In the wake of the “Green Paper” issued by the EU, will economic advisors follow in the suit of their neighbors across the pond?
Following the European Commission’s 18 February publication of an economic advisory paper (Green Paper on the EU Capital Markets Union, or CMU) talks on how to re-structure the EU’s market vs bank financing are on-going. The goal of the Green Paper is to free-up existing, but currently paralyzed, capital to be used by European businesses: according to the report, the main ways to encourage such free movement of capital is through a ten-year re-structuring process to move company financing from banks to markets.
A Green Suggestion by the Green Paper
The CMU is the springboard for discussions on the best policies for reducing the fragmentation of the European Market via a transition to primarily market-backed economies instead of the current bank-backed model. The CMU is following directly in the pathway of the 2014 Investment Plan introduced by the Juncker Commissioner.
The objectives of this paper and subsequent debate are simple: develop a more diversified financial system through more reliance on developed capital markets; unlock currently frozen capital assets around Europe to inject the economy with real cash, thus providing more investment choices and offering businesses a wider choice of low-cost funding; create a single capital market (instead of the multi-capital market that is currently being used) for the EU so investors are able to make cross-border investments without the myriad obstacles they currently face and enable businesses to better move through a borderless economic market.
The road to realizing these goals is, of course, full of challenges and pot holes. Investment in Europe remains heavily reliant upon banks (instead of upon markets, as is the norm in the American model), which inhibits the ease of cross-border investment. There are significant differences between EU members’ financing conditions and credit worthiness ratings, which makes transition to a market-based economy significantly more difficult. In addition, member states have differing rules and regulations regarding market practices in areas such as securitized instruments or private placements, and in the wake of the recent global economic crisis, buyers and shareholders of corporate debt are reluctant to go beyond their national borders when investing in emerging markets. If the proportion of bank-based SME financing is reduced, investors would be encouraged to look beyond their immediate horizons for investment opportunities, thus revitalizing European markets.
What Transition?
The existing European model is through 80% bank (in-direct) financing and 20% market (direct) financing—the Green Paper calls for a transition that falls in line with the American model, whereby the economy is financed 80% by markets (direct) and only 20% by banks (in-direct). This represents a clear abandonment of the existing European model—this would completely transform the European market to allow capitalism to emerge in its fullest form. Market financing is often referred to as direct financing because it happens through direct exchange of securities between investors and borrowers. In in-direct markets, or bank-based markets, the flow of securities goes through intermediary institutions, generally banks, which collect deposits of capital from savers and lends these funds to borrowers. However, as banks have become more active in capital-market activities, this distinction has become blurred. All economies have a mixture of direct and in-direct financing—the Green Paper discusses the benefits of transitioning from a heavily in-direct market (80%) to a significant direct-based market (40%) within the next 10 years.
This is, of course, being met with resistance. Specialists point to the lack of transparency in discussions and poor investment by European firms into further analysis of the risks and benefits of such a transition. Obviously, the short-term view of such a structure has many shortfalls, as were seen with the American banking crisis in 2008. Would a reliance on direct financing have the same effect in Europe? Debate and discussion by a diverse group of investors would be the best way to deduce the costs and benefits of such a transition.
Why Transition?
The Treaty of Rome, created more than 50 years ago, guaranteed the free movement of capital within the European Union. This vision has dwindled in light of the global economic crisis and shift in investors’ and shareholders’ habits. Investors have retreated to their home markets, which reduces the ability of capital to move freely throughout the EU. The arguments for the American model are strong, as are the counter-arguments. Employing this direct-financing model common in America seems efficient, but some are concerned that it would remove the responsibility of banks to make cautious and well-thought-out investments and loans.
The EU does not want to be in the same position as America, where tax-payers bear the responsibility for bailing out banks when they make irresponsible decisions. Transitioning to a more equal financing system (60% bank, 40% market) would reduce the pressure on banks and increase the ability of investors to make cross-border investments—all of this would put more money into the European economy, making way for more jobs. Widening the investment base of European markets would enable provide more competition, more benefits and fewer costs for investors and increase the abilities of shock-absorption without increasing the risk of indebtedness. While this topic is open for debate, the public has, as usual, taken little note of the latest decision by the European Commission. Decisions by the European Commission continually go unnoticed when they should, in fact, be discussed with fervor.
At the end of the day, it is easier to make a union of markets than it is to make a union of banks: the economy needs re-structuring, and fast. Galvanizing markets to increase their role in supporting European businesses is a much more viable option in the short and long term than attempting to unionize the diverse and competitive world of banking.