These days, creating jobs and boosting growth are the top priorities of European policymakers. In order to do so, policymakers are focused on measures that widen firms’ funding opportunities, which have so far been largely limited to bank lending.
In November 2014, the European Commission (EC) introduced a major project to create a deeper and more integrated capital market in Europe: Capital Markets Union (CMU). Until this point, European firms’ funding structure has mainly relied on bank lending; indeed, bank loans are more than 70 percent of debt in Europe versus debt funding via capital markets at more than 70 percent in the U.S. Being bank-centric, however, has proven to be detrimental to the broader economy when banks tighten credit conditions, as in the aftermath of the financial crisis. Developing a second pillar that connects non-financial corporations to capital markets is portrayed as a remedy to reducing the over-reliance on banks.
In a nutshell, the overarching objectives of CMU, as outlined in the EC green paper, are:
- To maximize the benefits of capital markets for the economy, jobs, and growth;
- To create a single market for capital for all twenty-eight European Union (EU) member states by removing barriers to cross-border investment within the EU and fostering stronger connections with global capital markets; and
- To develop a single rulebook for financial services which is effectively and consistently enforced.
CMU is undoubtedly a positive and necessary step in establishing a reliable corporate funding structure and in facilitating a robust recovery in Europe. That being said, several aspects of the CMU debate require further clarification and detailed discussion. Efficient allocation of capital by establishing deeper and more integrated capital markets in Europe is an ongoing topic. Up until now, attempts at developing integrated, efficient, and cost-effective capital markets in the EU have been fruitless and it has become clear that there is no silver bullet that will solve the problem.
Why Bank Lending is Broken
Why are traditional bank lending channels broken in the EU, despite the abundance of liquidity available in financial markets? That bank balance sheets undergo a sea change is at the crux of the shortage in credit. To be more specific, the leverage ratio of European banks rose from 5.5 percent in 2007 to 8 percent in 2014. The core Tier-1 ratio of the largest banks, a measure of capital based on the riskiness of bank assets, jumped from 7 percent in 2008 to over 12 percent in 2014. Furthermore, banks are much more cautious on lending compared with the pre-crisis period in Europe, thanks, in particular, to the non-performing loans (NPLs) in southern countries of the euro area. Taken together with the narrow spectrum of funding alternatives available to EU firms, banks’ balance sheet constraints and their hesitation to take on additional risk explain scarcity in bank lending. That being said, with the process of restructuring and deleveraging, as well as with the bank balance sheet stress tests, banks in Europe are now much more robust and better capitalized. What is more, a prolonged tightening process due to an ever greater risk perception came to a halt over the recent quarters. In this respect, it is reasonable to expect that bank lending could see a growth spurt in Europe.
Behemoths of Corporate Financing: Stock and Bond Markets
An elaboration of the depth of European capital markets is necessary in order to shed some light on capital markets’ potential as an alternative to bank lending. In doing this, it is essential to start with the behemoths of corporate financing: stock and bond markets. By and large, the size of the European capital market is meager compared with economies of similar scale, such as the U.S. More specifically, the EU equity market cap stands at around $12 trillion, which is less than half the size of the U.S. market cap of $26 trillion. What is more, at $4 trillion, the UK’s market cap alone accounts for the lion’s share of the EU aggregate, and the euro area equity market size lags significantly behind. The corporate bond market size is even narrower in the euro area: outstanding amounts of corporate bonds normalized by GDP stands at around 10 percent compared with 30 percent in the U.S. Taken together, looking at the market size alone, the euro area capital markets seem underdeveloped at first glance.
Size-related indicators, however, give only a partial glimpse of capital market depth, and outstanding volumes that are accumulated in the past may ignore important changes and trends in the present. For example, Initial Public Offerings (IPOs) peaked before the crisis on both sides of the Atlantic. In 2007, these amounted to $56 billion in the U.S. and to almost $70 billion in Europe. In both regions, IPOs declined as the financial crisis took hold and were able to turn the corner in the U.S. only with early policy intervention. Despite the rather late policy move in Europe, equity issuance (both IPOs and secondary issuance) surged in 2014, due to the expectations on quantitative easing (QE), and amounted to €63 billion, the highest annual volume since 2007. To gauge the importance of equity financing, balance sheet-related indicators provide a good benchmark as well. Equity as a percentage of liability on balance sheets of euro area corporations stands at around 50 percent and is only slightly less than U.S. corporations. Taken together, stock market financing is as much of a cornerstone of corporate funding in Europe as in the U.S.
Still, euro area stock markets suffer from other problems, such as ongoing fragmentation and home-bias, i.e., investors assign anomalously high weight to their domestic assets. These both became even more evident after the crisis. Contributing factors include information asymmetries, transaction costs, etc., and can only be worked out by harmonizing insolvency and corporate and taxation laws. However, these have proven to be extremely difficult in the past and expectations may prove overly optimistic even as a longer-term objective. Indeed, CMU proposals could be overshadowed by individual countries’ political agendas, given that rule-making for corporations and taxation are purely national member state competences in the EU.
For bond funding, the outlook is slightly different. Before the beginning of the financial crisis, corporate bond issuance was subdued in the largest economies of the euro area and fluctuated around €60 billion annually. With extraordinary monetary policies on both sides of the Atlantic, and, consequently, the search for yield, this has changed drastically over the recent years. Firms in the euro area started to tap the debt capital markets aggressively and issuance saw record volumes in 2009 as well as in 2012 and onward. Putting the upward trend in numbers, between 2012 and 2014, the €300 billion outflow in bank loans is compensated by €269 billion inflow from bond issuance. Thus, a clear substitution effect between bank lending and debt capital market instruments can be observed. Euro area corporations—at least those that are large enough to overcome the fixed cost of tapping bond markets—seem to issue bonds as long as there are favorable market dynamics. In this respect, the crucial point is the potential of CMU to warrant a supportive market environment for bond issuance over a longer period. The key to achieving this is by widening the investor base for corporate bonds. Indeed, the main driver of the issuance over recent years is the reduced cost of issuing corporate debt. Thanks to the investors’ search for yield as a result of the rock bottom benchmark rates, there is demand for corporate bonds from all ratings. The main investors and liquidity providers for the corporate bond market meanwhile are the institutional investors such as insurers and pension funds that have a strong preference for predictable and long-term cash flows. By introducing policy measures that lead to an even more active enrollment of insurers and pension funds in a larger spectrum of corporate bonds such as the non-investment-grade bonds, CMU may maximize the benefits of debt capital markets for corporate financing. For example, 401(k) or other tax-deductible retirement accounts have broadened the investor base in the U.S. substantially by encouraging savers to deposit their savings with pension funds, insurance companies, and mutual funds, which in turn invest these assets in the corporate bond markets. To the extent that CMU allows a larger investor base for corporate bonds, it will boost the issuance levels in Europe. However, acceptability of high volatility in pension returns or insurance company investments, as well as the likelihood of severe shortfalls during economic downturns, is a political discussion and beyond the scope of the CMU. What is more, if these shortfalls come during economic upheavals, when government resources are already constrained, or if they fall on the member state governments through guarantees or direct transfers, this would certainly be an undesired side effect of CMU.
Increasing Financing Options for SMEs
Another core objective of CMU is to ease the access to finance for euro area small and medium enterprises (SMEs), which generate around 58 percent of the gross value added of the corporate sector in Europe and account for almost 67 percent of private sector employment. Currently, SMEs have an even narrower spectrum of funding alternatives available to them. By and large, SMEs’ opaque organizational features and business strategies, together with exorbitant fixed costs of tapping the capital markets, largely limit their access to standardized public markets for equity and debt. Put differently, less than 1 percent of all SMEs are partly funded through capital markets. Therefore, SME financing primarily depends on the company’s internal funds or on bank lending, a phenomenon that is unlikely to change even if the capital markets are more integrated in Europe.
Recognizing the reliance on bank loans by SMEs, CMU offers solutions that come as a relief to bank balance sheets and risk perceptions by a stronger securities market backed by SME loans (SME-ABS). By creating tradable or “collateralizable” securities linked to SME loans, banks can transfer the credit risk of SME loans from their balance sheets to capital markets and free-up capital that should otherwise have to be held against the original loans. Therefore, strengthening SME loan securitization has the potential to bridge the gap between SMEs’ funding needs and the availability of bank loans. But why haven’t policymakers been able to revive securitization so far? The bottleneck here is the regulatory treatment against securitization. Put differently, capital and risk retention requirements are extremely tough on securitized assets and thus the SME-ABS market size has ebbed in 2014 to €104 billion, down from €178 billion in 2011. To enhance the SME-ABS market in Europe, investment must be encouraged by a recalibrated regulatory treatment. Establishing a concept of a “qualifying securitization” that is accepted globally could be an effective way to revive and sustain a stronger and safer securitization market. To be effective, the eligibility criteria needs to be sufficiently broad and the qualifying securitizations should benefit from preferred capital requirements. It is important to note, however, that unlike mortgage loans, the information on SME loans is much less standard and these loans have hardly any rating. In this vein, the potential of SME-ABS to revitalize lending to SMEs should not be overestimated.
Since efficient capital markets require clear information flows and transparency, creating a central credit risk database is considered a way to connect firms and in particular SMEs to the capital markets. Developing a credit risk database at the European level would also make loan securitization easier. Yet, comparable and reliable credit information on non-financial corporations, and especially on SMEs, can only be achieved with banks’ enrollment. Indeed, few institutions are as skilled and experienced in assessing and managing risks as banks—which is one of the reasons why they exist. Moreover, their often long-term client relations allow banks to gauge credit risk more precisely than any other creditors. Therefore, in pursuing new frontiers such as a credit risk database, CMU should incorporate banks to draw on their risk management expertise and build on banks’ client relations. Banks also need to commit their own balance sheets in the presence of transitory supply-demand imbalances and provide liquidity in capital markets. The success of CMU in this respect depends on abandoning proposals such as the Financial Transaction Tax, which would have tremendous detrimental effects on market making and thereby liquidity and weigh down capital markets’ attractiveness for investors.
All in all, the creation of larger and diversified capital markets that complement bank financing is of central importance for the recovery of the European economy and deserves every support. That being said, the current state of the CMU discussion is overly abstract and several measures may fall short of the unrealistically high expectations. Among these are the harmonization of insolvency, corporate, taxation, and securities laws, all of which are under the control of domestic jurisdictions. Even though securitization may help to boost lending to SMEs, the regulatory treatment against securitization and lack of information on SME loans stand as impediments for the market revival. The creation of a central European credit risk database may help to overcome the limited information problem for which private sector involvement is probably the most cost efficient way.
Orcun Kaya was a Deutsche Bank Fellow at AICGS in June 2015.