Capital Markets Union and the mirage of resilience
Drawing on rhetoric of resilient markets and the need for diversity, the European Commission is pushing for a capital markets union to extend market-based finance in the EU. This move risks marginalizing current attempts to control the potential for large up and downswings in the credit provision system. While it may generate credit growth in the short term, a capital markets union puts the EU at risk of future calamities due to unrestrained and uncontrolled growth in the system.
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 Capital Markets Union is the current flagship project of the European Commission. Initiated in 2014, several of its elements have passed through the legislative process in the European Commission and European Council in record time, with final legislation expected for the initiative on Simple, Transparent and Standardized (STS) securitization in November 2016. This initiative seeks to revive the securitization market in Europe, arguing that the transformation of bank loans into tradeable securities has the potential to lift growth, if properly applied.
The proposal has been rightly criticized for fixing the wrong problem (‘supply’ rather than ‘demand’ for credit), reviving a trend towards financialization, which is likely to lead to future asset-bubbles in sectors such as real estate. Overall, the initiative stands in stark contrast to post-crisis attempts to rein in the financial market activities of banks. Confident that regulatory measures have achieved their task of increasing the (short-term) resilience of the system, the Capital Markets Union initiative risks preventing the establishment of measures needed to control the strong up and downswings inherent in a market-based financing system (known as its ‘pro-cyclicality’).
Resilient, diverse and safe?
Pushing for the Capital Markets Union, Commissioner Hill has rhetorically embraced the trade-off between reducing risk and encouraging growth. This reasoning unambiguously equates the growth of credit with positive economic growth and ignores the possibility that a lower provision of credit might, through gains in financial stability, actually lead to more sustainable growth in the long run and avoid deleterious debt overhangs. Embracing market-based finance again post-crisis is not a trend unique to the European Union. Indeed, the Financial Stability Board, the transnational network of national financial authorities, made a similar move in 2012, when it pledged to transform shadow banking into “resilient market based financing”. Rhetorically, these initiatives build upon the regulatory changes post-crisis, which are supposed to have made the financial system as a whole more resilient, a. This rhetoric is echoed by the chairman of the Financial Stability Board, who in 2014 declared that the rule-making to fix the fault lines of financial markets had been “substantially completed” and emphasized the need for a diverse financial system that includes “market based finance”.
Learning only half the lessons of the financial crisis
What is remarkable about these rhetorical and regulatory initiatives is the insufficient appreciation of the pro-cyclicality (tendency for up and downswings) of the system of credit provision. This pro-cyclicality not only refers to the effect of disturbances (such as defaults by banks) on the short-term behaviour of the system as a whole, but also its longer-term effects when the system is functioning too well. Regulators have sought to prevent a repeat of the shutdown of the financial system following the default of a large interconnected financial player, such as Lehman, by increasing the ‘resilience’ of the financial system through new liquidity and core capital regulations for banks. These efforts notwithstanding, the larger underlying problem of the excess growth of credit pre-crisis has not been sufficiently addressed. The warning that, in addition to increasing the short-term resilience of the system, policies should also seek to ‘smooth the credit cycle’ by lowering excesses in the upswing has largely gone unheard. There is only one prominent measure post-crisis that seeks to curb excessive credit growth by banks in a boom – the counter-cyclical capital buffer. Such measures are prone to be ineffective, however, if shadow banks (non-bank entities that as a group engage in maturity, liquidity and credit transformation) step in to provide these loans.
The need to smooth the credit cycle
Further regulatory measures need to be installed to control the excessive financing of debt in the shadow banking system, in particular the pro-cyclical provision of funding liquidity for shadow banking entities. Yet, these measures to smooth the credit cycle in capital and money markets are still being proposed – and are years from being implemented. The dangers of the move to a capital markets union and the embracing of market liquidity as a cure for growth is that it might thwart the development of these regulatory measures. Already highly controversial due to the problems of measuring liquidity and further impeded by the lack of a clear ‘competent authority’, these initiatives risk being drowned by a policy that seeks to embrace markets and their potential to spur growth. Thus, while a leading proponent of macroprudential policies in the European Central Bank, Vice-president Constancio, might call for such measures to accompany the Capital Markets Union, such calls are likely to go unheard by the anti-regulatory spirit enshrined in the Capital Markets Union. To the contrary, the current review of regulation undertaken by the European Commission to eliminate unnecessary regulatory costs and impediments to market liquidity suggests a move in the opposite direction.