Capital Markets Union – another European failure?

Inclusive Economy31 May 2016Robby Riedel

The European Commission’s Capital Markets Union (CMU) initiative has been established to foster economic growth in Europe. Under the CMU, the Commission plans to increase the availability of corporate funding and promote capital market-based financing, particularly for small and medium enterprises (SMEs), to reduce dependence on bank financing. However, the stepping up of the capital market-based financial system and consequent financial liberalization is neither necessary nor desirable.

This expert opinion was written in response to our research article on the European Capital Markets Union: Europe and the financial sector: a continuing love affair.

The idea of creating new financial products and markets for SMEs is not an adequate solution. The same holds for the creation of new forms of securitization. Under current conditions, the possibilities for capital market-based corporate funding are sufficient. It can be assumed that there is no shortage of funding in Europe, as the Commission originally mentioned in its 2015 Green Paper on building a capital markets union. In fact, the main problem faced by SMEs is lack of demand for their products and services.

House bank principle has proven effective

The advantages of traditional bank lending are obvious. For one, the direct relationship between a company and its bank allows for better monitoring. Furthermore, banks are able to weigh the opportunities and risks of business involvement better than anonymous capital markets. If a company experiences temporary difficulties, it is easier to find strategies to address these through direct communication. In addition, one can assume that a creditor bank, as a matter of principle, has a genuine interest in trying to solve the problems of its debtors. Finally, there is also the possibility of renegotiating credit terms with a bank. These relevant advantages, especially for SMEs, are usually not available in capital markets.

Bank credit-based economies are more resilient

The financial crisis of 2008 has shown the inefficiency of free financial markets. Numerous studies point to the problem that both shareholders and alternative investors, such as private equity and hedge funds, are usually short-term oriented. The last financial crisis was not the result of negative developments in the traditional lending business. Rather, the crisis occurred because banks had drifted from the traditional business model to become actors in financial markets. As a result, banks expanded their investment banking and strengthened their trade in securities with their own money (proprietary trading). Historically, financial crises have never originated in corporate lending, but disruptions in banking systems have often resulted from price exaggerations in capital markets, as in the last crisis. Sharp declines in growth have been stronger in more capital market-based economies, than in bank-based economies. In addition, long-term growth is not dependent on whether an economy is more capital market- or bank-based. Thus, the view of the European Commission of a capital market-based financial system leading to more growth does not stand up.

High losses on the investor side from capital market products

For both institutional and private investors, there is a high risk of loss when trading in capital market products. During the financial crisis, losses for banks arose mainly from credit substitution transactions and positions in the trading book, and less from traditional lending (the banking books). This difference in losses is also due to the fact that banks have to meet different regulatory requirements and are, therefore, more inclined to take risks in their trading books, because they have to underlay these transactions with less equity.

Increased systemic risk moves to the shadow banking system

Regarding the CMU, financial institutions would act as both creditors and intermediaries in the capital markets. Especially big banks would participate in the CMU. Thus, their supremacy and importance would grow successively in the system. This would be accompanied by an undesirable concentration of market power in the banking and financial system, leading to ‘too big to fail’ banks. It is also likely that risks will increasingly migrate to the shadow banking system. However, this area of the financial market is subject to less regulation. Actors in the shadow banking system are often characterized as operating on short notice and highly speculatively. Any regulation of the banking sector would be absurd if banks continue to transfer risky businesses to the shadow banking system. Consequently, regulatory measures in the shadow banking system and effective regulation of banks are necessary to prevent risk migration and regulatory escape.

CMU misses the initial objective and creates many risks

All in all, it is doubtful that the CMU will lead to more growth and employment in Europe, as pursued by the EU. Ultimately, the CMU would cause more instability in the financial sector. In fact, SMEs would not benefit from the CMU. Only large financial intermediaries have an increased interest in the liberalization of the market. Thus, the Commission is well advised to abandon its plans for the European Capital Markets Union.