Ms. Christine Lagarde, the European Central Bank president, said in a recent speech in Frankfurt that “creating a European SEC” to replace the patchwork of national market watchdogs would help raise the huge sums needed to tackle the triple problems of “deglobalisation, demographics and decarbonisation”. In addition, Ms. Lagarde emphasised the need for an end to the system of national financial exchanges, stating that: “a truly European capital market needs consolidated market infrastructures - and this is where the private sector can show its determinations, too”.
This article is an analysis of the benefits, challenges and risks that a more unified European market would bring.
Currently, each eurozone state has its national financial watchdog that regulates the financial exchanges within its national borders; in Italy that responsibility falls to The Commissione Nazionale per le Società e la Borsa (CONSOB) regulating the Borsa Italiana. Each member state has a different equivalent state body, with a different rule book for its financial exchanges, all overseen by the European Securities and Markets Authority.
The European capital markets trail behind when compared to the ones in the US, even when accounting for the lower GDP per capita of the EU. Prior to Brexit, the EU’s capital markets’ global share of activity was 22%, while today it has fallen to 14%, as the City of London was a significant capital market for the EU. The US, which has approximately twice the GDP per capita of Europe, has a capital market triple the size of the one in Europe, with the equity market in the US being 4 times bigger than the collective European equity market. With a more vibrant capital market in the States it is more likely that the next Google will come out of the States, rather than Europe. A smaller global footprint significantly reduces the attractiveness for companies to trade in European markets, as there are fewer investors present. This significantly stunts the growth of EU’s economies, as it hampers investment and creation of new start-ups that could reinvigorate economic growth on the old continent.
Ambitious goals require ambitious funding
Europeans are proud to be the leading force in tackling the world’s greatest societal challenges, be they environmental, technological or demographic. However, the European market for securities does not reflect the unifying goals of the Union. It is not “strategically autonomous” to supply the public and private sectors of the EU with the capital necessary, as the EU still relies on other countries, especially on the UK in critical market areas, such as FX trading & derivatives. In addition, in the eyes of many investors, the European markets do not offer returns as great as the US or emerging economies markets. This hampers economic growth, as governments and companies in the EU have higher financing costs.
This is reflected by the low participation of foreign agents in European markets and lower IPOs (Initial Public Offerings), where firms offer their shares or corporate bonds for sale to the general public.
A smaller market is less attractive to investors, which in turn leads to fewer opportunities for companies to raise capital on the market, or to higher costs, due to less available capital from investors. This pushes European firms to rely more on banks for funding. This stunts growth and innovation of European companies as banks have a smaller appetite for risk than investors, demanding higher cost for their capital. In turn, that makes it more difficult for European companies to raise the capital required to make innovations that could change the world. It is estimated that banks would struggle to provide the necessary funding for the private sector to grow in line with EU’s goals and especially for firms in infant, technologically ground-breaking industries. In a recently conducted ECB survey, it was found that nearly 40% of small- and medium-sized enterprises consider lack of investor appetite as a “very significant obstacle” to raise funds to invest in green technologies.
Can further unification lead to growth?
Ms. Lagarde seems to think so. European markets are fragmented, with each European country having a separate stock exchange, with the EU having double the number of exchanges of the US. This means that potential capital is spread around across several locations making it more difficult for firms to find investors. Furthermore, it is a lot more difficult for investors to disperse their capital across several different European markets, as each market follows different national regulations. Ms. Lagarde's opinion is that the EU should consider giving ESMA more power. She calls for: “...a broad mandate including direct supervision”, as well as unifying the rule book across all European markets. Comparing the various European markets, those with greater depth like the French, Dutch, Swedish and Danish markets could instigate growth in smaller EU markets by incorporating them into their own market infrastructure.
Moreover, unifying the rules of the market would make it easier for deep pools of long-term capital such as pensions and insurance to enter into cross-border transactions. This would further increase the depth and effectiveness of capital markets, additionally bringing higher growth rates for retirement savings of current EU workers. Governments would also be pleased as they would have to fill fewer holes in current pension funds to guarantee a decent pension for its future seniors.
Union for better growth or Jenga towers made out of bad debt?
Some of the biggest lenders in Europe were quick to praise Ms. Lagarde’s comments and calls for a more unified rulebook on capital markets, albeit with a twist. The commercial banking sector actively advocates for this new rule book to have more relaxed rules on securitization.
As explained in the film “The Big Short”, securitization is a process of combining different uncorrelated securities that the banks have issued into a single Jenga Tower (a Collateralized Debt Obligation CDO), then selling portion of the Jenga tower to investors & financial institutions in the market, providing commercial banks with more liquidity to issue even more debt, increasing their profits. Theoretically, the Jenga Tower could be stable, however it is difficult for regulators to oversee how risky the mortgage securities comprising the Jenga Tower (CDO) are, opening the possibility for its collapse, which could spark a financial crisis.
Banks believe that an easier process for securitization might reduce default risk to themselves, helping pass the risk down to the investor. The banks would in turn be able to reduce the interest rates, easing the interest burden of governments and companies.
However, having mass securitization of debt across multiple countries might increase the risk of financial institutions filling these instruments with unsatisfactory default risk debt, making them more prone to defaulting. The risk of contagion is a lot greater when the markets are more interconnected, which increases the chance for an economic crisis to spark a rise in defaults, which could lead to the products of securitization losing value, sparking a financial crisis equivalent to the one in 2007/8.
A lot of actors seem to agree that further economic unification of capital markets is a great way forward. However, success depends on how rules are created, especially regarding how market infrastructure and functioning of the markets is incentivized, as well as how well regulation, supervision and accountability is implemented. Furthermore, the success of unification also depends on investors’ perception of these changes. A unification done well and simplified could increase attractiveness and deepen capital pools, promote competitiveness and international cooperation, helping the EU supercharge its economic growth.