Capital Markets Union: Optimising investment and financing conditions, increasing resilience
Speech by Yves Mersch, Member of the Executive Board of the ECB,
at the Morgan Stanley Global Investment Seminar,
Terre Blanche, Provence
11 June 2015
Ladies and gentlemen,
European integration has taken many different paths since the start of the ambitious “European project”. From time to time, some Member States have decided to integrate further than the rest. Among members of the euro area, especially, a more ambitious degree of integration is warranted because interdependencies in a currency union are much more pronounced than in a Single Market. Consequently, euro area governance needs to go beyond mere intergovernmental cooperation.
The most recently launched integration project, the capital markets union (CMU), is different. For a change, we are not dealing with an exclusive euro area project but with a genuine EU-wide project. This implies that the CMU has to be designed in a way that is compatible with the broad need of the entire European Union.
Today, I will outline the governance principles that I believe are most conducive to achieving the two main benefits of CMU, which are:
- more diversified and better functioning capital markets to finance growth; this implies creating an investment union on the supply side and a financing union on the demand side; and
- enhanced private risk sharing to increase the shock-absorbing capacity of the whole system.
A competitive market at the service of the economy
CMU is meant to empower capital markets to play their role fully in financing growth alongside the banking sector. It will do so mainly through two avenues:
First, CMU seeks to enlarge capital markets to encompass a wider diversity of financial instruments. These will be available to a larger investor base and will finance a broader range of investment opportunities.
Second, CMU aims to enhance the efficiency of capital markets, fostering their ability to allocate financial resources competitively to the most valuable investment opportunities.
It will achieve this by improving transparency and hence access to capital markets. One aim of CMU is to make information more readily available to a range of investors. This will reduce barriers to entry and expansion so that competition is enhanced. One way CMU can help is by promoting the voluntary disclosure by small and medium-sized enterprises (SMEs) of standardised raw financial information, such as periodic, audited financial statements. These will provide potential investors with relevant information. Moreover, CMU can provide an incentive for setting up voluntary scoring processes for non-listed companies.
This increased transparency will also enable investors to compete for the most profitable opportunity and allow projects to attract the most advantageous financing conditions.
CMU will not only foster competition among investors (perspective: investment union) or borrowers (perspective: financing union), it can also foster competition among financial centres themselves. While the United Kingdom undoubtedly hosts one of the world’s largest financial centres, I expect CMU to allow financial centres to compete more directly with each other, benefiting from their comparative advantages. For example, Luxembourg has the second most developed mutual fund industry in the world; and has – like Ireland - established itself as a centre for cross-border investment fund industries, such as “undertakings for collective investment in transferable securities” (UCITs); and the largest pension fund industry (relative to the size of the economy) is located in the Netherlands.
Competition among borrowers, among investors and among financial centres themselves will result in a more efficient allocation of resources. Market infrastructures are crucial in supporting this process. Take the examples of the Eurosystem’s TARGET2, the central bank euro payment settlement platform, and the “TARGET2-Securities” (T2S) project, which aims to create a single multi-currency platform for securities settlement in Europe. Several central securities depositories have already given the green light for T2S to go live on 22 June. By separating infrastructure from service, T2S will foster competition between what are currently national monopolies. TARGET2 and T2S represent a single set of infrastructure for Europe’s settlement industry and have the potential to become a pan-European, and ultimately a global, standard.
In a broader sense, CMU constitutes a structural reform at EU level – similar to the reforms we need in product and labour markets at Member State level. Structural reforms will make our economies more responsive to change and, therefore, less dependent on regulatory intervention. They will foster competition and efficiency.
The same applies to CMU, which is precisely about competitive and efficient markets. These two principles – competitiveness and efficiency – should also be the guidelines for the very design of CMU.
We need common framework conditions to allow capital to flow more freely across borders and for capital markets to develop and integrate further. But full harmonisation is by no means a prerequisite for CMU to be successful.
Rather, the Commission will need to ensure that common principles and standards are applied to core areas so that markets will function more efficiently across borders. For example, tax- and insolvency law lies at the core of national preferences and competences – and this will remain so for some time to come.
Tax regimes reflect the level of public good provision an electorate is willing to finance. This level can differ from one country to another. Nevertheless, Member States could agree to halt the discrimination of risk capital versus leveraged funding that exists in most national tax regimes.
Similarly, Member States might agree to favour investment in infrastructure that includes European long-term investment funds (ELTIFs). Promoting a “most favoured tax clause” for retail investment reliant on ELTIFs could encourage households to invest in those products.
Such an approach would respect the sovereign right to levy taxes. At the same time, it would help to overcome the over-prudent new capital requirements under the Solvency II Directive, which weigh heavily on institutional investors. With the pretext of safeguarding financial stability, these requirements create undue negative incentives to long-term investment and risk-taking.
Progress is also achievable in specific areas of insolvency regimes without widespread harmonisation. After the adoption of the Bank Recovery and Resolution Directive, wouldn’t it make sense to reach a common understanding on an EU-wide resolution framework for credit institutions? In order to level the (European) playing field, this would imply agreeing on the pecking order of banks’ creditors in insolvency proceedings.
Likewise, the development of CMU should be accompanied by measures to deal with the potential emergence of new risks outside the banking sector and by more supervisory convergence. National competent authorities are key, given both their expertise in assessing the risks emerging from specificities in domestic capital markets and their proximity to local economic agents, such as SMEs and financial intermediaries.
Summing up, removing the main obstacles to the cross-border functioning of capital markets will allow for a more level playing field and thus lay the ground for competitive capital markets. Improved competition leads to lower prices, a wider variety of choice and greater innovation.
Empowered in this way, capital markets will be at the service of the real economy and finance growth.
Beyond that, better developed capital markets can also enhance risk-sharing.
Enhanced private risk-sharing through CMU
The crisis has shown that the financial integration observed in the euro area since its creation has been partly driven by debt-based wholesale banking flows, which were prone to cyclicality and sudden reversals in the face of shocks. These cross-border flows offered limited risk-sharing and interconnectedness constituted an element of weakness that accelerated the European banking crisis.
In addition, the over-reliance on debt – as opposed to equity financing – proved to be a drag on the recovery once banks started to deleverage. Take the bursting of the dot-com bubble from 2000 to 2002 and that of the US housing bubble from 2007 to 2009. While both destroyed similar amounts of wealth (about USD 6 trillion each), the shock of the dot-com bubble bursting was transmitted through the equity market, where burdens are shared with those who provide financing. The ensuing recession mainly propagated by the wealth channel was comparatively mild.
In the subprime crisis, however, the burden fell disproportionately on poor, highly leveraged households with no immediate burden-sharing in place. These households had to cut back drastically on their spending and the consequent fall in demand plunged the United States and the world economy into the most severe economic crisis in generations.
These historical episodes illustrate that high leverage or excessive reliance on debt instruments can amplify shocks. By contrast, greater reliance on equity could contribute to financial stability by providing loss-absorbing buffers for financial and non-financial firms.
One important step in the development of equity financing is to reduce the bias in taxation observed in many Member States, which provides preferential treatment for debt – as opposed to equity financing. Again, this does not mean that we need full harmonisation. Agreeing on common principles of taxation does not require a harmonised level of taxation. Taxation is a national prerogative for good reason.
Still, the Commission and legislators should ensure that financial markets are integrated in such a way as to help companies and households cushion local shocks. They can do so by agreeing on shared principles and measures that promote cross-border holdings of debt and equity and direct cross-border exposures from banks in one jurisdiction to firms and households in another. National ring-fencing of deposits in the absence of crises will certainly not support cross-border risk-taking.
Let me conclude.
CMU is a window of opportunity for the European Union, as a whole, to establish a reliable and trusted system that efficiently allocates savings to innovative and job-creating investments. It can grease the wheels of the entire financial system, stimulating the flow of capital. At the same time, increased competitiveness among financial intermediaries and more robust market infrastructures improve resilience to shocks.
For this to happen, we may need compatible standards and agreement on harmonised principles. But we will not need undue centralisation.
CMU is about competitive and efficient capital markets. I hope that the legislator will ensure that CMU, itself, will also ascribe to the principles of competitiveness and efficiency. This way, I am confident that CMU will achieve its core aim of enhancing financing for growth and fostering private risk-sharing.