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Unleashing capital

15 September 2014 By Hugo Dixon

One of the biggest projects for the next European Commission, which takes office in November, will be to create a “capital markets union.” President-elect Jean-Claude Juncker last week gave Britain’s Jonathan Hill the task of creating such a union “with a view to maximising the benefits of capital markets and non-bank financial institutions for the real economy.”

The prime goal of capital markets union should be to develop healthy sources of non-bank finance that can fund jobs and growth. The European Union suffers from clogged up and fragmented capital markets, which are a fraction of the size of their U.S. equivalents. Changing this is vital because banks, especially in the euro zone periphery, are on the back foot and not able to finance a recovery on their own.

How exactly should this capital union be created? In some cases, no doubt, there will have to be new regulations. One of the ironies of creating any single market – and the capital markets union project can also be viewed as completing Europe’s single market in capital – is that rules have to be passed to break down barriers that balkanise the market.

But new rules are not the only answer. The main thrust of capital markets union should be about liberating, not controlling, markets. In pursuing this, some of the regulations put in place in the wake of the financial crisis will need to be revised because they are holding back non-bank finance.

One target should be regulations that prevent the revival of securitisation – the practice of taking loans, packaging them up and trading them on the markets. Securitisation got a bad name because of the role it played in the U.S. subprime crisis. But the experience in the EU was not nearly as bad. Default rates on EU securitisations between 2007 and 2013 were only 0.6 to 1.5 percent, compared to 9.3 to 18.4 percent for America, according to the European Central Bank.

Despite this relatively good experience, the EU market has been virtually regulated out of existence, while the U.S. market has rebounded. One of the rules requires insurance companies to hold a lot of extra capital if they buy securitised loans. As a result, they are not interested in buying. Both the ECB and the Bank of England have urged that the rules should be relaxed for “high-quality” securitisations with clear and simple structures.

Another part of the financial services industry that has been clobbered by regulation is credit rating agencies. To some extent, this is justified. They were guilty of bad practices in the runup to the credit crunch. But credit ratings are often needed before companies can issue debt on the capital markets. The slew of new rules implemented by the EU may have gone too far and may be imposing so much cost that it is a drag on smaller companies accessing the markets.

The Commission should review whether specific elements of the regulations should be relaxed. The guiding principle should be to free up the rating agencies to give an honest view about the risks as they see them, but not to treat these views as if they are sacrosanct.

Vigorous capital markets do not just require companies to be able to issue debt and equity to investors; they also require investors to be able to sell those securities without suffering a big hit in the value of their investments. The ability to trade securities smoothly in the secondary market makes it more attractive to invest in the first place. It allows investors who do not necessarily want to lock up their money for the long term to provide permanent capital to companies in the form of equity and back long-term investment projects, such as those in infrastructure.

There is one EU initiative which could gum up such trading and so make it harder to fund jobs and growth: the financial transaction tax (FTT) which 10 EU countries including Germany, France and Italy plan to impose. Details of the scheme have not been determined. But if the tax is set at too high a level, it could reduce liquidity and so make EU capital markets a less attractive place for investors to put their money in.

There is understandably a desire to make the financial industry pay more tax given the mess it caused in the credit crunch. The snag is the FTT hits investors and companies, not banks. There are two better ways of taking money from the banking industry: levies, which tax banks depending on how much they rely on short-term hot money; and a financial activities tax (FAT), which taxes their profits and remuneration and would be justified because they are exempt from VAT.

Many countries have adopted some form of bank levy. But there is a patchwork of different systems and rates. The EU should try to put some order into different countries’ bank levies. Meanwhile, the 10 countries that are still committed to the FTT should abandon it and switch to the FAT. They should also invite the other 18 member states, which don’t want the FTT, to join them.

There will undoubtedly be resistance to the idea that rules governing capital markets should be relaxed. But what is required is sensitive adjustments to particular regulations rather than wholesale deregulation. This also fits in with one of Juncker’s other priorities: to cut unnecessary red tape.


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