The Capital Markets Union
The CMU is the latest EU initiative aimed at smoothing the way for integrated cross-border capital markets activity, writes Diego Valiante
At a glance
• The Capital Markets Union launched by the EU last year is designed to help remove barriers to cross-border capitals market activity.
• The asset management industry is still a long way from acting on a truly pan-European basis.
• Further action is needed to improve the integration process.
The recent financial crisis in Europe showed the limited extent to which financial integration has been achieved so far. Asset prices had converged but there was limited cross-border holding of assets.
Evidence suggests that Europe’s multi-currency area needs private risk-sharing mechanisms to withstand structural output shocks. This can be achieved via the risk diversification that different allocation channels for private savings provide. Capital markets can provide a means for this diversification to stabilise the financial system and to promote a more efficient and effective funding for the economy.
The Capital Markets Union (CMU), launched last year by the European Commission, is designed to help remove barriers to cross-border capital markets activities. This should enable it to ensure the stability, efficiency and cohesion of the single market. In the past decade, integration of the private sector via the single market has faced strong resistance from national vested interests. More is to be expected as the European Commission tackles legal and economic barriers.
Europe’s financial structure lacks capital market activity to support its underlying economy. Banking sector assets are more than three times Europe’s GDP. It is not by chance that financial instability continues to bite in the two regions where the financial system is less diversified – that is, Europe and China.
A report supported by a group of academics and experts, entitled ‘Europe’s untapped capital market: Rethinking integration after the great financial crisis’, collected ample evidence that Europe’s capital markets are poorly functioning and underdeveloped. The outcome of this financial structure is a landscape with a limited role for market-based finance. Bond issuance of governments and financial institutions is the only exception, but this activity is mostly a result of the financial difficulties of recent years.
While acknowledging great heterogeneity across countries, EU households held, on average, between 2007 and 2014, more than 30% of their financial assets in cash and deposits. This compared with only 13% in the US.
European non-financial corporations’ (NFCs) liabilities are the smallest (relative to GDP) compared with other advanced economies, owing to the limited contribution of listed shares and corporate bonds. NFC debt funding is 77% in bank loans compared with less than 40% in the United States.
Overall, the EU economy lacks equity funding as the average contribution to the liabilities of European non-financial corporations is below other advanced economies. Equity markets, in particular, are fragmented along geographical borders. That is despite trading on new multilateral trading facilities (MTFs) showing pan-European interest in liquid shares. The aggregate turnover of EU markets is only a fifth of their US counterparts.
Despite the recent astonishing growth, the asset management industry is still only competing across the EU to a limited extent and has a scarce retail penetration. Distribution channels of investment products are a bottleneck and mostly segmented by local banking systems and national marketing laws. There are over 32,000 investment funds in Europe compared with roughly 7,600 in the US, with average size respectively of €186m and €1.34bn.
There is a lack of scale. Many of these investment funds are set up to charge upfront fees and other fixed charges. Insurance and pension funds invest almost 70% of their assets in fixed income and more than 70% of their investments in equity are in unlisted shares, while this share is above 90% in the US.
Facing overwhelming evidence about the poor quality of Europe’s financial ecosystem the CMU has not delivered much so far. Legislative proposals on securitisation and simplified prospectus will be unable to tackle more fundamental legal and economic barriers to cross-border trading. Too much attention has been given to the sell-side, while policy-makers should embrace the interests of European investors.
From an investor perspective, barriers lie in the price discovery mechanisms. Company data continues to diverge across the EU. It is apparent in execution, as distribution channels remain a bottleneck for the investment products industry. It is also evident in enforcement, as diverging private and public enforcement mechanisms raise significant artificial barriers.
As a result, Europe’s capital markets are still in the hands of 28 national supervisors. These often fight to defend the national interests of small and inefficient financial industries that offer access to local capital markets.
The recently created European Securities and Markets Authority (ESMA) has only limited mediation powers. Its management cannot even vote, leaving the responsibility to protect the European interest to the sum of the national interests. It is a Europe with poor enforcement powers in the period of most intense rule-making for a sector that requires strong deterrence.
The Commission is in the process of launching important initiatives to harmonise insolvency procedures and to investigate distribution channels and local marketing rules for investment products. However, further action is necessary to improve the financial integration process and to achieve the needed private risk sharing for the stability of Europe’s single market and for the benefit of its investors.
Diego Valiante is the head of financial markets and institutions at the Centre for European Policies Studies (CEPS)