A recent blog post by European Central Bank (ECB) vice president Luis de Guindos and executive board members Fabio Panetta and Isabel Schnabel spelled out the key advantages of a capital markets union (CMU) that should not be overlooked during this difficult and uncertain economic climate.
In particular, the ECB stressed that CMU would lessen firms’ reliance on bank financing by allowing easier access to market-based financing instruments.
It would increase cross-border ownership of stocks and debt securities and cross-border business financing would be an important way of sharing risks.
There would be positive effects from a macroeconomic stabilisation perspective while at the same time helping economies across Europe prove more resilient to local shocks.
Is equity financing more resilient than debt funding?
The blog pointed out that equity markets tend to have particularly strong risk-sharing properties and equity funding is more resilient to shocks than debt funding.
Boosting capital markets via policies to increase equity financing would support growth and innovation.
The ECB said recent research indicated that firms with higher growth potential generally resorted more to (public or private) equity financing than debt financing and that capital markets proved better at financing innovation and new sources of growth.
The authors concluded that this made capital market funding particularly attractive with a view to boosting Europe’s potential growth after the pandemic.
Stefan Hofrichter, head of economics and strategy at Allianz Global Investors, agrees with most – but not all – of the EU’s argument.
“Deepening the financial markets in Europe by further developing the CMU would surely be welcome as it facilitates financing of investment projects notably for SMEs. I also agree that equity financing is more resilient to shocks than debt financing.”
But he disagrees with the risk-sharing argument with respect to bonds.
“For sure, this is – currently – the common line of reasoning as bonds are sold to a large number of investors and, hence, enable the spreading of risks.
“However, there were times in the past when loan financing by banks was perceived to be ‘safer’. Why? Because the due diligence process by banks handing out loans which then remain on the banks’ balance sheet, is probably more diligent than for bonds which are sold to the public.
“This argument has seen a revival post-global financial crisis, when highly rated bonds defaulted.”
EU equity markets remain under-sized
Pablo Portugal, managing director of advocacy at the Association for Financial Markets in Europe (AFME) echoes Hofrichter’s largely positive view on the EU’s proposal.
“Covid-19 has clearly amplified the need for deep and well-integrated capital markets in Europe in virtually every area. It is clear that the post-pandemic recovery and sustainable long-term growth cannot be funded solely through government support programmes and the provision of bank loans.”
Portugal says the increased levels of debt in the corporate sector, as a result of government sponsored liquidity schemes, could generate a debt overhang which would act as a drag on the recovery. He argues that measures to recapitalise businesses through additional equity or the resizing of debt should be at the forefront of policymakers’ considerations.
He adds that the recently published CMU Action Plan contemplated a review and simplification of listing rules, which was welcome in the context of promoting access to public markets, particularly for SMEs.
“This is especially important as initial public offerings (IPOs) of equity remain subdued and equity markets remain under-sized in the EU, in some cases losing ground to other jurisdictions,” Portugal says.
Currency and carbon benefits from a capital markets union
Even before the pandemic, the ECB was a strong supporter of the CMU project.
Its thinking is essentially that a CMU would allow European firms to benefit from more diverse funding sources, which would allow them to adapt more effectively to changing funding conditions
A CMU would also speed up the transition to a low-carbon economy, according to the ECB. It references recent analysis suggesting that an economy’s carbon footprint shrinks faster when it receives a higher proportion of its funding from equity investors than from banks or through corporate bonds.
Another advantage relates to currency.
The authors of the blog maintain that integrated euro area capital markets would strengthen the international role of the euro, as deep and liquid financial markets are fundamental to a currency’s ability to attain international status.
By reducing transaction costs, deeper markets would make using the euro more attractive for international financing and settlement.
Progress on equity market integration stalled after 2015
European capital markets – and especially equity markets – remain underdeveloped and insufficiently integrated at the European level.
While there was a strong positive trend in capital market integration following the great financial and euro area crisis, the integration of equity markets progressed little after 2015.
Despite the EU Commission’s continued support, back in November 2019 the Financial Times questioned whether the EU’s Capital Markets Union plan could be revived.
This followed the current commission’s reaffirmation that it would champion and complete the CMU action plan that the previous Juncker-led commission had made a top political priority but had been frustrated in progressing.
On taking over the presidency (pre-Covid), Ursula von der Leyen’s EU manifesto made it clear, that with the building blocks of the CMU were largely in place, it was time to go further.
Covid-19 may finally end Europe’s reliance on banks
However, as the FT reported at the time and referencing 2019 figures from the AFME, the EU’s reliance on bank lending had actually increased with 88% of companies’ new funding coming from banks and only 12% from capital markets.
But a lot has happened since with the landscape significantly changing due to Covid.
The pressure on banks is now immense as companies across Europe look to recapitalise. Consequently, alternatives to bank financing may have to figure more prominently.
Given this backdrop, the EU’s consistent and repeated calls for CMU may finally pay off.
AFME’s Portugal is encouraged by the EU’s unfailing messaging on CMU. He says it indicates the Commission’s commitment to taking CMU to the next level, which may include significant expansion of retail investor participation in capital markets.
Essentially this would mean citizens investing in market instruments rather than keeping their money in deposits.
Currently, New York and London are the two main hubs of capital market activity, handling nearly 45% of global capital market activities, according to a recently published PwC report.
Given the investor disruption triggered by the Covid-19 outbreak, a robust and well-functioning CMU would appear (as the EU insists) to be more important than ever.
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