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Ending EU’s bankcentricity

2 June 2014 By Hugo Dixon

The European Union needs more non-bank finance. Banks are on the back foot. On their own, they won’t be able to fund the jobs and growth the EU is desperate for. Non-bank finance needs to take up the slack.

The European Central Bank and Bank of England have made a good start by identifying the importance of reviving securitisation – the process of packaging loans into bond-like securities which can then be traded on the market. The two central banks have just published a joint paper describing blockages in the system which have all but killed EU securitisation since the financial crisis.

But securitisation is only one piece of the non-bank finance landscape. Similar leadership is needed to invigorate venture capital, equity investment, bond issues for small companies, shadow banking and so forth.

Following the financial crisis, securitisation – in common with other types of market-based finance – has had a bad name. This is only partly deserved. Securitisation certainly shares the blame for the U.S. subprime crisis that triggered the global credit crunch. Banks didn’t just originate mortgage loans and sell them off to third-party investors – something sometimes described as “plain vanilla” securitisation. They engaged in increasingly exotic and wild practices.

Not only did the banks lend to borrowers who were unable to service their loans. They constructed opaque financial instruments – sometimes securitisations of securitisations – in the hope of jacking up promised returns.

What’s more, the institutions that bought the securities often weren’t suitable owners. Sometimes, they were highly-leveraged short-term investors who were only able to buy these instruments because the banks selling them the paper were effectively acting as lenders of last resort. Sometimes, banks hung onto the securities themselves. As a result, when the subprime market exploded, the banking industry was dragged down too.

Securitisation was supposed to diversify risk away from banks. It did nothing of the sort. Why then, one might ask, are the ECB and the BoE keen to revive these weapons of mass financial suicide? Partly because the EU securitisations have been declared guilty by association with the United States. In fact, they are largely innocent. Default rates on EU consumer securitisations between 2007 and 2013 were only 0.05 percent, according to Standard & Poor’s. The equivalent for the U.S. was 18.4 percent.

It is ironic, given this comparative record, that the U.S. market has rebounded while the EU one is virtually dead. But the state of EU banks, particularly those in the euro zone, makes it important to breathe life into the market. As a consequence of the credit crunch and the subsequent euro crisis, banks are rightly being more tightly regulated. They are also shrinking. If finance doesn’t come from some other sources, Europe could be condemned to years of slow growth.

Securitisation is a good alternative source of funding, provided it develops in a controlled way. It allows banks to keep making new loans while still shrinking their balance sheets. It can also transfer credit risk to lowly-leveraged investors who don’t have to be propped up by the taxpayer if there’s another downturn.

The ECB and BoE have come up with a series of proposals for letting this market develop in a healthy way. Most of what they advocate involves unblocking arcane parts of the financial system’s plumbing. But the big proposal is to distinguish between plain vanilla and more exotic securitisations, and then regulate the former less harshly.

While this is an excellent initiative, it should only be seen as part of the solution to Europe’s “bankcentricity.” That is to say, Europe is far more dependent than America is on banks to finance business activity. A broad-based approach is needed to develop healthy non-bank finance.

Other debt securities have an important role to play. Large companies have little trouble issuing bonds in the EU. But that’s not so for smaller companies. Europe would benefit from a bigger junk bond market: more “mini-bonds” – where smaller companies tap the market for cash; and more private placements  – where bonds are sold to investors outside the formal market environment.

There’s also scope to expand lending by non-banks. The two most promising avenues are peer-to-peer lending, where internet sites match borrowers with lenders; and shadow banking, a broad term for non-bank lending which, though it has become something of a dirty word since the crisis, would be valuable if properly regulated.

Non-bank finance doesn’t just mean non-bank debt. Europe doesn’t just suffer from bankcentricity; it also suffers from “debtcentricity.” The economy would be more resilient if companies relied more on equity.

In that vein, European policymakers need to see what they can do to encourage both more issuance of equity on stock markets and more venture capital for startups and rapidly growing companies. One policy change could be to remove the bias in the tax system that stems from the fact that interest payments on debt are tax-deductible but equity dividends are not.

The ECB and BoE will be important actors in ending the EU’s bankcentricity. The ECB is the pre-eminent financial regulator for the euro zone; while the BoE is the equivalent for the City of London, Europe’s financial centre. But politicians also need to get on the stage. Heads of government should make developing healthy market-based finance a priority for the new European Commission which takes office next year.


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