By Denitsa Marchevska
The Capital Markets Union project is one of the legacies of the Junker Commission, which are expected to gain new momentum in the next term of the European Commission. President Ursula von der Leyen asked Valdis Dombrovskis, her chosen nominee for Executive Vice-President for An Economy that Works for People, to focus on speeding up the work towards the creation of a functioning Capital Markets Union (CMU). During a recent informal meeting held in Helsinki EU Finance Ministers also agreed that the CMU project should be revitalised (although they seem to have agreed on little else). Accelerated progress on developing a strong capital market in Europe is considered to be essential for ensuring the long-term competitiveness of EU banks.
With a little over a month (hopefully) remaining until the confirmation of the new College of Commissioners, taking stock of the CMU project seems to be in order.
What is the Capital Markets Union?
The CMU project was launched in 2015 as a key element of the Junker Commission’s plan to boost jobs, growth and investment across the European Union. In its essence, the CMU was a project aimed at facilitating better access to alternative funding sources for EU businesses, which are heavily reliant on bank lending and are thus particularly vulnerable to instability of the banking system. The CMU was meant to benefit SMEs and start-ups in particular by making it possible for them to raise cheap funding directly through capital markets, venture capital, crowdfunding platforms and the asset management industry thus overcoming obstacles to borrowing from traditional banks, which stem from their perceived higher risk profile. Furthermore, a strong capital market in Europe was to act as a buffer and insulate the real economy from localized shocks through increased cross-border risk-sharing.
The problem with the CMU was, however, that the creation of a strong and integrated capital market requires the integration of a range of other spheres such as taxation, financial regulation and insolvency regulation. Those issues have proven sensitive and difficult to overcome by Member States who fear a loss of sovereignty when it comes to policy-making. As a result, progress has been slow. The Commission has sought to focus on relatively uncontentious issues such as product market rules and supervision while steering clear of controversial large-scale harmonisation attempts.
Why does the EU need strong capital markets?
EU businesses remain heavily reliant on bank lending in stark contrast to their counterparts in the US. Corporate lending is also largely limited to banks based in the same country making potential spillovers of instability especially damaging to the economy.
In 2017, only 17% of the funding made available to EU businesses was provided by alternative funding sources meaning that bank loans represented an average of 83% of corporate financing. Figures for individual EU states stand even higher. The majority of those funds were borrowed nationally. For comparison, bank loans accounted for just 32% of corporate funding in the US in the same period. Such imbalances are a key reason why US companies prove much more resilient that their European counterparts. Whenever crises like the one in 2008 strike it is much easier for them to tap alternative income streams.
The situation is compounded by the fragmentation in the EU banking landscape itself. The Eurozone is said to host more credit institutions than China despite the fact that the latter’s population is four times larger. The overcrowding in the European banking sector is by no means a sign of its exceptional performance. Data shows that EU banks’ return on equity is nearly 50% lower than in the US.
These systemic weaknesses spell trouble even in times of prosperity but the rising likelihood of a recession in the coming years makes them all the more troubling.
The Brexit question
When talking about the EU capital market one cannot ignore the elephant in the room. The 2016 Brexit vote posed arguably the most significant obstacle to the achievement of a well-functioning capital market in Europe. The UK’s departure from the bloc would leave London, the EU’s biggest capital market, outside of a potential CMU. Although some have argued that Paris or Frankfurt could easily take up London’s role after Brexit, the truth is that the UK accounts for nearly one third of the EU capital market activities, which is more than the share of France and Germany combined. Such a gap will be difficult to fill in the foreseeable future. In this context, Britain’s exit will likely make EU businesses even more reliant on traditional bank lending in the short- to medium-term. Furthermore, it will also result in a considerably loss of expertise, which the bloc would desperately need if it is to make an integrated capital market work.
Fears about the future of capital markets post-Brexit are by no means limited to continental Europe. A recent survey amongst financial technology company founders based in the UK showed that at least one in four believes that Brexit will hinder access to capital. British financial services firms have been working hard to build their legal entity footprints across the EU in order to shield themselves from the worst consequences of a disorderly Brexit.
The way forward (or backward)
All in all, completing the Capital Markets Union was always going to be a difficult task but Brexit has brought about a whole new set of obstacles. With the Brexit deadline looming large and signs of a global economic downturn becoming ever more evident, however, it is imperative that progress is made swiftly. It remains to be seen if Mrs. Von der Leyen’s Commission will be up to the task.