not calibrated correctly could create distortions in financial markets, leading to further fragmentation and higher costs for investors.

5. Emphasise importance of liquidity and market-making The success of the initiative to make capital markets more efficient will also depend on whether or not markets can be made broader and deeper and on the availability of the necessary liquidity. Market-makers serve a crucial role in fi-

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nancial markets by providing liquidity to facilitate market efficiency and functioning. Market-makers are critical for the financing of the economy, as was recently confirmed by the ECB.² The Commission needs to place market-making and the importance of providing liquidity at the forefront of the CMU. Liquid capital markets will boost the process of moving capital from slowly growing sectors to dynamic innovative industries and raise confidence of investors. The adoption of the Banking Structural Reform proposal without adaptations will have significant adverse impacts on the potential CMU. The separation of trading activities out of the universal bank will render market-making more expensive for customers and decrease liquidity in markets. Hurdles and disincentives to providing liquidity and market-making may also arise from the introduction of a Financial Transaction Tax (FTT). By increasing the cost of secondary market trading – even fractionally – in participating Member States, the FTT would reduce liquidity and so make capital markets a less attractive place for investors, impacting both primary and secondary capital markets and dis-incentivising on-exchange trading and clearing. The negative consequences of the tax would be proportionate to its huge effective magnitude, taking into account the cascading effect in its application.

6. Revise rules for Securitisation The Commission needs to revitalise the market for simple, standard and transparent securitisations, including those products suitable for SMEs. This should be based on a dedicated European securitisation framework addressing the inherent risks associated with securitisations, including a revision of the capital requirements for securitisations. The EBF also supports a more lenient supervisory formula that replaces the current squeezing effect of external ratings. This should be applied to securitisation vehicles that comply with a set of eligibility requirements as simple, standard and transparent.

 See p of the Opinion of the European Central Bank of  November  on a proposal for a regulation of the European Parliament and of the Council on structural measures improving the resilience of EU credit institutions (CON//) [https://www.ecb.europa.eu/ecb/legal/pdf/en_ con___f_sign.pdf].

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7. Review the Prospectus Directive The Prospectus Directive needs to be reviewed to make it easier to comply with, in particular for SMEs. The threshold for producing the prospectus should be significantly higher (as it is in the US) to ease the burden on SMEs. A revised Prospectus Directive should make it easier and cheaper for firms to go to market, while still preserving a high level of investor protection.

8. Remove existing tax barriers The first Giovannini Report of November 2001 identified 15 barriers associated with the clearing and settlement of cross-border securities transactions within the EU. Two of them (barriers 11 and 12) are tax barriers. The complexity and cost of obtaining the tax relief to which an investor is legally entitled often lead investors to forego the relief. Even though the financial intermediary has access to accurate customer information and is subject to high compliance regulation standards, obtaining tax relief to which its customers are entitled is often not practicable. Full withholding at the maximum tax rate is often the outcome and constitutes a major disincentive to cross-border investment in capital markets. National provisions requiring that taxes on securities transactions must be collected via particular local settlement systems may narrow the choice available to investors and impair cross-border activity.

9. Promote tax transparency for cross-border shareholders All issuers and all intermediaries should comply with the same tax compliance requirements, including reporting requirements under the OECD Common Reporting Standard (CRS) and the Revised Directive on Administrative Cooperation (DAC2), i.e. all issuers and intermediaries should ensure that the beneficial owners are identified and disclosed under the prescribed procedures wherever they are located.

10. Improve financial education and SME knowledge The Commission should take steps to improve the level of financial education in the EU, for both (retail) investors and SMEs. This would help (retail) investors to better understand the functioning of capital markets and their role within markets, while

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SMEs would benefit from increased knowledge of possible funding options available within capital markets. To sum it all up, Capital Markets Union must unlock the latent potential of EU financial markets to support bank funding in the economy. It needs to result in innovative, effective initiatives that enable financial markets contribute to growth, and that instils companies with the confidence they require to invest and create more jobs. The banking sector fully supports the European Commission’s growth and jobs initiatives. We look forward to see concrete measures such as the plans to revive securitisation markets. We are actively seeking partners to collaborate on CMU as a project that centres on free circulation of capital in the EU and appreciate the renewed focus on integration in our financial services markets, ultimately completing what we in Europe started out with more than half a century ago.

Cyrus Ardalan

A Vision for Capital Markets Union A Capital Markets Union (CMU) represents a significant opportunity for the EU. It comes at a timely moment as Europe emerges from the deepest crisis in a generation. When the financial crisis hit in 2009, European policymakers responded quickly, reforming the financial sector in an effort to restore confidence and financial stability. Many consider their efforts to have succeeded. Financial market regulation has been overhauled, banks are more resilient and financial markets are more transparent. With the creation of the banking union, euro area banks now have a single supervisor and a recovery mechanism is now in place for failing banks. However, the focus on restoring financial and economic stability has come at the cost of economic growth. The recovery in Europe has been sluggish, with EU GDP growth of 0 % in 2013 and 1.3 % in 2014, compared to the US, which has achieved above 2 % GDP growth since 2012. While the previous Commission can be praised for their efforts, the new intake of Commissioners represents a new spring in Europe, with fresh views and a renewed focus. The Commission’s priority has understandably now shifted from a focus on financial stability back towards growth. The creation of a CMU has become one of the significant policy initiatives aimed at promoting economic recovery. A CMU can provide a vital step in enhancing growth in the EU through reducing the costs of financing, rebalancing the intermediation process by diminishing the EU’s excessive dependence on bank financing and making the EU generally a more attractive place to invest. It provides a timely opportunity to develop a large, fully integrated pan-European market by unlocking barriers that have prevented the growth of capital markets both within and between member states.

What is meant by Capital Markets Union? The idea of a CMU has been the subject of extensive discussion and writing since it was announced by President Juncker. The concept is quite general and high level but there is general agreement on what it represents: development and integration of EU capital markets with a view to rebalancing the intermediation process to improve access, diversification and efficiency of financial markets. Following publication of its Green paper, the Commission’s intentions and objectives are also now well understood and appear to have broad support. The Commission is clear that CMU is not a ‘union’ in a legal sense of the word

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like Banking Union, and unlike Banking Union it encompasses all 28 members of the EU. The Commission Green Paper presents a two part strategy. The first focuses on priorities for early action such as a review of the Prospectus Directive, the private placements market and high quality securitisation. The second part of the strategy focuses on more fundamental long term considerations impacting the development of the markets as a whole.

Why is a Capital Markets Union in Europe important? The need to expand the role of capital markets has been highlighted in many forums: – Financial intermediation in the EU remains concentrated and heavily dependent on the banking sector. It is estimated that between 70 – 80 % of all intermediation in the EU is undertaken by the banking sector and the balance through the capital markets. In the US the ratios are virtually the reverse. – Capital markets are better positioned in certain areas than banks to meet the critical needs of the EU: – Infrastructure finance: Investment in infrastructure is one of EU’s principal priorities. In the current interest rate environment infrastructure investment can have high returns and provide an important economic stimulus. Infrastructure finance requires long term financing which has been historically provided by the banking sector. Recent regulation (for example the Net Stable Funding Ratio) has made such financing unattractive to banks. Project bonds provide a source of attractive long term financing. – Financing of growth companies: SME financing has been traditionally undertaken by banks. While this may be appropriate for most SME’s a more limited group of perhaps 5 – 8 % of businesses of all sizes have strong ambitions to grow and are also the principal source of jobs creation. For these companies capital markets financing providing equity and early stage investments are the key to their growth. – Capital markets can indirectly support bank lending. Banks can reduce their risk profiles and meet the needs of their clients more effectively through securitising parts of their portfolios and selling these to institutional investors interested in these assets. This enables banks to free up their balance sheets

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and focus on activities best suited to bank finance e. g. SME lending and export finance. Capital markets on a pan European basis provide venture capital markets better risk diversification given the smaller number of available deals. In contrast bank lending to SME’s markets are adequately diversified at a national level. Capital markets provide risk management tools that are important for the real economy, notably exports and infrastructural finance. A strong capital market can help disperse risk more effectively in the financial markets and enhance stability and resilience of the EU financial markets.

Capital markets are therefore a very important incremental source of funding and, equally importantly, they can provide funding that is not available through banks but which is critical to growth and employment creation. Unlike banks, capital markets provide a broad array of instruments with varying risk return characteristics. As a result they can address the specific needs of issuers and investors more effectively.

What can be realistically achieved? The size and sophistication of the European economy provides the EU with an opportunity to create one of the largest and most sophisticated capital markets. Significant progress has already been made in recent years through the Financial Services Action Plan and the work of the Giovannini Group, however, much more needs to be achieved. For these markets to develop, they need to be attractive to institutions seeking, as well as investors providing, finance. A vibrant and efficient capital market requires breadth, depth and liquidity. Issuers want ease of use, flexibility, low relative cost and realistic requirements on disclosure. Investors seek returns, liquidity, security and ease of investing compared to other investment opportunities. Finally we need to have institutions that bring issuers and investors together, providing liquidity and promoting the development and use of these markets and fostering innovation. This involves banks and other institutions such as financial exchanges focused on capital markets. The expansion of capital markets in the EU raises significant challenges and it is important that realistic goals are set and expectations managed against these. The US capital market should be studied when considering Capital Mar-

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kets Union, but it is important to recognise that the US model can never simply be replicated in the EU, as it has a number of unique and specific characteristics: – The relative size of US capital markets is partly attributable to the stock and ongoing issuance of mortgage backed securities. This distinction derives from a number of sources including government guarantees and tax incentives. – US capital markets have enjoyed a more harmonised legislative framework for a great deal longer than the EU. Institutional and cultural distinctions follow directly from this basic distinction of time. – The growth of US capital markets over the years has been driven by a number of significant policy initiatives, the unintended consequence of which has been to promote capital markets. These have included Glass-Steagall, interstate banking restrictions, and Regulation Q. – European firms are more likely to be held privately, and to wish to remain so. Some of this may change as capital markets develop in the EU. However there are significant cultural differences that exist and are likely to remain for some time. – US institutional asset pools are both larger and more actively engaged in the capital markets than their European counterparts. This is the case notwithstanding the fact that saving levels are comparable in the two markets. A successful CMU can significantly improve the balance of intermediation in the EU. It would however be unrealistic to expect the percentage of intermediation in the EU undertaken through the capital markets to approach those of the US. An important initial piece of work that needs to be undertaken is a comprehensive assessment of the extent to which rebalancing is both realistic and desirable. This would set out by product the opportunities for an expanded capital markets in the EU given current institutional and economic structures. This should be analysed by country as large national differences exist across the EU. A road map for policy makers and market participants would provide an important benchmark against which opportunities can be assessed, progress judged and expectations managed. It would also form an important element in the action plan discussed later.

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Achieving CMU: Develop a supportive financial eco-system and the market will do the rest Moving the EU capital markets even half way towards the share of capital markets intermediation in the US would require a near doubling of capital markets in the EU. Such an increase involves significant changes. These will need to go beyond tweaking with a subset of products. It will necessitate a change of the whole complex intermediation eco-system. This is a project and will need to be carefully managed in a phased approach over a long period of time. The Commission Green Paper recognises this by separating its discussion into two sections namely priorities for early action and measures to develop and integrate capital markets over the longer run. The Commission’s focus on securitisation, private placement regime, and the Prospectus Directive are important and sensible initiatives. However they are unlikely to result in a significant shift in the balance of intermediation. While pursuing these initiatives will provide key early ‘wins’ which are important for momentum, it is vital that focus on the more challenging long term structural requirements of a capital markets union are not lost. Short term tactical gains, while important, should not be achieved at the expense of more broad based change. The two must be pursued simultaneously. A clear and comprehensive road map will help safeguard this. By adopting a holistic approach and preparing a comprehensive framework the EU can identify and help put in place the prerequisites for capital markets to thrive. Financial intermediaries are dynamic and innovative. If provided with the right environment and incentives, they will drive growth of the capital markets and a rebalancing of the intermediation process will follow. An EU framework should establish a taxonomy identifying the key stakeholders on one side and their respective drivers to engage in the capital markets on the other. The key stakeholders are the issuers of capital markets securities who need financing, investors who manage savings and intermediaries who bring these two parties together. A variety of factors drives their respective decisions and can be grouped in a number of ways. One simple approach would be to look at the various drivers according to their impact on the ease, cost and willingness of each of the stakeholders to engage. The range number of drivers is large. Some of the key ones to consider are: – Standardisation of rules: Creating a common framework for securities ownership rights, simplification and harmonisation of the core requirements of the Prospectus Directive and divergences in listing requirements for exchanges.

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Disclosure requirements: Initiatives to develop light touch but consistent disclosure requirements notably in presenting key credit data on a comparative basis would greatly facilitate capital markets access. Many EU corporations remain private and therefore provide limited information and are reluctant to provide full disclosure on their activities. Capital costs: The costs of undertaking capital markets activities need to be looked at in their totality. These include capital costs associated with market making activities, inventory financing through the repo markets and the costs of mandatory holding securitised products. A similar analysis would need to be undertaken from the perspective of investors under Solvency II. Insolvency regimes: EU bankruptcy regimes vary hugely across Member States which result in significant differences in recovery levels. Insolvency law should be harmonised across the EU to bring consistency and certainty. Fiscal incentives: Tax treatment of equity and debt differ greatly. The tax deductibility of debt and taxation of equity and dividends distort the equity markets. Equally, transaction taxes on tradable assets have a direct arithmetic impact on liquidity, ultimately reducing price certainty and increasing the cost of raising capital. Transaction costs: Taxes and levies on transactions can significantly increase the costs of intermediation through the capital markets. This is particularly true with smaller stocks and less liquid fixed income assets. The FTT is an example of a pan-European initiative with material risks for liquidity as witnessed in Sweden. Liquidity: The provision of liquidity for capital market instruments is a fundamental prerequisite for the development of capital markets. Within growth markets, illiquidity the ‘liquidity risk premium’ may reduce the amount of money raised in the primary markets by up to 40 per cent by creating uncertainty over the price formation of the secondary market. Recent regulatory changes have led to a significant decline in liquidity in capital markets. The impact of this needs to be carefully assessed and any negative consequences addressed. Administrative and legal restrictions: While most investment schemes are accessible in theory by non-nationals, driven by state aid rules, in practice these schemes are challenging to use outside of each member state. Venture markets are naturally continental in scale due to the difficulty in diversifying risk within single countries. Member States need to create schemes which are more directly accessible, or which allow companies to access investment from investors from other schemes without the requirements of each scheme proving incompatible. More generally there needs to be greater coherence of policies to ensure interoperability of different regional systems and schemes.

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Making capital markets easier to use and reducing costs of intermediation will go a long way to a gradual rebalancing of the markets. However this will also need to be supplemented by specific measures that increase the willingness of stakeholders to use capital markets. Firstly knowledge of capital markets products is poor and fragmented. A program of educating stakeholders will be important to increase awareness and take up of products. Intermediaries have an important role to play in this area. However the lack of trust in capital market products will make this challenging and require careful and thoughtful management. Secondly Europe still lags behind the US and increasingly Asia when it comes to embracing a culture of entrepreneurialism. This is particularly important in that job creation is driven to a large extent by these growth companies and they have the most to gain from the capital markets. It is important, in the context of CMU, to examine national attitudes to entrepreneurialism recognising differences in education, risk appetite and treatment of failed businesses, both culturally and through the credit rating system. As part of this the Commission should consider the success of start-up hubs such as Silicon Valley and increasingly London’s Tech City where an aspiring entrepreneur can go to connect with a diverse network, productive environment and specialised funding.

Achieving CMU: Developing strong institutions to promote capital markets A final area that is critical to the development of capital markets is the role of financial intermediaries. This is an area which has not received much attention and yet which is central to the whole process. Financial intermediaries have a number of important roles including: – Identifying both investors and issuers and bringing them together – Educating participants on the markets and providing them with ongoing information on market developments and opportunities – Structuring transactions to meet the needs of a diverse range of clients – Providing liquidity and creating markets for financial products – Linking pools of liquidity across markets – Supporting clients to manage their market risks – Sponsoring the development of the capital markets as a whole through innovation and advocacy

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For CMU to develop an environment where strong capital market oriented institutions exist and thrive must exist. These will need to comprise of both large global but also strong regional institutions that are familiar with local markets and with small and medium sized companies. The existence of strong European entities will be critical as they are both most familiar with local conditions but also have a strong vested interest in building these markets and introducing local firms to the capital markets. The need for innovation could be particularly important for smaller and medium sized companies which are of particular focus in the EU. Regional institutions may have a particularly important role to play here. Capital markets products have traditionally been developed for and marketed to large sophisticated institutions, which is where the focus of the larger banks has tended to be. The development of the high yield markets in the US is a good example. This large and important market was developed through the efforts of an individual working outside the mainstream banks. Current measures aimed at bank structural reform, high compliance and capital costs, compensation caps and the general negative perception of investment banking all have significant negative consequences and their impact needs to be carefully assessed. The existence of a very sophisticated and broad based institutional setting in the US has been one of the key drivers of capital markets development in the US at a time when resources committed to investment banking in Europe are being cut significantly.

What should the role of the Public Sector be? Governments and regulators will need to play an important role in fostering the growth of capital markets. Firstly they can put together a vision and roadmap against which market participants can grow their activities. The Green Paper on CMU represents an important first step in this regard. This can help nudge the private sector to move more quickly, invest and give greater priority to promoting capital markets. Secondly they can help eliminate some of the key regulatory and policy constraints that are inhibiting the growth of the capital markets. There are many examples of regulations having unintended consequence and hampering the growth of capital markets. In other cases legislation needs to be introduced or harmonised if some of the objectives of CMU are to be achieved. Thirdly there may be specific circumstances where the public sector could play a direct role in supporting the development of capital markets. There are cases for example of market failure and information asymmetries. The construc-

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tion period and uncertainty surrounding an infrastructure project can be a major impediment to the use of project bonds providing an important role for the EIB. Information on a standardised basis from banks can be crucial to the securitisation of SME or MME loans. Fiscal incentives to encourage investments in seed capital and for start-up companies such as the UK EIS and SEIS schemes provide useful models for promoting start ups. Finally the Commission could also look at potential opportunities to accelerate innovation and help develop markets for financial instruments that would be new to the EU and designed to address the specific characteristics and needs of the EU markets. Financial institutions often take a short term view on the economics of introducing new products or the application of existing products to a new set of users. Development costs can be high and the results uncertain and may take time to reach fruition discouraging institutions form making the necessary investment particularly in this resource constraint environment. EU institutions can act as a convenor to bring financial institutions and asset managers together to explore for example opportunities for new equity like instruments, securitisation of SME loans, crowd funding etc.

Concluding remarks: a vision for Capital Markets Union Capital Markets Union is a timely initiative that can enhance the effectiveness, depth and scope of capital markets in the EU. Capital markets are already developed to varying degrees across the EU, benefit from a common rule book and oversight from existing supervisory bodies. However they are less liquid and deep than their US counterparts, resulting in reduced supply of credit and price certainty. This ultimately reduces the supply of and increases the cost of capital, particularly in the equity markets. The challenge is therefore to strengthen capital markets as a central component of the financial intermediation process in the EU. This requires a detailed and comprehensive review of key drivers of capital markets development and measures to promote them. A detailed road map covering the medium term needs to be established against which this project and expectations can be managed. Tactical fixes falling within the competencies of the Commission can be implemented quickly. Issues that require all member state agreement e. g. fiscal and insolvency laws will be far more challenging and will need to be addressed over the medium term. Finally behavioural and cultural considerations can only be managed over the long run.

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The road map should include the following elements for each phase: Review of capital markets by products and an assessment of their potential for growth The key drivers and prerequisites for issuers and investors to use these products and for markets to develop The regulatory, policy and institutional changes that need to be taken to promote change The measures required to provide for the right institutional setting for intermediaries to develop The potential role of the public sector to promote markets and deal with market failure The timetable for the rebalancing to occur

The EU Green Paper is an important initiative. It is however the beginning of a potentially long road. A tactical approach to promote certain products is a useful beginning. This should not however distract attention from the much greater and longer term challenge of creating an effective eco-system for capital markets to prosper and grow.

Sir Jon Cunliffe

What has to change?

The title of this session, ‘What has to change’, reminds me of the question: ‘how many psychologists does it take to change a light bulb?’ The answer is ‘only one, but the light bulb has to want to change’. It is an obvious but important point. The European Commission can harness political energy, initiate legislation and try to change the way that people see things. But unless the member states really want to address barriers to Capital Markets Union (CMU), we will not make much progress. History shows us how far we were able to go with the amount of political capital we had under Giovannini, which is not an insignificant weight, but the question is how much political capital is there? CMU does not, as people have said, necessarily mean EU legislation, though that can be very important in addressing barriers. But if all we do is measure success by the number of legislative proposals – as some in the EU tend to do – we will fail. We have to accept that there are very different views about the respective roles of capital markets and banks in the different member states EU, which exist for reasons of history and culture and their effects on the way people save. But it’s also for reasons of vested interest, some of which we may be able to tackle. As a result, it’s important that we keep and maintain a vision of the ‘size of the prize’. For politicians to be able to sustain the momentum that will be needed over time to achieve CMU, there needs to be not just a vision, but some quantification of the benefits of CMU and some explanation of what is the ‘size of the prize’. In the case of CMU, we’re not dealing with something like Banking Union, which is a financial stability project that you can accomplish quickly at the stroke of a legislator’s pen by creating two institutions. Rather, this is an effort that is going to have to be sustained through a long number of years. For that to happen, there are three important responsibilities incumbent upon those who want CMU to succeed: First: they need to establish and maintain a vision of ‘the size of the prize’, i. e. some quantification of the benefits of CMU. Second: they need to show that the risks inherent in capital markets can be addressed – just as in recent years they needed to show that the banking system could be made safer.

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Third: they need to achieve some early wins. Policymakers cannot sustain political momentum simply by making promises about the future that may or may not ever be fulfilled. There is a phrase “jam yesterday, jam tomorrow, but never jam today”, from Lewis Carroll’s Through the Looking Glass and What Alice Found There, which was memorably picked up by Keynes [Economic Possibilities for Our Grandchildren” Works, vol. IX, pp. 329 – 30] and is often used in an economic context. But I contend there has to be some jam today because it will be very difficult to sustain the momentum behind CMU if the message we present is that we are building something purely for tomorrow, with no tangible benefits – i. e. no ‘jam’ – to be found today.

Taking these in turn The Bank recently published our own paper on the economics of CMU. This does not focus on particular market segments, but rather tries to understand the broader channels by which CMU brings economic benefit. Our paper therefore sought to set out the vision, the prize, what’s at stake and how it might work. I’d like to draw attention to two specific points. The first is that the capital markets channel allows much more diversity in the nature of investments, giving more efficient matching between savers and borrowers in the intermediation process. Obviously the EU is not the US – we’re a collection of member states under supranational rules – so we shouldn’t expect we can do what the US has done, because we have a different history. But to make a point that others have made: one-third of all household assets in the EU (including property) are held in the form of bank deposits; in the US, that figure is only 10 %. The difference is the amount of savings in the US that goes into the capital markets channel. This gives you some idea of the scope we have to increase efficiency And the second point I’d make on the economics of CMU is the way it can achieve cross border risk sharing in a way that cross-border bank lending does not. In the paper, we modelled what would have happened if we’d had so-called full risk sharing through equity markets during the euro crisis. This work showed that, by spreading the cost of the economic hits to crisis countries like Greece and Spain across the broader range of EU countries, the impact on consumption in Greece and Spain would have been much lower. Our estimates suggest that full risk sharing in equity markets could have reduced the drop in consumption in those countries by about 2 percentage points if there had been risk-sharing across capital markets.

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Of course, this does also mean that investors in other countries would have seen losses on their investments. But that diversification and sharing of economic risk would probably have led to a better economic outcome, not just for Greece and Spain, but for the euro area and the European Union as a whole. So there are big gains here to be made in economic risk sharing. As well as having a vision of the prize we need to show that we can manage the risks of CMU. CMU is not happening in a world of ‘static capital markets’. Since the early 1990s we’ve seen huge growth in assets under management in capital markets and a great explosion of the number of funds and strategies that exist in this universe, such that it is now a complex taxonomy of different strategies, firms and funds. – And the crisis – in part through the impairment of the banking system, in part through the effects of exceptional monetary policies – has accelerated these developments in market based finance. – Indeed, nearly all of the growth in corporate lending since the crisis has come through the capital markets channel, the corporate bond market, and the size of Assets Under Management since 2008 have increased by nearly 50 % since 2008. At the same time, the willingness and the ability of the core banking system to support capital markets by providing liquidity and by performing market-maker functions has shrunk. Market-maker inventories for US fixed income have shrunk by 75 % since their pre-crisis peak – meaning they are back to pre-2003 levels despite the size of US corporate bond funds having tripled over the same period. This puts us in a world in which the capital markets channel is growing, types of funds and investments are growing, but the ability of the core system to support it has instead shrunk. Furthermore, international authorities such as central banks and regulators are now looking very closely at the potential systemic risks of this large capital markets universe – and whether, if we get sharp adjustments, we could find shocks in the capital markets world then transmitting to the broader financial system. We should be clear here that capital markets and asset managers – the sorts of things we’re talking about in CMU – were not a key cause of the crisis. There were some proximate triggers in the capital markets, through assets and activities like subprime and securities lending, but they largely related to banks and banks’ activities; and, in my view, the underlying cause of the crisis was the undercapitalisation of the banks, which really brought the system down.

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The monthly outflows from investment firms and funds have historically been very stable, and during the crisis did not exceed 6 % for any broad fund class. Throughout the crisis then, the capital markets provided a secure and stable place for financing. This is not to say that there are no risks here: we have to be able to show this activity is not harmful ‘shadow banking’ which could pose systemic risks. We as regulators and authorities have an obligation not to fight the last war, but to identify on the horizon what might be the next crisis and ensure that we are prepared to deal with it. As a result we need to look at some of the strains and possible risks that you do see in these markets. The largest of these capital-market risks that we’re monitoring at the moment is the risk around liquidity. I mentioned that the market-maker base, the ability of the core banking and investment banking system to support capital markets, has shrunk. At the same time, because of very low yields and the sort of monetary policy we’ve seen, investors have gone for high-yielding investments – emerging market corporate bonds, high-yield corporate bonds, etc. The opportunities to exit these investments are narrow and investors do not seem to be pricing that in because they’re not charging any premium for the possible lack of liquidity. This combination of less liquid investments by funds, on the one hand, and expectations by investors that they can exit their investments on a same-day basis, on the other hand, may not be compatible. Investors may be operating under an illusion of liquidity. And in turn, that could pose risks of a rush to a crowded exit if investors did change their mind about these asset classes and there was a sudden adjustment in the price of these assets – for example, when monetary policy normalises. We need to understand this risk and see what we can do about it. I do not believe the answer is to go back to pre-crisis levels of market liquidity because the very interesting thing about that liquidity was that it was there consistently only until the day you really needed it – and then it wasn’t. That is why we need to look hard at liquidity risks I have just mentioned. I’m often told by participants in the private sector that we’re being ‘inconsistent’ as authorities. We’re pressing on the accelerator of CMU with one foot and we’re pressing on the brake with regulation of capital markets on the other. I am not so sure there is a tension between financial stability and growth. I think as European policymakers and authorities, if we’re going to sustain the momentum of CMU, we need to show we understand the risks, and we’re trying to build a safe and stable capital markets union that takes account of those risks. Indeed, the worst thing that could happen to the CMU agenda is that it is interrupted by some sort of bump in the capital markets that leads people to

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overreact to the potential risks in capital markets and consequently shut down the entire effort to strengthen the capital-markets channel in the EU. The need to pursue CMU and the need to ensure capital markets are regulated in an appropriate way to ensure they are on a sustainable footing are therefore complementary, not opposing, agendas. As a result we need to show that we’re managing the risks, and doing so may also direct where we put our political energy in choosing CMU projects that support both economic and financial stability objectives. Here, I want to make a very big plug for the role of equity finance. And I want to make that plug from a financial stability perspective. The financial stability agenda may indeed help us to focus our energy on the more important parts of CMU – and specifically, financial stability considerations would point towards putting a particular emphasis on equity. Again, the prize is pretty large. Listed equity markets in the EU are about 60 % of the US. Relative to GDP, listed equity markets in the EU are about 60 % of their size in the US. When you look at the gearing of EU firms (i. e. their debt/equity mix) it’s similar to the US. However, where the equity portion in the US is relatively heavy on publicly listed equities, in Europe it is dominated by privately-owned unlisted equity – specifically, family-owned firms. This is clearly due in part to cultural and historical reasons. An AFME survey found ‘a culture of risk aversion’ among the borrowers, and probably a culture of aversion to equity to the risk involved on the part of the savers, with respect to investment in SMEs in Europe. And this is something that Europe has got to find ways of addressing – although cultural aversion is not always best addressed by legislation. This matters for a number of reasons. First, because one of the things you hear from banks is that the reason they don’t lend to small and medium sized enterprises (SMEs) is that those SMEs are over-geared. They’ve got too much debt already and not enough equity – and they have no easy way of expanding their equity base because it’s family and unlisted. SMEs don’t want to open up their equity to public listing, because of the risks, and therefore they can’t borrow because they’re assessed to be too high risk by potential lenders. So if these SMEs are going to grow and if they’re going to borrow more, they need to have more risk capital. The second point is the liquidity risk I mentioned. If you look at the outflows from equity investment funds during times of stress the outflow of funds is about 5 % of the daily activity in equity markets. These markets are big, deep, and liquid. In part, this is because equity products are standardised – so they have a more diversified investor base. If you look instead at investment grade corporate

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bonds in the US, daily average outflows under stress were around 20 % of daily activity. And you can imagine what the impact is when outflows from an asset class are equal to 20 % of daily activity, and what that means for price moves in a certain direction. So from a financial stability point of view, unless and until corporate bond markets become more standardised and develop that deep and diverse investor base, equity markets are more liquid and can cope with stress more easily. Third, from an economic risk-sharing point of view, equity allows for sharing of risks through variable dividend flows across countries. Imagine the impact of an economic shock in Spain on both parties in relation to a German investor investing in a Spanish firm. If that investment is in the form of equity, the Spanish firm may respond by reducing its dividend payment, which could also lead to a reduction in the price of the shares, and which would lead to a loss for the German investor – but that is a smooth adjustment process. Alternatively though, if the investment is in the form of debt (e. g. a fixed-income bond), the Spanish firm cannot try to adjust the income flow without defaulting and restructuring the debt – which can lead to quite difficult financial stability events. And if instead you shared risk in the form of a bank in Germany lending to a bank in Spain, who in turn finances the Spanish firm, the only way that you can transfer the pain back to the investors in Germany might be through bank defaults – and that’s an even bigger problem. So when I think about risksharing, equity provides a much smoother risk-sharing channel. My last point is that we are probably, as a planet, over-leveraged. There’s a recent McKinsey report that says that since 2007 there has been a $57 trillion increase in debt across all major economies – public and private, corporate and household. The fact is debt and debt financing have grown hugely in the world economy and particularly in the advanced economies and we need to find some way of encouraging the move back to risk capital from debt more easily. Finally, going back to ‘Alice Through the Looking Glass’ – jam yesterday, jam tomorrow, but never jam today. I think the one suggestion I often hear arises from the work that the Bank of England and the ECB have done around securitisation. I think securitisation actually has the ability to offer some benefits – maybe not today, but the day after tomorrow. European mortgage backed securities held up reasonably well during the crisis relative to their US counterparts. We didn’t have much subprime. We don’t want complex, opaque, difficult to value securitisation products and we don’t want them held by over-leveraged investors who find it difficult to take price changes. We want simple, transparent and comparable securitisation. And if we have that through an industry standard that the

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authorities recognise, we could look again at some of the regulation that’s been applied to securitisation relative to other asset classes and that will help banks to fund themselves and help them to take things off their balance sheet. Banks’ balance sheets are now under huge pressure because of the capital rules and they need to find ways to free that up, which would find ways of giving long-term investors exposure to housing assets that better match their liabilities, which is quite difficult for them to do at the moment because they don’t have the front end capability that can actually originate those securitisation products. So I think there is something that could be done. People tell me that securitisation doesn’t stack up as an economic proposition now and that might be true at a time of very low interest rates and when funding costs are very cheap, but I hope and believe that monetary policy will normalise at some point and I think if we can put the investment into securitisation now, that could be our offer of ‘jam today’. To conclude, the EU can use the CMU initiative to create opportunities for capital markets to promote growth in the real economy for its member states – but ultimately, the light bulb has to want to change. The prize for getting CMU right is big. But in pursuing this, we also need to show that we understand the potential risks in capital markets and know how to address these. In light of these risks, equity markets and securitisation are two key areas where we should focus our attention, allowing us to pursue both economic growth and financial stability objectives in tandem.

Patrick Kenadjian*

The European Capital Markets Union: how viable a goal? 1. An important initiative The European Commission’s Capital Markets Union (CMU) initiative launched on February 18, 2015 with the issuance of a Green Paper entitled Building a Capital Markets Union¹ (the Green Paper) is praiseworthy, both in terms of its goals and in terms of its approach. The dominance of bank financing in Europe has long stood out in comparison to other advanced economies, in particular the United States, and an additional source of financing, especially one which can provide equity financing, which banks do not provide, would be a welcome diversification of sources of financing. The way in which the Commission is approaching the issue, by looking both to what the private sector can provide as well as what the public sector should do, and selecting a staged approach to the project, to gather momentum for it and not to have to wait to do something until everything has been done, is also praiseworthy and seems characteristic of a welcome new way of approaching European issues. The Green Paper’s prose style is also a model of legibility and accessibility for the invested lay person and refreshingly free from insider jargon. It is flanked by two much denser consultations on the Prospectus Directive² and securitization.³ The benefits a CMU could bring with it for the European Union (EU) include (i) the diversification of funding sources for the “real economy” away from a quasi‐monoculture of bank financing, which would contribute to the resilience of the financial system, (ii) overcoming the fragmentation of the capital markets in Europe, which could contribute to a more efficient capital allocation across the EU, replacing what is now at best a capital markets federation, with many small stock exchanges and home markets for capital with a true CMU and (iii) enhancing growth and prosperity by boosting investment in and by private compa-

* The opinions expressed herein are the author’s own.  European Commission, Green Paper, Building a Capital Markets Union, COM ()  FINAL, February , .  European Commission Consultation Document, Review of the Prospectus Directive, February , .  European Commission Consultation Document, An EU framework for simple, transparent and standardized securitization, February , .

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nies and in infrastructure, thus helping alleviate the current high levels of unemployment. The Green Paper focuses on some specific products, in particular securitization and infrastructure finance and on providing financing alternatives to a particular segment of European issuers, small and medium sized enterprises (SMEs). These priorities have the advantage of being concrete goals by which both the advantages and the progress of the project may be measured, but equally the drawback of appearing to be pulling together a rather scattershot set of themes from current debates in European governmental and financial circles. In particular, pairing together aid to SMEs, the poster child of what everyone agrees Europe does well in the “real economy,” and the revival of securitization, the bad boy of the financial crisis of 2008/2009, makes for quite an odd couple of priorities, and several participants at the conference questioned how much systematic thinking had gone into the Commission’s proposal. Of course the Commission only took office on November 1, 2014 and the CMU proposal was pushed to the fore quickly as a matter of political and economic priority, to put as much skin on the bones of an appealing slogan launched last July 15 in the European Parliament by the newly elected Commission President, Mr. Juncker and put on the desk of a new commissioner, Lord Hill of Oareford, who leads a newly revised and renamed Directorate for Financial Stability, Financial Services and Capital Markets Union, successor to the Internal Markets and Services Directorate led by former Commissioner Barnier. That they came up with as cogent a project as they did in as short a time is a tribute to all concerned. The Green Paper offers up a set of five principles: (i) maximizing the benefits of capital markets for the economy, jobs and growth; (ii) creating a single market for capital for all 28 Member States by removing barriers to cross-border investment and fostering stronger connections with global capital markets; (iii) being founded on financial stability, with a single rule book effectively and consistently enforced; (iv) ensuring consumer and investor protection; and (v) attracting investment “from all over the world.” The goals of the project are to improve access to financing for business across Europe (in particular SMEs) and investment projects such as infrastructure; increasing and diversifying sources of funding from investors in the European Union (EU) and “all over the world;” and making markets work more effectively and efficiently within Member States and cross-border across the EU. The time line proposed by the Green Paper includes a consultation phase which closes on May 13, 2015, followed by an action plan to be published

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by the Commission during the third quarter 2015, with the building blocks of a “well regulated and fully functioning Capital Markets Union” in the EU by 2019.⁴ The consultation is meant to identify the nature of the problems currently limiting capital markets in Europe, possible solutions and their prioritization. In line with the new European Commission’s overall approach, which prides itself on introducing only one-fifth as many legislative initiatives as its predecessor, there is less emphasis on legislation and more openness to market driven solutions. In line with the pragmatism expected of a Commissioner from the United Kingdom, the proposed approach is made up of individual steps in a phased approach, meant to harvest “low hanging fruit” first to build up momentum to tackle more contentious issues in a medium term and then a long term, rather than succumbing to the temptation of offering an overarching vision of what the Capital Markets Union should look like in the end.

2. But what is the right strategy? This approach is refreshing but also has its limitations. It shows an openness to collecting the views of both providers and users of capital and a willingness to start small to achieve a larger goal. But, precisely because the outlines of the larger goal remain rather unclear, the approach runs the risk of resulting in a grab bag of initiatives chosen because they seem easier to achieve or happen to be top of mind in Brussels or London City circles rather than because they are the best steps towards a more unified capital market in Europe. Commissioner Hill stated at an appearance at Washington’s Brookings Institution on February 25, 2105 that he views this as building from the bottom up versus providing a blueprint of what the project would look like if it were being built from scratch, balancing the goal against the disruption, with early measures being the pegs in the ground which will allow the project to build momentum to tackle the more difficult questions later. The problem with this approach is that it may just as easily lose as gain momentum. There is a well observed phenomenon in the arc of reforms after a crisis, according to which the pendulum swings most strongly towards reform in the immediate aftermath of a crisis, which is when it is easiest to undertake the most difficult reforms, and then swings back the other way, making additional reforms ever more difficult. The 2008/2009 crisis provided the impetus for the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of

 Green Paper, see footnote  above.

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2010 in the United States (US) and the Basel III reforms at the G-20 level. Both those reforms are being increasingly called into question by segments of the financial industry and certain politicians as the financial crisis recedes into the past. Likewise the Euro crisis provided the impetus for the Banking Union in the Eurozone. The CMU is at least in part a reaction to the slower recovery from these two crises in the EU, but whether there is enough impetus left from either of these crises to fuel serious reforms in the capital markets in Europe and whether that impetus will wax or wane over the life of the project is yet to be seen. It is to be feared that in the absence of either a big idea to ignite enthusiasm for the project or a deepening of the current stagnation into another crisis, the impetus is likely to wane, in particular in view of what could be termed a rather relaxed timetable with building blocks (not completion) in place only by 2019. Of course, the year 2019 was presumably chosen not to make things easier on reformers but because it already is a practical “drop dead” date for legislation, since that is when the current legislative term of the European Parliament ends and any legislation not adopted by then would face an uncertain future with a new Parliament and Commission. The current uncertain status of the draft directive introduced late in the last Parliament to implement the recommendations of the Liikanen Group is an example of this. The issue of momentum is an important one given that it is likely to affect central elements of the project. One example of this is enunciated in the third principle of the Green Paper, “a single rulebook for financial services which is effectively and consistently enforced”⁵ (emphasis added). This raises the question of how to deal with the discretion that the 28 Member State securities regulators have in interpreting the rules of the “single rule book” that the European Securities Markets Authority (ESMA) writes. Anyone who has ever participated in a cross-border initial public offering (IPO) in the EU knows how different these interpretations can be. As Nicolas Véron and Gutram Wolff note in their excellent piece on the CMU, “[o]verwhelming evidence from market participants suggests that the current regime of national implementation and enforcement of even the most harmonized EU regulations results in diverging practices and market fragmentation.”⁶ The problem is very well put in a speech they cite by Steven Maijoor, Chair of ESMA in which he said that the breadth and complexity of the single rule book gives regulators the latitude to make so many choices, including interpretation of the rules and intensity of supervision that “diversity in these

 Green Paper, p. .  Nicolas Véron and Gutram B. Wolff, Capital Markets Union: A Vision for the Long Term, Bruegel Policy Contribution, Issue /, April , p. .

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choices will have the result that the single rule book will not in fact be seen as such by investors and market participants.”⁷ We will return below to how difficult solving this problem may be from an institutional point of view and it is not clear that putting off its resolution will make it easier to deal with in the future. The staged approach may simply result in kicking the bigger cans down the road, an exercise in which many commentators think Europe has few peers, with the exception of course of the United States. Véron and Wolff suggest setting up an array of working groups to tackle the most complex and technical issues, including insolvency and debt restructuring, taxation and the retrospective review of the aggregate impact of capital markets regulation passed in the last decade but not, interestingly enough, the institutional regulatory structure.⁸ They cite in this connection the success of the Giovannini Group and the de Larosière report. I think we are still facing a number of the barriers the Giovannini Group identified over a decade ago and de Larosière was working in the immediate aftermath of the crisis, when the pendulum’s momentum towards reform was at its strongest. Still, having task forces with a clear mandate can serve as a focal point for continued momentum, sometimes even leading to radical change, as the UK’s experience with the Independent Commission on Banking, which Véron and Wolff also cite, demonstrates. So this is clearly an idea worth pursuing, “faute de mieux” as the French would say. In his February 25 remarks at Brookings, Lord Hill said the project was an ambitious one, but the Green Paper leaves open how ambitious it will be and one public sector participant in the conference queried whether the consensus we were achieving in favor of the project might not be due precisely to the uncertainty over how ambitious it would be. A more systematic approach towards CMU, as suggested by Cyrus Ardalan, Vice Chairman of Barclays Bank, would involve an attempt to match up fundamental drivers for the three main constituencies in the capital markets, issuers, investors and intermediaries with the key reforms required to facilitate those drivers to create an effective ecosystem in which products will develop. I would add that for each driver it will be important to distinguish “nice to have” elements from essential elements. For more detail, I refer the reader to the accompanying article by Cyrus Ardalan in this volume.

 Steven Maijoor, “Regulations, pension funds and efficient financial markets,” Speech at the National Association of Pension Funds Investment Conference in Edinburgh, March .  See footnote  above, page .

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3. Why we need more capital markets based financing in Europe It is quite clear that the contrast between the US and the EU in terms of the percentage of financing provided by the capital markets and the banking sector, coupled with the slower recovery of the EU from the crisis of 2008/2009 and the natural limitations on banks expanding the provision of credit in the aftermath of a balance sheet crisis, exacerbated in this instance by changes in capital requirements for banks in reaction to the last crisis, have naturally turned minds to thinking that Europe could profit from expanding the proportion of financing channeled through the capital markets rather than through banks. It is generally – albeit not universally – accepted that in a balance sheet recession not only does the private sector focus on paying down debt and is thus reluctant to borrow and spend, causing sustained weakness in aggregate demand and lower growth, but that the banking sector is also less willing to lend because it needs to improve its balance sheet and increase its reserves. Thus, the natural tendency of the private sector to retrench is reinforced by the difficulty the banking sector has in providing funding. A bank which is deleveraging in a recession is generally doing so not by raising new equity capital in the market, but by shedding assets in various ways, including by not rolling over existing loans or extending new ones. Shedding assets also maintains downward pressure on asset prices which can exacerbate bank losses, making them even more reluctant to lend, regardless of whether there are borrowers willing to take on new debt. While the extent of this reluctance appears to depend on the strength of the balance sheet of the banks involved and the degree to which they rely on wholesale funding, with banks which have the weakest balance sheets and are most reliant on wholesale funding most being severely affected, there is ample evidence that the banking sector is a pro-cyclical element in a balance sheet recession, as bankers’ ability to borrow from each other and to replenish their capital from the market is reduced. Over time, as bank balance sheets recover, this effect will diminish, which could also have the effect of slowing the momentum for the more difficult reforms required by CMU. For the moment, however, the effect is present and the reforms in the capital adequacy rules for banks under the Basel III regime have contributed to reinforcing this element. Banks not only have to hold more capital, with many elements which previously counted as capital being phased out, but will also need to maintain a leverage ratio based on total balance sheet assets, not just measured by risk weighted assets, so that the bar for bank capital is being raised at a time

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when sources to replenish it, whether from the market or from retained earnings are not plentiful. There is on the other hand academic research which supports the idea that in the aftermath of a balance sheet recession capital markets will be in a position to provide more financing more rapidly than a banking sector which needs to deleverage, and also that there is an argument from financial stability in favor of diversifying away from a monoculture of bank financing towards a more balanced approach to financing the “real economy”. As one of the participants in the conference, Andreas Dombret, member of the Executive Board of the Deutsche Bundesbank noted in his remarks, this has nothing to do with deciding which of bank or capital markets financing is superior to the other, and everything to do with diversification of funding sources. Professor Dombret suggested that capital markets based financing may increase pro-cyclicality, but I think that the 2008/2009 crisis provides evidence that banks which themselves rely in part on capital markets financing are just as likely to be pro-cyclical in their lending. When the value of assets increases banks can both lend more against the rising value of borrowers’ collateral and themselves borrow more against their own assets in the repurchase agreement market. A corporate treasurer who relied on a single source of credit would be viewed as at best naive and at worst negligent in her duties. Surely the same should apply to countries and regions. Professor Dombret also cites empirical studies for the United States showing that integrated capital markets cushion around 40 % of the cyclical fluctuations among the US federal states, with an additional 25 % being smoothed by the credit markets, leaving 10 – 20 % to be cushioned by fiscal policy, and only 20 % to be absorbed by consumption, thus leading to less volatility in consumption, the engine of economic activity. Currently in Europe it is the credit markets which absorb the shock so that 60 % of the effect must be absorbed by consumption, leading to significantly greater volatility. The recent Bank of England study on the CMU published in February 2015,⁹ puts it this way: a 10 % fall in income in EU countries can depress household consumption by up to 0.6 %, versus 0.2 % in the US and Canada. As one of the public sector participants at the conference put it, capital markets, especially equity capital markets, allow cross-border risk sharing in a way that cross-border lending cannot. There are also important political considerations which speak in favor of the project. It allows the EU to develop “a project for 28”, i. e. one involving all the

 Niki Anderson, Martin Brooke, Michael Hume and Miriam Kűrtősiová, Bank of England Financial Stability Paper No. , A European Capital Markets Union: implications for growth and stability, February .

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European Union Member States. Coming after the Banking Union which only involved 18 and then 19 Member States, this can be a way to keep the EU’s financial center, London, in the game at a time when the status of the UK as a member of the EU is again being put in question. It also holds out the promise of being able to do something to boost growth in Europe at a time where the European Union, as a result of the policies applied in Greece, Ireland, Portugal and Spain as a condition of EU support in their debt crises, has increasingly become associated with austerity and sacrifice, rather than peace and prosperity, thus resulting in alarmingly low levels of support for the European Union even in countries that were among the initial signatories of the Treaty of Rome. Doing this in a way which promises to increase access by the poster boys of the EU’s real economy, the SMEs, to more diverse sources of financing is an additional bonus. Europeans are reflexively pro-SMEs. SMEs are not corporate giants, which can be hard to love, but family owned enterprises. There are 21.6 million of them and they employ 88 million people, representing 58 % of Europe’s value added and 67 % of Europe’s employment. According to ECB data quoted in the AFME/BCG study discussed more fully below,¹⁰ loans to non-financials in the Eurozone and the UK have fallen by 11 % over the course of 2013. If one focuses on loans to the non-financial sector of less than €1 million, which can be used as a proxy for lending to SMEs, those loans fell by 4 % according to this study, with the fall being greatest in the countries most affected by the crisis. However, as discussed more fully below, it is not entirely clear that any shortfall in SME financing is due to supply side rather than demand side issues, so that, as Douglas Elliott of Brookings has observed, promoting the CMU as an aid program for SMEs may backfire if, for cultural or practical reasons, SMEs turn out to be uninterested in capital market access. However, at a time when EU banks are suffering from narrowed margins due to low interest rates and tightened capital adequacy rules, offering them an alternative source of revenue through fee-based capital market activities which are less capital intensive than their traditional lending business, should be welcomed by the industry itself. A revival of securitization should allow banks to reduce their balance sheets while increasing their lending capacity in proportion to the loans they can securitize. Of course, these last two initiatives will also profit the so-called shadow banking sector, a group even less popular that the regulated banks. At some point, the political implications of this issue will no doubt

 Association for Financial Markets in Europe and the Boston Consulting Group, Bridging the growth gap, Investor Views on European and US capital markets and how they drive investment and economic growth, February .

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have to be faced up to. But in the meantime one could also say there is a political dimension in the project for the financial sector as well. It has been the subject of much criticism since 2008 for its role in the financial crisis and the recession which followed. It is now being offered an opportunity to show what it can do for the common good to help promote growth and investment in the real economy. This is not an opportunity it should let slip away, but one it should rather grasp with enthusiasm. In responding to the consultation, however, I would hope the industry would be careful that its response not be seen primarily as a wish list for the rollback of regulatory reforms and political initiatives undertaken since the financial crisis. It is clear that some reforms seem to go in a direction incompatible with the goals of a CMU. For instance, the proposed financial transactions tax (FTT) proposed by the Commission in September 2011 to apply to transactions in shares, bonds and derivative products among financial institutions seems incompatible with the goal of boosting liquidity and reducing volatility in capital markets. Less liquidity and more volatility may also result from the new leverage ratio introduced under the Basel III rules, since the ratio is expected to reduce the inventory of securities financial institutions can afford to hold. Lord Hill has been quoted as saying that “now is a sensible time to take stock of the overall impact of regulation, in particular the legislation of the last five years, and look at it through the prism of jobs and growth …To make sure that we have got the balance right between reducing risk and fostering growth.” This is clearly music to the ears of the industry, but I would hope its response will be carefully calibrated with reference to both political and economic realities. There is, for example, evidence that regulators and supervisors are concerned about the impact of the leverage ratio and would be open to reasoned evidence that its effect might be counterproductive. A systemic argument can also be made that this measure repeats the mistake of pre-crisis regulation in that it focusses on the health of individual institutions while ignoring its macro-economic effects on the stability of the markets in which the institutions operate. I see no similar evidence of official concern on the FTT front.

4. But should we really expect CMU to stimulate growth? At this point it is worth noting that the Green Paper assumes that the CMU agenda will promote investment in infrastructure and by SMEs, which will in turn promote a return to growth. There is however a line of thinking to the effect

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that the pre-crisis levels of growth people have in mind, especially when they analyse the current recovery, may simply not be sustainable and thus that there is no “investment gap” to be closed by measures such as the CMU. One need not adhere to the overall theory of secular stagnation put forward by Larry Summers to be concerned by the sharp demographic slowdown in Europe, coupled with lower total factor productivity growth. Daniel Gros examines these factors in CEPS Policy Brief No. 236¹¹ and comes to the conclusion that current demographic trends in Europe imply a significantly lower growth rate, which in turn implies that a lower (equilibrium) investment-to-GDP ratio will be needed to keep the capital/output ratio in Europe constant. Thus, seeking to boost the investment rate in the short term may succeed mostly in pulling forward investments which might have been made anyway and not really contribute to growth. Alternatively, it could result in reducing the rate of return on investment which would tend to contribute to moving investment out of Europe. In other words, there could be elements of pushing on a string in trying to increase investment. It is my personal impression that businesses, including SMEs, are not investing mainly because they do not see increased demand for their goods and services sufficient to justify the cost of the investment. The conclusion Daniel Gros reaches is that increasing consumption must come first, as it has in the recoveries in the US and the United Kingdom. Unfortunately there is little evidence of a consensus to do this in the EU. Because SMEs are largely privately held, we have only anecdotal information on why they do what they do. We have better information about publicly held companies whose public reporting shows many of them sitting on large amounts of cash and using more of that cash to repurchase their own stock, pay dividends or acquire existing productive capacity from other companies rather than to make new investments to expand their own productive facilities. This would tend to reinforce the view that industry in general does not see a lot of productive investment opportunities in the current economic climate, regardless of whether or not funds are available for this purpose.

5. Where will the investors come from? To come back down to earth from the macroeconomic sphere, a second issue raised by the CMU project is where will the investors for the expanded capital

 Daniel Gros, CEPS Policy Brief No. , Investment as the key to recovery in the euro area?  November .

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markets come from? It would be a mistake to launch the project on the assumption that “if you build it, they will come” without being quite clear on who “they” are likely to be. As the excellent Bank of England Financial Stability Paper No. 35 of February 2015 on the CMU cited above¹² points out, banks provide the lion’s share of financing in Europe because that’s where the European savings are, not in mutual funds, pension funds, asset management companies, venture capital funds, the equity markets and bonds. One of the participants at the conference suggested that half of European savings are held in the form of bank deposits. The Commission Staff Working Document accompanying the Green Paper notes that 96 % of EU households have deposits with a bank, but only 5 % have direct investments in bonds and 10 % in shares, while 11 % own shares of a mutual fund and 33 % are invested in a pension plan or life insurance. Looking at asset allocation, the Staff sees currency and deposits representing 33 % of households’ financial assets. In contrast, US households hold only 13 % of their financial assets in bank deposits, compared to 31 % in equity.¹³ What will push these savings towards the capital markets? Perhaps zero and negative interest rates will help. But so long as most European pensions are either provided by the state or simply by line items on corporate balance sheets rather than by segregated funds to be invested independently as in the US, it is hard to see where the European money is to come from. There was a lively debate at the conference on whether it was too late for this European pattern to change. One academic panelist challenged the status quo by pointing out that if European corporates came to the same conclusion US corporates had come to, which is that payments into a defined contribution plan could be considerably cheaper for them than an ongoing commitment to provide a defined benefit to retirees, this pattern could change in Europe as well. With pension and retirement obligations being discounted at record low interest rates, these are sure to be growing at an alarming rate, so that a shift to defined contribution payments should be making more and more sense to corporations. Dirk Schoenmaker’s contribution to this volume sets out this argument in more detail. It is also possible that in countries which realize that public pensions may not be sufficient to allow a comfortable retirement, the development of privately funded supplemental retirement funds, such as the “Riester Pension” in Germany, may provide additional private sector funds to be invested in capital markets products. But as matters stand, the estimates the Bank of England arrives at in Finan See footnote  above.  Commission Staff Working Document, Initial reflections on the obstacles to the development of deep and integrated EU capital markets, accompanying the document Green Paper Building a Capital Markets Union, February , , p.  – .

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cial Stability Paper No. 33 are that currently the sources for capital market investments in Europe range from between 20 to 50 % of the amounts available in the United States, broken down by categories of investors. The only exception appears to be the insurance sector, which looks to be 50 % larger in Europe, but which is about to become subject to new investment rules under the Solvency II regime for capital adequacy which may significantly restrict its ability to invest freely, as noted in a January 2015 IMF Staff Discussion Note on securitization¹⁴ to which I will return below. But even if the funds to be invested in the capital markets were equal as a percentage of GDP on both sides of the Atlantic, the impediments in Europe, which both the Green Paper and the Bank of England paper point out would remain. These revolve around market fragmentation, due in part to a “home bias” on the part of investors, especially individual investors, fed by large information asymmetries, including the continuing difficulty in obtaining information about cross-border investment opportunities within Europe, which result in a lack of market depth and liquidity, two key components for attracting outside investment, not only from “all over the world” but also from other Member States. Small scale opportunities will not attract investors, especially institutional investors, in large numbers, especially if the cost of acquiring information is high and the difficulties in exiting an investment are also high. The Bank of England CMU paper cites a 2007 study by BME Consulting according to which 36 % of EU investors polled did not even know they could invest in another EU country. Views gathered by the European Union Committee of the UK House of Lords indicated that some 94 % of European citizens shied away from buying a foreign financial product.¹⁵ There is also considerable fragmentation in terms of infrastructure. Véron and Wolff note that whereas there are only three stock exchanges in the US there are either 13 or 15 in the European Union, depending on whose statistics you use.¹⁶

 Miguel Segoviano, Bradley Jones, Peter Lindner and Johannes Blankenheim, IMF Staff Discussion Paper, Securitization: The Road Ahead, January .  House of Lords, European Union Committee th Report of Session  – , Capital Markets Union: a welcome start,  March , p. .  See footnote  above, p. .

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6. Are we facing a supply or a demand problem, and for what financial products? The Bank of England Paper also considers cultural factors which might result in European SMEs’ relative lack of resort to the capital markets as compared to their US counterparts. It notes that in Europe SMEs are largely family owned enterprises which are carrying on an inter-generational project rather than companies founded by an individual with a view to cashing out in an initial public offering. They are consequently publicity shy and disinclined to provide public disclosure about themselves. These observations ring true to my ears. One need only think of how large the family owned Italian clothing and fashion houses became before finally consenting to open their capital to outsiders. I think it is quite possible that even with enhanced access to capital markets, the bulk of SMEs will decline to take advantage of the opportunity to allow other investors into their equity. There is also the question of how much appetite new capital markets investors will have for equity investments, especially illiquid ones in SMEs. A recent report in the German press noted that Germans spend more per year on bananas than on purchases of shares of stock.¹⁷ It has long been known that Germany, a country of risk adverse people, lacks an “equity culture,” but even in the US, generally thought of as the home of equity investing, recent studies show that 78 % among the younger generation of the Millennials are not inclined to invest in stock.¹⁸ Will EU investors be less averse to equities than US Millennials? The historical evidence tends to point to a greater risk aversion among European investors in general, as evidenced by data cited by Véron and Wolff on the maturity of investments, which shows a greater preference for shorter term maturity investments in Europe.¹⁹ This would negate one of the main advantages of capital markets over bank lending, which is the ability to provide loss‐absorbing equity capital. I suspect that many of the calculations of the financial stability advantages of the capital markets cited by Professor Dombret and the Bank of England paper depend on this effect and Jon Cunliffe’s contribution to this volume confirms this. Capital from the capital markets is more shock absorbent than bank debt if it takes the form of equity. If it takes the form of bonds you will end up with the same need for painful restructuring as  Cash.ONLiNE, Der deutshe Haushalt gibt mehr Geld für Bananen als für Aktien aus, Leider. April , .  Srividya Kalyanaraman, Millennials are saving but their fear of stocks could hurt them, investmentnews.com, April , .  See footnote  above, p. .

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with bank loans, although if it is held outside the country of the issuer it will have a risk sharing effect across the Union. It is also important to understand, as the excellent Commission Staff Working Document accompanying the Green Paper notes, that investor home bias is greatest in EU equity markets, thus limiting the extent to which potential losses can be shared across borders.²⁰ Véron and Wolff cite a figure of 64 % of EU equity holdings being of domestic origins²¹ and it recently made headlines in Germany that over 50 % of the shares of the companies in the Dax index were held by non-Germans. This is one of the dangers I noted above in identifying the success of the CMU with the number of SMEs which take advantage of the capital markets. I think that a much stronger argument can be made in favor of SME receptivity to properly structured private placements of their debt, based on my experience over the years with their willingness to cross the Atlantic to access the US private placement market, a topic to which I will return below. The Bank of England Financial Stability Paper also endorses this possibility and there are estimates that up to 35 % of the US private placement market is made up of European issuers. However, there is a certain softness to the data on whether SMEs have a funding gap. An analysis cited in the February 2015 AFME/BCG report entitled Bridging the growth gap cited above,²² is to the effect that more money is available to European SMEs than to US SMEs, with the outstanding stock of SME finance in the US standing at €1.2 trillion versus €2.0 trillion in Europe and gross financing at €571 billion in the US compared to €926 billion in Europe. While the SME sector is larger in Europe than in the US, providing far more employment (67 % versus 49 %) and more of the value added (58 % versus 46 %) according to the report, so that one would expect them to receive more financing, this suggests that a more differentiated view of the financing needs of SMEs may be necessary. One of the conference participants, Anshu Jain, Co-Chief Executive Officer of Deutsche Bank, cited statistics according to which lending in the EU periphery remains 29 % below its pre-crisis peak, while it has fully recovered in the core and that 17 % of Spanish SMEs and 14 % of Italian SMEs cite access to finance as their most pressing problem as compared with only 9 % of German SMEs. Perhaps more importantly, loans below €1 million, those most likely to be made to SMEs, carry an average interest rate of 3 %, almost double the 1.63 % for loans above €1 million, with interest rate “spreads” between European large caps

 See footnote  above, p. .  See footnote  above, p ..  See footnote  above, p. .

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and SMEs having widened by 47 % since 2008. For further details, please refer to Anshu Jain’s contribution to this volume. The Commission Staff Working Document contains similar data on loan spreads.²³ So there does seem to be regional need for SME financing which could benefit from a more uniform access to capital. Some differences will of course remain. With liquidity being dependent on the size of bond issues, an interest rate differential between SMEs and large caps is to be expected.

7. How much scope is there for securitization in Europe? With respect to securitization, the Bank of England rightly notes that the size of the US market is influenced – distorted might not be too strong a word – by the presence of the so-called Government Sponsored Enterprises (GSEs), known as Fannie Mae and Freddie Mac, which are now also government controlled since September 2008. They still repackage over 70 % of US mortgages, providing a large, liquid and uniform market for securitization products in comparison with the much more fragmented European markets. To that I would add that the US also has the student loan market as a source of homogeneous securitizable loans due to the exorbitant cost of higher education in the US as well as a larger auto loan market, so that the sources for underlying assets available for securitization are correspondingly larger. In contrast, the European market for securitization has historically been reduced by the preference to date of many banks to issue so-called “covered bonds” based on the German Pfandbrief model, under which the loans stay on the originating bank’s balance sheet. Covered bonds have three significant advantages for the issuing bank. These bonds can be used as collateral for central bank lending, they get better capital treatment and a percentage of them can count towards the new liquidity requirement under Basel III. So they have been syphoning off much of the raw material for securitization in Europe and, all things being equal, may continue to keep the securitization market smaller than in the US. However, another new feature of Basel III, the leverage ratio, may change that equilibrium. The assets in the “cover” for the covered bonds will in turn have to be covered by a minimum amount of capital, regardless of their risk weighting. This will almost certainly make further issuances of covered bonds more expensive for the issuing bank as keeping a mortgage portfolio on a bank’s balance sheet will be more expen See footnote  above, p. .

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sive. Although the existing cover for already issued bonds will remain trapped on the issuers’ balance sheets, this should free up future assets for securitization. The impact on this trend of purchases by the European Central Bank of covered bonds as part of tis quantitative easing program is for the moment uncertain. Nonetheless, as the January 2015 IMF Staff Discussion Note on securitization cited above²⁴ points out, investors incurred large losses on securitized structures in 2007/2008 and while advocates of European securitization may be right that the track record of European securitizations was far better than that of US securitizations in terms of defaults and investor losses, investors do not necessarily make these distinctions and it may take a while for investors to return. The gap between the size of the securitization markets on the two sides of the Atlantic is also enormous, with outstandings representing 59 % of GDP in the US versus 11 % in Europe. The Note also observes that for insurers in the EU it may be cheaper in terms of capital to hold whole loans than securitizations of those loans. Finally, the Commission’s consultation paper concedes that to get this market going will likely require a revision down of the capital cost of holding such securities.²⁵ Beyond these considerations, as noted by another speaker at the conference, there are still an estimated €300 billion in European savings exported annually which might be available for investment in Europe if we could figure out whether their export is due to a lack of opportunities in Europe or problems with the plumbing of the European capital markets. Of course some of this amount is cyclical rather than structural, so would need to be adjusted, but it is a significant amount.

8. What will attract foreign investors? There is also the question of how the project proposes to attract investors “from all over the world” and with what kind of products? If the investors to be attracted are large institutions, their requirements as to type of instrument and size and liquidity of markets, given their own size and scope, may well be very different from the requirements and preferences of domestic European investors. There is no patent recipe for this. The representatives of the funds industry at the conference suggested a number of sensible measures mostly centering around the indisputable need for greater transparency. However, while agreeing that they

 See footnote  above.  See footnote  above.

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would improve the market, I fear they will prove both expensive and difficult to implement. The Green Paper also notes a number of these, including, for SMEs, the absence of consistent accounting standards across Europe. There is, of course, already a consistent set of accounting standards for publicly traded companies in Europe, in the form of International Financial Reporting Standards (IFRS). The problem is that the conversion from local accounting standards, for example the Handelsgesetzbuch (HGB) in Germany, under which local companies are required to prepare their individual (i. e. unconsolidated) financial statements for corporate law and tax purposes, to IFRS can be expensive and complex, as all of us who have been involved in IPOs in Europe, where IFRS statements are required, are aware. The Green Paper suggests the possibility of a simplified version of IFRS for SMEs, especially for those seeking access to certain trading venues and, presumably also for private placements. I think that a sort of “junior IFRS” for SMEs would be counter-productive. It would involve the cost of preparing a second set of financial statements, but these financials would not be acceptable for use if the SME ever wanted to take the next step and go public on a regular stock exchange, thus requiring a second conversion. The Commission Staff Working Document notes that the IASB has already developed a simplified form of IFRS financial statements for SMEs, but does not allow them to be used for listings.²⁶ Based on my experience with the adoption of IFRS by German companies, I would also expect a prolonged period of uncertainty and experimentation as to the content, meaning and reliability of these “junior IFRS” financials, thus reducing their usefulness to both issuers and investors. The reflex to seek for simplification and exceptions from accounting rules is certainly a natural one. It was also part of the program which the US Congress put together in the so-called JOBS Act (the Jumpstart our Business Startups Act of 2012) but which has turned out not to be used by the intended beneficiaries, the so-called Emerging Growth Companies (EGCs). In fact, in a list of seven potential advantages the JOBS Act provides ECGs compiled by Ernst & Young,²⁷ reduced financial statement requirements came in second to last among investors. The two main advantages offered by the JOBS Act according to this list were the ability to publish only two rather than three years of audited financial statements and deferred effective dates for new accounting standards. However, one year after adoption of the Act, 2/3 of the EGCs were not taking advantage of the ability to show only two years and 79 % were not taking advantage of the deferred adoption of new accounting standards according to the Ernst & Young re-

 See footnote  above, p.   Ernst & Young, The JOBS Act: One-year anniversary, April .

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port. The failure to use slower adoption of new accounting standards may well be due to the way the Securities and Exchange Commission (SEC) implemented the rule and the three versus two years relief is a different issue from simplified financial statements, but the US experience shows that well intentioned tinkering with financial statements may not bring the expected benefits. That said, I understand that the issue across Europe is far from trivial, both from the view of international comparability of financial statements and because of the sometimes very different principles on which “local GAAP” is based. For example, HGB statements were designed primarily for use by and protection of creditors, while IFRS attempts to reconcile the greater pro-shareholder orientation of US GAAP with a more simplified or principled approach to presentation where things such as “hidden reserves” allowed by HGB would be disclosed. However, European private issuers generally use their domestic financial statements when accessing the US private placement market and the lawyers and investors involved become familiar enough with those statements and how financial covenants work under them to do those deals, so it may be that uniform financial standards turns out to be one of those “nice to have” elements which are not “must haves”.

9. Distinguishing “must haves” from “nice to have” I also tend to question how essential requirements for uniform tax treatment, corporate governance and insolvency law, which both the Green Paper and several participants at the conference have proposed could be necessary or useful for the CMU to succeed, actually are. I have no doubt as to the usefulness of these items as ways to simplify and enhance access by European issuers to the capital markets. However, there can be an element of “wish list” building in these arguments which reminds me of the two Giovannini reports on Crossborder Clearing and Settlement Arrangements in the European Union from November 2001 and April 2003, which ended up dealing with far more than just clearing and settlement. Among the barriers to clearing and settlement the reports identified, Barrier 3, for example, dealt with differences in corporate law, Barriers 11 and 12 dealt with taxation, Barrier 13 with laws of property ownership and Barrier 15 with conflicts of law.²⁸ If adopted, they would clearly make clear The Giovannini Group, Second Report on EU Clearing and Settlement Arrangements, April , pp.  – .

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ing and settlement much earlier. In the same way, all the foregoing suggestions would simplify expansion of capital markets in the European Union, but need to be examined in the context of various parts of that market and of the overall project, including market access for SMEs, securitization and private placements. One point repeatedly made is the impediment which the “tax bias” in favour of debt over equity presents, since interest paid on debt by a corporation is tax deductible whereas dividends must be paid out of after tax earnings. While I think that this is undoubtedly true, it is just as true in the US and despite this bias on both sides of the Atlantic, one side has significantly broader and deeper capital markets. So I do not think tax bias is the key to this difference. Besides which, since under EU rules changes in EU taxation measures require unanimity of all 28 Member States, insisting that this must change could be seen as tantamount to finding the greatest conceivable obstacle and declaring it to be essential to the project. Actually, as Véron and Wolff point out, the experience of the FTT shows there is another route to tax changes within the EU, based on the enhanced cooperation procedure, which allows member states to agree among themselves and only for themselves on an approach to taxation.²⁹ While the FTT may be a poor example to use, given that it appears seriously at odds with the CMU, it does suggest that a basis for change could be found which does not require unanimity and thus avoids a veto by one or a few Member States. If it can be applied to throw sand in the gears of securities transactions, it could also be applied to change the tax bias towards debt, if there was the political will to do so. With respect to the argument that absent uniform – and presumably high – corporate governance standards no one will invest, I suggest that the rush to invest in Alibaba tends to prove the contrary, as does the experience of US internet and print media companies which have two classes of stock, super voting for insiders and low voting for investors. In addition, the sometimes significant differences in state corporation law among the 50 states of the US have been taken in stride by investors. Investors are often ready to make accommodations if presented with an appealing investment case. Thus, I consider differences in corporate governance as an obstacle to be overcome, but not a “must have.” I understand entirely that with respect to insolvency law differences in judicial procedure under which an insolvency proceeding may take nine months in Finland and six years in Italy is a concern. But I would suggest that it is mostly a concern in a securitization context where investors are trying to calculate not only chance

 See footnote  above, p. .

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of default but also loss upon default over a diverse portfolio, where loss depends crucially upon an ability to estimate how long it will take to recover a portion of one’s investment. Chart 7 on p.19 of the Staff Working Document accompanying the Green Paper, taken from the World Bank Doing Business report 2014 shows how closely recoveries in insolvency correlate with the length of the insolvency proceedings in various European jurisdictions.³⁰ The Staff Working Document goes on to state that harmonization of procedures is only a first step and that “as long as insolvency law remains national in character” investors will have difficulty assessing the risks of cross-border investments and will be reluctant to make them.³¹ Putting the bar at a European level insolvency law seems a very high hurdle indeed. So, yes, insolvency procedure can be an important concern for securitization, but as I do not believe that SME debt is likely to be securitizable, as it is far too heterogeneous, I think this issue is far less important for SME access to capital markets. I know there has been talk of securitizing SME debt, and in fact the Commission consultation paper on securitization cited above mentions the existence of ongoing projects to securitize SME debt in the European Investment Bank and the European Investment Fund³² but when pushed, most experts, even on the Commission staff, acknowledge that simplified securitization would most likely apply to other bank assets. This would, as noted by Charles Roxburgh, Director General, Financial Services, HM Treasury in his statement to the House of Lords Committee, whose report is cited above, free up room on bank balance sheets for more SME lending. I think this route is more likely to be followed rather than trying to securitize SME loans themselves to any great extent. This conviction is reinforced by the data cited by Véron and Wolff concerning SME securitizations. There appears to have been virtually none which were sold to the public since 2007– 8. Instead those which have occurred since, apparently principally in Italy and Spain, have been retained on the balance sheets of the issuers and used for collateral for borrowing from central banks.³³ That is to say that the originator of the loans, which knows the credit quality of the issuers retained them. In contrast, what I do not think can be put only in the category of merely “nice to have” is, as noted earlier, a single rule book, uniformly applied, and there lies a serious problem. There is in theory an entity which is charged with setting uniform standards for the European capital markets, ESMA, but it does not have the right to overrule decisions interpreting and applying these    

See See See See

footnote footnote footnote footnote

 above, p. .  above, p. .  above.  above, p. .

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standards by the 28 Member State securities authorities. It employs fewer than 200 people, as compared to 3,500 at the SEC or 2,500 at the UK’s Financial Conduct Authority. In fact it has fewer employees that the Finnish Financial Supervisory Authority. ESMA’s board of supervisors is made up of representatives of these authorities who hold all the votes on the board (neither the chair nor the managing director of ESMA have a vote) and half of its budget is funded by these authorities. There is an ongoing review of the European Supervisory Authorities (ESAs), including ESMA, by the Commission, but it does not exhibit any appetite to attack sensitive issues such a further centralization of authority in securities regulation. And the otherwise excellent Staff Working Document accompanying the Green Paper also tiptoes around the issue.³⁴ Seen from the outside, one can conceive of two equally unpalatable solutions to this problem. The first is to turn ESMA into a European SEC or found a parallel organization to exercise direct rule making and enforcement authority towards capital markets participants. This is in essence where the Banking Union ended up, with the European Central Bank in a position to overrule national competent authorities. Following this route in the capital markets would almost certainly guarantee alienating the 28 national authorities whose cooperation will be crucial to the success of the CMU project and the number of staff which would have to be hired to accomplish this goal would require years to assemble. The second is to make ESMA write its rules with such a level of detail that the national authorities would have little scope to interpret them differently. This would go against the way regulation has been traditionally written in the European Union, focusing on broad principles rather than crafting detailed rules. I have often compared this to writing a constitution rather than a cook book. Even if the ESMA staff were tempted to write very detailed rules, it would need far more staff than it currently has to do so and this initiative could easily be blocked at the source by the national authorities who sit on ESMA’s supervisory board. While it is possible that the competent national authorities will let their powers be diminished willingly, we have an expression for the probability of such events in the US, it is like expecting turkeys to vote for Thanksgiving. The statements by Charles Roxburgh and the Bank of England to the House of Lords Committee cited above make clear that the UK is squarely against the first solution³⁵ and private conversations with representatives of the Bank of England convince me they are no more enthusiastic for the second.

 See footnote  above, p. .  See footnote  above, p.  and  – .

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There are however subtler and far more European proposals being put forward by others more versed in the intricacies of EU law and practice than I which may offer a way out of this problem. Véron and Wolff, for example suggest several bases on which ESMA’s powers could be expanded.³⁶ While some of them strike me as overly optimistic, the idea of granting ESMA “authority to approve new securities issuances and to authorize funds under legislation such UCITS and AIFM, with a transfer back of much the actual regulatory work but as part of a binding EU network in which ESMA would have effective policy control”³⁷ strikes me as cleverly taking a leaf from the “single supervisory” and “single resolution” mechanisms of the Banking Union model and potentially feasible as part of a characteristically EU solution.

10. What the private sector can do now There are also things the private sector can do to advance the project. In particular, the financial services industry could take the lead in developing standards and documentation for a Europe wide private placement market. There are several projects ongoing in this area, including the Pan-European Corporate Private Placement project sponsored by ICMA and announced in February 2015. I find the project very promising, but for one problem, the presence of dueling forms of documentation under English and French law.³⁸ This is a bit reminiscent of the battle of the Betamax and VHS formats for video cassettes, which in its day slowed down the spread of video cassettes as consumers could not make up their minds which to adopt. Uniformity can only be achieved with agreed uniform documentation. I agree with the AFME/BCG “Bridging the Growth gap” report cited above which came out almost simultaneously with the ICMA Pan-European Corporate Private Placement Market Guide in February of this year. AFME/BCG advocate standard documentation like that in use in the US debt private placement market in the form of the Model Note Purchase Agreement, developed by the private bar and used uniformly for private placements to US insurance companies. The AFME/BCG report which polled market participants reports that “[i]nterviewees emphasized that the lack of standardization in deal documentation and processes significantly hindered European Private  See footnote  above, p.   See footnote  above, p. , citing a forthcoming paper by Alan Houmann and Simon Gleeson, “What would constitute an effective capital markets union”.  Pan-European Private Placement Working Group, Pan-European Corporate Private Placement Market Guide, February , pages  and .

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Placement Transactions”.³⁹ I think they are spot on with this observation. While I concede that the Model Note Purchase Agreement used for US private placements may be no one’s idea of a masterpiece of legal drafting, the ability to boil choices down to a comprehensible few makes the process much easier on all concerned. It has done for the US private placement market what ISDA’s standard terms and conditions have done for the derivatives market.

11. Why the US is not necessarily the best model for Europe Having said that, I do not believe imitating the US is always going to be the best way for the EU to go. References are often made to the JOBS Act and its impact. On that I would note that the Act was focused on facilitating IPOs for EGCs and did this primarily by removing many obstacles the SEC had put in the way of first time issuers over the years and which do not generally existing in Europe. It allows confidential filings, allows EGCs to test the waters before their prospectus has been cleared, reduces executive compensation disclosure and defers the applicability of Sarbanes Oxley Act certification, none of which are issues in Europe. We have seen above that the accounting rule relaxations have not been widely taken advantage of. The Act does contain provisions on crowd funding, but the SEC has yet to issue rules to allow them to be used and discussions with underwriters indicate a wariness towards inclusion of retail investors, so these provisions do not offer much of a model for Europe. I would also add that there is at least anecdotal evidence that institutional investors are increasingly moving into the crowd funding space in their search for yield, so that the nature of these markets may be changing in a way which the public sector has not yet perceived. There are also any number of other ways in which the US would be a poor model for the EU. I mentioned above that Fannie Mae and Freddie Mac were largely responsible for the larger securitization market in the US. This was not intended to recommend them as a model for Europe. Although it is true that they succeeded in attracting foreign capital to the financial of the US housing market, the US has ended up with a monoculture in mortgage securitization even greater than Europe’s reliance on bank financing. Securities class actions are another example Europe would do well not to follow. Finally, I am not sure the SEC is a model for Europe either, although its aura of tough enforcement  See footnote  above, p. .

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and the degree of transparency and predictability of market practises which have been able to develop under its rules have certainly contributed to the development and stability of capital markets in the US.

12. Conclusion: the need to be ambitious In conclusion, to return to our point of departure, I think there is a viable goal here but that there are two main problems with the Green Paper. The first is how to motivate change without overpromising results which the EU is simply not capable of delivering in the short term. The constraints on sources and uses of funds discussed above are very real and cannot be overcome in the short or medium term. Anything can be done in the long term, but that will require patience which may be incompatible with the enthusiasm needed to move the project forward. The second is that the Commission does not yet know how ambitious a project it can make the CMU. In a sense, that is up to all those who will respond to the Green Paper’s call for comments. There are many positive aspects to the project. If successful, it would rectify an imbalance in financing sources in Europe which should contribute to greater financial stability. It would offer a form of financing, equity, which banks do not offer and which is more risk absorbing than bank debt. This risk absorption has the advantage of occurring automatically and not requiring the kind of potentially disruptive restructuring debt does. It might also help reduce the extensive exporting of capital from the EU which has contributed to the global imbalances economists like Ben Bernanke have blamed for contributing to everything from the 2008/2009 financial crisis to the current low interest rates. So, it is devoutly to be hoped that the response to the consultation will encourage more overt ambition as well as a more systematic approach in what emerges from the Commission this summer. As Véron and Wolff note, only “ambitious initiatives with transformative longterm impact…. would justify the ‘union’ label.”⁴⁰

 See footnote  above, p. .