The new European Commission, chaired by Jean Claude Juncker, has launched as its flagship project the so-called Juncker Investment Plan, whose success depends closely on another extremely important initiative, the Capital Markets Union (CMU), which is nothing less than promoting the creation of a deep, integrated, and diversified European financial market (and not only for the eurozone), modeled on that existing in other countries, specifically the United States.
As the title clearly indicates, my speech today at this University will attempt to provide a critical view of this highly important initiative by the European Commission. This critical view, I must clarify, does not refer to the idea of the Capital Markets Union itself, but rather to its practical execution. On the contrary, the CMU not only constitutes a very important project for the EU, but is even a fundamental element to complement the Banking Union. This critical view does not aim to question the project, but rather seeks to ensure its viability. But before entering into this constructive criticism, let us review the CMU project, both its motivation and its main features.
When comparing the European financial system with that of the United States, it is not difficult to identify some distinguishing characteristics. First, the weight of bank financing in Europe is much more prevalent than in the United States. Roughly speaking, while in Europe the non-financial private sector (households and companies) is financed 75% via banks and 25% through the markets, in the United States the proportion is the opposite: only 25% of productive economy financing is carried out through bank financing. Second, the relative weight of debt instruments versus equity instruments (shares) is also markedly different: at the end of 2015, the net financing (resulting from computing liabilities minus financial assets) of non-financial companies in the United States consisted of three-quarters equity instruments (shares and reserves), while in Europe net financing via equity instruments did not reach 50% (that is, debt represents more than 50% of net financing) – Source: Bank of France.
In short, regarding the financing structure of the non-financial business sector, Europe presents two distinguishing features compared to the United States: greater dependence on bank financing and less use of equity instruments.
These differences go beyond the headline figures. Thus, undoubtedly, the United States has a much more diverse financial ecosystem, with a significant presence, for example, of private equity funds and distressed assets funds, so relevant for post-crisis management. In addition, it has other unique entities, such as the government sponsored entities that operate in mortgage markets (the famous Fannie Mae and Freddie Mac) and which partly explain the low weight of bank financing in the United States, since mortgages on housing do not remain on bank balance sheets, but are securitized and sold to these agencies.
In other matters, the differences are not as great as sometimes thought. For example, the number of banks on both sides of the Atlantic are similar: in the United States there are about 6,000 banks, compared to 5,270 in the eurozone or 6,800 existing in the EU as a whole. Or, if we think of the largest American banking institution, JP Morgan, its weight on American GDP, 18%, is not so different from the 20% of the largest bank in the eurozone by balance sheet size, BNP Paribas (it would be different if its weight were measured against French GDP, something that no longer makes sense in the Banking Union). If we take the data from the end of 2015 for Global Systemic Banks in the United States and the Eurozone (the six largest in each economic bloc), their combined weight is 72% in the United States versus 92% in the eurozone, that is, the euro area is higher, but not significantly (Source: FDIC Global Capital Index and own elaboration). In short, the financial systems in the eurozone and the United States differ significantly, although some of the figures, such as those relating to the relative weight of banks on the economy, indicate not as much as sometimes thought.
Before the 2007/2008 crisis, these differences had an almost anecdotal character: they were one way and we were another. But given the greater success of the United States both in the speed of recovery after the crisis and in the level of GDP achieved, it is legitimate, even obligatory, to ask whether the typology of the European financial system is a drag on growth in the eurozone.
The differences in the structure of the financial system in the eurozone compared to that of the United States may have implications in scenarios of financial risk, that is, of crisis.
First, it is obvious that greater diversification of private sector financing, a lower weight of banking and a greater weight of the market, allows the economic costs of a crisis to be diluted among a greater number of agents, thus reducing the concentration of damage on bank balance sheets and, thereby, limiting potential credit restriction problems. But although it is obvious that we need more and better capital markets, we cannot ignore that a financial system more based on markets will also be more procyclical and will suffer more pronounced adjustments in crisis than one based on banks (which support their clients going through temporary difficulties). In short, the greater presence of markets is felt in a faster adjustment but also in a cruder and more intense adjustment. A different matter is the debate, especially in the Anglo-Saxon world, about the impact of oversized financial markets (It is estimated that the size of financial markets currently represents 15 or 16 times world GDP, when in the eighties of the last century it was barely half). To the extent that markets not only finance the economy and anticipate its future behavior, but also influence its evolution, analyzing this question is not only legitimate, but essential, although it exceeds the purposes of this brief reflection.
In turbulent times, a more diverse financial ecosystem facilitates the digestion of the crisis. Specifically, investors in distressed assets were fundamental in establishing a firm floor in the valuation of real estate damage in Spain and have actively helped the transformation of non-financial companies that, as a consequence of the crisis, presented excessive levels of indebtedness. And how desirable it would be to have in Europe powerful investors who could quickly take charge of the foreclosed assets of European banking, since in countries like Spain the problem is no longer the realistic valuation of these, but rather the absence of private institutional investors with sufficient capacity to absorb the volumes existing on bank balance sheets.
But the advantages of a financial system like the American one are not limited to turbulent times. In Europe we have an endemic problem of lack of capital for companies, specifically the absence of an efficient venture capital system to finance new companies or “start-ups”. If Europe really wants to remain relevant in the 21st century, it must win the battle of employment, productivity, and innovation, and a deeper, more efficient, integrated, and diversified capital market is a necessary, though not sufficient, condition to achieve it.
The Juncker Commission has understood the importance of the mission to provide the European Union with an integrated capital market that diversifies financing sources and, at the same time, complements the Banking Union, thus supporting European economic growth. This project, in a sense, inherits that political vision of completing the single market, abandoned in the face of the virulence of the financial crisis that began in 2007, albeit with a notable change in perspective: while before the crisis the perspective was to increase market efficiency in the Union, now the vision is to strengthen financial stability and move in the medium term toward a more diversified financial system less dependent on banks. From a political perspective, it is undoubtedly attractive precisely because, even though its purpose is to complete the Banking Union process, the project is not restricted to the eurozone, but in fact the United Kingdom, with a financial center as powerful as London, is the greatest potential beneficiary of this Capital Markets Union.
The strategic approach chosen by the Commission is to prioritize pragmatism. On the one hand, it is a long-term project that will take decades to complete. On the other hand, and to avoid exhaustion in support for such a long-term project, it seeks to identify achievable intermediate objectives in the short term (quick wins or low hanging fruits) that allow this project to start and maintain cruising speed and thus avoid the risks of weakening political support typical of transformation processes with very extensive calendars. Once these short-term objectives were completed, the second phase would begin and the long-term, most complex ones would be undertaken.
In any case, it is a project whose success depends entirely on the private sector. The role of public authorities is to eliminate existing legal and regulatory barriers, but only the private sector can shape that single capital market that cannot be built by decree.
The CMU project is organized around 33 measures covering six priority areas, which I will briefly enumerate, highlighting the most important measure in each:
Let me state upfront that criticisms of the approach chosen by the Commission should not be understood as a criticism of the project itself. On the contrary, of all the pending elements to perfect the Banking Union, and therefore the Monetary Union, the creation of a pan-European financial market is the one of greatest importance. Moreover, from a political point of view, not negligible in the context of the Brexit vote, it allows the Monetary Union to be strengthened while incorporating into the project those EU members who are not members of the Monetary Union. For countries with developed financial markets it represents a great opportunity, and for those new member states, with less developed local financial markets, it represents the possibility of developing them and connecting them with the pan-European market.
It would be reckless to doubt the current Commission’s commitment to the CMU project; after all, it is the most ambitious European construction idea after the launch of the Banking Union. But the very insistence on the global idea, without deepening it, together with the chosen strategy of short-term pragmatism, conceal some medium-term difficulties that cannot be ignored if we want this project to move forward. After all, the Giovannini report identified in 2001 fifteen barriers in the area of cross-European securities settlement alone, and only in 2016, with the launch of the Target 2 Securities project by the ECB, are we beginning to eliminate these.
In short, the short-term political overselling of a project that will require considerable political capital in the coming decades to be completed may lead to a certain frustration if improvements are not observed in a few years. The choice of a pragmatic but relatively unambitious strategy in the short term (the low hanging fruits) is worrying in this sense. On the one hand, it must be recognized that it avoids the frustration of not observing short-term results but, on the other hand, the most complex reforms, such as the harmonization of national insolvency processes, are left for a later phase, in which the political capital supporting the CMU project may have diminished.
The difficulties of some of the reforms necessary to drive the project in the medium term, what we might call the high hanging fruits, cannot be underestimated. For example, the harmonization of national insolvency processes will require profound changes in the rules of EU member states. The Association for Financial Markets in Europe (AFME) has identified some of the key areas, such as:
Finally, there remain the barriers to the CMU linked to tax matters, the mere mention of which already needs little explanation: we are not only talking about a very sensitive area, but also one of the few areas in which unanimity of member states is still required to approve any change. And in case anyone does not understand the practical difficulties in this area, let us remember that one of the problems raised is the balance between debt and equity, that is, how to limit the current bias favorable to debt and against equity.
Even though it is very positive for the European economy to diversify its financing sources and become more like the American financial system, we must also understand very well the dangers associated with financial markets and financial innovation linked to regulatory arbitrage. After all, the 2007/2008 crisis was born in the United States from the combination of market financial innovations (CDOs and SPVs, for example), and solvency crises in a securities firm and an insurance company (which embarked on non-traditional activities unrelated to insurance). And this is relevant because underlying the CMU proposal is a logical inclination toward favoring innovation in products and intermediaries; as one might say in Maoist fashion “let a hundred flowers bloom”.
Market adjustment is more effective, but also more abrupt, immediate, and profound. In other words, although a bank can never, nor should it, finance clients who have become insolvent, it is no less true that it will always try to help a client going through temporary difficulties (something especially valid in the Spanish model of relationship banking, based on long-term customer loyalty). On the contrary, market financing is characterized by its volatility, not only in terms of prices, but also quantities. That is why it is vital that there be a more effective corporate insolvency regime, because in a context of greater presence of market financing, it will be needed. In short, efficiency in adjustment has a price and to minimize costs we must understand very well the collateral effects and identify the institutions to be developed to contain them.
Regarding the development of new intermediaries and products, we must be mindful of elements of regulatory arbitrage, both in terms of investor protection and solvency, as well as possible impacts on financial stability.
Here our position is clear: welcome is the competition that makes us better for the benefit of our clients, but with equal activity and risks, equal regulation, whether we are talking about fintechs, new products, or new intermediaries performing banking functions. And if this is not the case, the European economy and economic agents will pay for it, whom we must serve better through the CMU project. After all, the 2007/2008 crisis, as already mentioned, was a crisis of misused financial innovation and capital arbitrage. Experience should help us not to repeat the same mistakes.
Moreover, we must prevent the trees, the new ones associated with fintech operators or those of traditional operators, from preventing us from seeing the forest. To cite one example, every week the news appears in the media about a new emerging operator, usually a fintech, whose expansion plan includes its intention to finance the non-financial private sector with 50, 100, or 200 million euros, but few of us notice the data published once a month by the Bank of Spain, which reports that Spanish banks grant 100,000 million euros each quarter in new credit operations to households and companies. The forest, then, consists of banks that offer high-quality services and do so safely and effectively.
It is difficult to reconcile this project to create a Capital Markets Union in the EU with other European initiatives that, de facto, are contributing to fragmenting that single European financial market that was greatly affected by the process of renationalization of markets that occurred during the crisis. Thus, initiatives such as the financial transaction tax (FTT), still under discussion, not only fragment markets by their implementation scheme (national and limited to a few countries) but will push financial activity out of the European Union and toward emerging regions, such as Asia. It is never intelligent to levy taxes on mobile tax bases, and only global cooperation and coordination in these matters, which are improving so much lately, can allow progress.
But it is not only the FTT, but to this are added the different bank levies in member states, the penalization of long-term financing by banks and insurers in Basel III and Solvency II, or the negative impact that these regulations and those of structural separation such as the Vickers reform or the proposal by former Commissioner Barnier have had on the liquidity of financial markets.
Within the plans for the CMU, the review of the unintended effects of the aforementioned regulations is included, but perhaps it would be time to abandon others such as the FTT and structural banking reforms. It makes no sense to use European political capital to build the financial market and at the same time slow its development, so it is necessary to demand from European authorities, and also national ones, political courage and coherence not to play two opposing hands at the same time.
When creating the Capital Markets Union in the EU, we must consider the differences between the EU and the United States also regarding the size of their companies. Indeed, even though in both zones SMEs are a very relevant source of wealth creation, employment, and innovation, in the EU the average size of companies is much smaller than in the United States. And this is very relevant when designing the financial system that Europe needs, since SMEs cannot easily access market financing; above all, small companies depend and will continue to depend on bank financing.
In view of this particularity, the combination between bank financing and markets should be biased toward banks in the EU: a 50/50 will be better than the 75/25 of the United States. Moreover, if we consider the role of publicly sponsored mortgage securitizers (GSEs), Fannie Mae and Freddie Mac, whose activity in Europe is carried out by credit institutions, this conclusion is reinforced. Second, we must think of schemes that favor SMEs within the CMU: I refer, specifically, to studying whether securitization schemes can be designed, possibly sponsored by public bodies such as the EIB and that are attractive both for the banks that finance them and for the small-sized companies themselves.
And finally, and perhaps most importantly, we must understand what the barriers are that prevent SMEs from growing in size in order to eliminate them to the extent possible.
As already noted, banking, as a financier of the European productive economy, currently plays a predominant role, although the Capital Markets Union, when developed, will allow other alternatives to exist for financing the productive economy. But we must be extremely careful in designing the transition to a diversified model of financing via markets and banks, since the market alternative will require many years, even decades, to develop. The CMU is a very long-term project; one need only observe how long it is taking to eliminate the barriers to securities settlement identified by the aforementioned Giovannini report.
One of the problems of the current financial architecture derives from the frontloading of banking reform in the EU, that is, very strong incentives are being introduced to reduce the size of the banking sector in the EU and the eurozone, without parallel creation of market financing alternatives. And although, at this time, financial conditions ensure that there is no credit crunch in Europe, we cannot rule out that, once the economic cycle and recovery advance, bottlenecks in financing will occur, resulting from that asymmetry in the transition to the new steady state for bank financing and for market financing. It is surprising that the discussion of the CMU is focusing on the final result, without assessing how the transition to the new regime will be achieved or the dangers that may arise during it.
Finally, there is a tendency to underestimate the role that banking institutions play in the United States as facilitators and first-order agents of financial markets. In other words, it is the most sophisticated banking institutions that allow both smaller banks and non-financial companies access to the financing possibilities offered by the market. Again, balance sheet size is not the only significant indicator, and it is necessary to assess the high value-added financial services that banks provide to the economy. In this sense, the emergence of pan-European banking institutions is not only essential to perfect the Banking Union (and avoid the renationalization of financial systems in future crises) but also to allow the benefits of the Capital Markets Union to reach all economic and financial sectors of all member states.
In other words, how paradoxical it would be if the CMU were a magnificent opportunity for large American banks, and for European ones, by virtue of excessive regulation that confines them within their national borders, a missed opportunity.
As already noted, the advantage of the CMU in terms of European construction is designed to benefit all EU countries, and not only the eurozone, even though it is an almost perfect complementary element to the Banking Union. But this does not prevent us from asking an uncomfortable question: Can there be a Capital Markets Union without parallel institutional progress? I refer, of course, to whether the CMU requires the creation of a European Securities Commission, just as the Banking Union has required the creation of the Single Supervisory Mechanism around the ECB and the creation of the Single Resolution Board in Brussels (like the implementation of the euro, which required the creation of the ECB).
This is not a settled question, since not only is there little appetite for advancing this type of institutional integration in EU countries that are not part of the eurozone, but also within it, the willingness of governments to undertake deeper union is increasingly scarce (for example, in Germany). The best, from a practical perspective, would be for the CMU project to be compatible with coordination around ESMA of National Securities Commissions. But we should not forget that the development of financial markets in the United States has been accompanied by the creation of federal supervisors such as the SEC or the CFTC.
These institutional questions are being ignored, and probably with good political judgment, in the current CMU project. However, it is necessary to promote a debate, perhaps only academic for now, on the institutional aspects of the project.
The central theme of this APIE Course in Santander is “What we have learned from the crisis”. The main message of the preceding paragraphs is that we must build, for the future, a better financial system, deeper, more diversified, and better regulated, but also, and I would say above all, well supervised. This construction may require years, even decades, but after facing such an extraordinary crisis, an event that occurs once every hundred years, it is worth betting on long-term solutions, and not only on quick fixes, which also, of course, are part of the response to any crisis. Likewise, we must be attentive to the incentives created by the new regulatory paradigm: after all, we know that crises repeat over time, but their nature always mutates. And, in some cases, the collateral effects of new incentives may take a long time to manifest. For example, after the 1929 crisis, the United States implemented in 1933 the prohibition of banks remunerating customer deposits, the so-called “Regulation Q”. Well, this allowed the development of the Money Market Funds (MMFs) industry and for these to constitute a source of financing for the national and international banking sector in the United States. With the outbreak of the crisis in 2007 and 2008, the fragility that excessive dependence on short-term financing from MMFs represented for the banking system became evident. That is, a measure from 1933 ended up creating a fragility that exploded in 2008.
Let us therefore pay attention to both the short term and the long term. The CMU is among the long-term projects, so we must obtain from our leaders sufficient support and impetus to complete the task.
Thank you very much.
José María Roldán, Chairman of the Spanish Banking Association
