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Capital idea

21 July 2014 By Hugo Dixon

What is capital markets union? Jean-Claude Juncker, the European Commission’s president-elect, has embraced the goal of creating one for the European Union. But so far it is more of a slogan than a set of policy actions. There’s no harm in having a catchy term to encompass a myriad of specific plans, but the idea needs fleshing out.

The first thing is to clarify the goals. One is to finance jobs and growth throughout the European Union. Another is to have a financial system that is better able to absorb shocks. Banks are shrinking and so can’t do the job of funding economic expansion on their own. Nor are they good at coping with crises. Indeed, they often magnify them, as the credit crunch and euro zone saga showed.

The solution is to beef up non-bank finance – everything from shares and bonds to shadow banking and much else too. It is also to integrate further the EU’s capital markets. That will lead to greater critical mass and lower financing costs, as well as soften the blow of an economic shock by sharing the pain across a wider area provided risk is really transferred from bank balance sheets.

The phrase “capital markets union” is a conscious echo of the EU’s new banking union. But there are several important differences. Britain is not part of the banking union, but it should be in the capital markets union – the project wouldn’t amount to a row of beans if it excluded the City of London. And a capital markets union should not involve the European Central Bank supervising the EU’s securities markets on top of euro zone lenders. Supervision is certainly needed to stop market participants engaging in shenanigans such as manipulating interest or exchange rates. But that can be achieved mainly through existing national authorities.

So what then is needed? There are five main pillars.

First, deregulation. The EU is supposedly committed to free movement of capital. But there are still barriers. For example, non-bank lenders established in one country are not automatically free to extend credit across the EU unless they get banking licences in other countries. This gums up the flow of capital. Such restrictions should be removed.

Other regulations are so tight that they prevent specific capital markets developing. For example, occupational pension funds, a huge potential source of capital, are often prevented from investing in long-term infrastructure projects and “unrated” loans. Earlier this year, the Commission proposed a directive to address this problem.

Similarly, new rules have strangled the rebirth of securitisation, the packaging up of loans so they can be traded on financial markets. The ECB and the Bank of England are trying to get these relaxed.

Second, transparency. Capital markets only thrive when there is a good flow of information. But this is lacking in two areas – small and medium-sized enterprises (SMEs) and infrastructure finance – as a report prepared for EU finance ministers argued last year.

The study’s authors, Alberto Giovannini and John Moran, argued that the EU needed a credit risk database to connect SMEs to the capital markets. Meanwhile, governments should publish information on past public infrastructure projects so that markets could play a bigger role in supplying funds for future schemes.

Third, spreading best practice. Sometimes, specific markets have developed well in a few EU countries but not across the board. For example, private placements, whereby debt is issued directly to a select group of investors rather than through a public offer, have taken off in Germany but not elsewhere. Italy has developed a “mini bond” market, allowing smaller companies to issue bonds.

There are many reasons why markets have developed in some countries and not others: tax, regulations, laws, business culture and so forth. What is needed is to analyse the causes in detail and then spread best practice.

Fourth, standardisation. For a single capital market to develop, it is not always necessary to have the same rules everywhere. But it often helps to have a similar approach. Otherwise, investors can spend so much time getting their heads around 28 different rules that they can’t be bothered.

The EU has already done a lot to streamline financial regulations. It has not completed the job. Perhaps the most glaring problem is in insolvency procedures, where the EU suffers from a patchwork of regimes. Often they are opaque, unpredictable and encourage long-drawn-out court procedures. While harmonising rules would be a challenge, it is still required for a fully-fledged capital markets union.

Finally, tax. In most EU countries, companies have an artificial incentive to leverage themselves up because interest payments are deductible from their taxable profits. As a result, companies rely too little on equity and too much on debt. One bad consequence is that recessions are deeper than they need to be.

The EU does not have the authority to harmonise tax regimes. However, there is increasing appreciation of the damage caused by this distortion and it will be easier for countries to tackle the problem if they are not moving alone. So the EU could have a role to play in coordinating change.

It is good that Juncker has made capital markets union one of his priorities. Now he needs to spell out what he means by it – and come up with an action plan for delivering it.


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