The Drama Under the Radar: the EU’s capital markets union
This post is the third in a five part series from Jakob Vestergaard exploring reforms to the EMU that the Commission is hoping that member states will commit to at the end of June. Read part two here.
The free movement of capital across borders in the European Union has been a core priority for decades, and yet European capital markets remain fragmented. The Capital Markets Union (CMU), launched in late 2014, reiterates and reinforces the political quest for capital markets integration. To European citizens, the CMU is branded as a project that stimulates growth and jobs creation. But the suspicion lingers, that the CMU will make at best a limited contribution towards those ends, and that the more immediate objective driving the agenda is to improve the profitability of European finance. To see its essence, one most look below the radar.
The CMU is a subjugating yet silenced political drama first and foremost because of its envisaged revival of European securitization markets. Whereas just a few years ago, securitization was widely considered a key cause of the financial crisis and a primary source of systemic risk and financial instability, today it has become a centrepiece of ongoing efforts to reform the EU’s economic and monetary union. Ironically, securitization has become one of the few truly ‘active ingredients’ of the EMU reforms, somewhat against odds, as we shall see.
Old agenda rewamped
The political project of integrating Europe’s capital markets has existed for more than 50 years. One of its earliest systematic expressions dates back to the Segre-report, commissioned by the EEC Commission in 1966. But old age is no hindrance to celebration. When Jonathan Hill, then newly appointed Commissioner of financial stability, launched the CMU in November 2014, soon to be followed up by a Commission Green Paper in February 2015, the accompanying gospel was jubilant. To some commentators, the CMU was no less than the “most significant EU proposal of the last ten years”. Knowing how old the capital markets integration project is, it is tempting to dismiss the trompets, and categorize the CMU as old wine in new bottles. But that would be a mistake. Actually, the CMU is just as much the opposite: new wine in old bottles.
Yes, it is old wine in new bottles, in the sense that the half-century long discourse on harmonizing capital regulation across borders is now rearticulated in a post-crisis discourse that emphasises “union” as opposed to “single market”. But the CMU action plan has elements that are entirely new to the capital markets integration agenda – which require special attention because they are presented in ways that are incomplete and misleading. A core component is the effort to encourage “simple, transparent and standardized securitizations” (STS securitization).
Ewald Engelen and Anna Glassmacher recently observed how puzzling it was that the STS agenda rapidly moved from the margins to the fore of CMU plans, despite the fact that STS is “formally not about an alternative to bank credit, but about bank funding, and as such only reinforces the dependence on bank finance which the CMU sets out to correct in the first place”. Beyond this discrepancy between the narratives and the content of the CMU, laid out by Engelen and Glasmacher, it expresses a truly astonishing political ‘magic’ that securitization had been so fundamentally reframed in Europe as to be seen a major source of our future prosperity, only a few of years after a devastating financial crisis that, at one point, even threatened to cause a collapse of the euro.
By means of deep conceptual cleansing, securitization suddenly was no longer associated with financial crisis connotations – systemic risk, off-balance sheet, procyclicality and excessive leverage – as it had been previously. Rather it was a key component of a New Dawn discourse, which saw opaque “shadow banking” relabelled as “resilient, market-based finance”. We’ll return to this, but first a few words on the official political rationalities underlying the CMU.
The political rationalities of the CMU
In the key policy docs and press releases of the Commission, the CMU is presented as a package of initiatives concerned first and foremost with creating new sources of financing for small and medium enterprises (SMEs). Overall, the CMU has two dimensions; one aims at enhancing the mobilization of funds, the other at improving the scope and efficiency of their allocation across the EU. The ambition of fostering a financial system that is closer to that of the US, where capital markets play a larger role than in Europe, features centrally in motivating the CMU. Thus, a key goal is to make SMEs less dependent on banks for financing.
More specifically, the Commission hopes to mobilize, at much larger scale, two sources of financing for SMEs that currently play only a marginal role: institutional investors, such as pension funds and insurance companies, and households. In this logic, the CMU is all about more directly connecting savings with investments.
As for allocation of funds across Europe, the working assumption of the CMU is that standardization and harmonization is key. Only if and when the same rules, norms and procedures apply in all EU member states, may capital move freely across borders and realize the vision of an integrated European capital market. For a seasoned EU observer such notions may sound hopelessly outdated, but the fact is that despite decades of talk of the free movement of capital, capital markets in Europe remain highly “fragmented”, as the phrasing goes these days.
At the end of the day, the Commission’s efforts to launch a CMU in the service of providing financing for SMEs, is motivated by a concern with growth and jobs creation, of course. In the CMU Green Paper, for instance, the opening paragraph solemnly declares that the creation of growth and jobs is not only the highest priority of the Commission, but the highest priority of Europe. “To get Europe growing again”, the Commission explains, “our challenge is to unlock investment in Europe's companies and infrastructure. But despite the hyperbole, there is reason to moderate one’s expectations as to the growth enhancing effects of the CMU.
Simplification, harmonization and standardization
One of the central objectives of the Commission’s efforts is to reduce the barriers that may impede SMEs’ access to financing. A core aspect of this is to assess the documentation that companies are required to publish to raise funds on capital markets. Providing such information can be cumbersome and costly, so the Commission has endeavoured to simplify and standardize the information that companies are required to report. Ideally, this should lower the costs for SME and ease their access to capital markets.
Another key standardization effort consists in developing standardized quantitative data that can be used in assessing the creditworthiness of companies. The objective here is to make it easier for non-experts and lenders outside the formal banking system (such as insurance companies and pension funds) to access such information that may facilitate their decision to allocate funds to SMEs at the other end of Europe (or not). Developing pan-european formats and data for assessing the creditworthiness of SMEs is of paramount importance, the Commission contends, if barriers to cross-border financing of SMEs are to be overcome.
Seen in isolation, this is unproblematic. But skeptics observe that there are several flaws in the notion that a pan-european standardization of the information that guides decisions about SME financing would foster growth and jobs creation across Europe. First, evidence suggests that solid assessment of the creditworthiness of SMEs requires not standardized data, at-a-distance, but local knowledge. Reliable assessment of creditworthiness requires knowledge of the economic environment in which an SME operates, of its management and the competition it faces. This is the type of knowledge a local bank has, which an institutional investor at the other end of Europe doesn’t. It is difficult to believe that this knowledge-gap can be bridged by standardizing the reporting formats and assessment methodologies for SME capital market financing. Would a pension fund based in, say, Germany or Finland really be more inclined to invest in, say, an Italian SME, just because its financial and management reporting follows a pan-european, standardized format?
Securitization made safe…
Securitization denotes the practice of pooling debt (for instance, bank loans) and selling their related cash flows as tradable securities. In other words: Investors buy the securities and receive in return the repayment of (a portion of) the underlying debt, with interest, over the course of its residual maturity. In its immediate aftermath, many saw securitization (especially in the US housing market) as a key cause of the global financial crisis. So how could securitization become one of the Commission’s favoured strategies in promoting growth and prosperity, little more than a few years further down the road?
As indicated in the opening remarks, by championing so-called “high-quality” securitization, the Commission implicitly adopted a distinction between “good” and “bad” securitization. In this reasoning, good securitization distinguishes itself by being simple, transparent and standardized, and the Commission is assigned a key role: benign securitization is promoted, at the expense of more complex and malign forms, by lowering the capital requirements for STS securities, which makes them considerably more attractive for investors.
But the notion that securitization could be reinvented and sanitized so as to emerge and prosper in simple, transparent – and hence thoroughly benign – form is heroic at best, possibly even a contradiction in terms. Vincenzo Bavoso demonstrates that whatever hopes one may have for simplicity and transparency in securitization, evaporate if one allows tranching:
“The idea of having simple and transparent transactions does not seem consistent with the practice of tranching, and to this extent, the Commission could have provided a tighter definition of high-quality securitisation”
Why this fuss about tranching? The term is originally from the French word ‘tranche’, meaning slice or portion. Tranching, then, is the practice of slicing or portioning debt, before it is sold to investors in the form of tradable securities. So several different securities are constructed on the basis of the same pool of, say, mortgage loans, to match the different risk, reward and maturity preferences of different investors. Alluring as this sounds, tranching inherently and inevitably further complicates what is already a complex financial practice, which produces financial products that can be more than a little difficult to understand and assess, even for highly professionalized market participants.
Why, then, did the European Commission allow tranching in its sanctioned mode of so-called “high-quality” STS securitization? Your guess is as good as mine. But it is safe to say that the Commission’s choice on the matter likely reflects the interests of European finance more than it does societal concerns with financial stability.
The CMU as growth strategy
The conceptual cleansing of securitization – and the inevitable risks to financial stability that comes with it – would be easier to accept if securitization was of paramount importance to the promotion of growth and jobs in Europe. But there is little evidence to suggest that.
In fact, it holds true for the CMU initiative more generally, that it is difficult to see how it could have a substantial growth enhancing effect. If economic growth has been constrained in Europe after the crisis, it has been on account of weak aggregate demand much more than anything to do with the availability of financing for SMEs.
But even if we entertain the idea that European growth has been impeded by poor access to financing, why would this be any different by removing cross-border “barriers” to capital movement? The fact that SMEs have a strong preference for bank financing – as opposed to capital market financing – in the existing, fragmented financial system, does not bode well for the capital markets union. Why would SMEs be more interested in cross-border capital market financing than they are in its national equivalents?
The upshot of all this is that the CMU is unlikely to have much impact on growth and jobs in Europe. Its main effect, by far, is discursive. Key aspects of market-based finance, previously considered risky and potentially destabilizing, are now acquitted, sanctioned and officially promoted, with potential dire consequences for future financial stability in Europe.
It is difficult to avoid the temptation of categorising the CMU narrative as essentially a fairy tale. Apart from the obvious – that it serves the interests of big finance – the CMU narrative is a fairy tale in the sense that it serves to convince and appease the Commission and its technocracy that the EU does have a strategy, after all, to promote growth and jobs creation, despite the fact that European monetary and fiscal policy will likely remain constrained for the foreseeable future.*
* For readers interested in an account that explains the CMU as an institutional innovation to address macroeconomic governance gaps in the EU’s economic and monetary union, I strongly recommend recent work by Benjamin Braun and Maria Hübner.
Image credit: Pom' via Flickr (CC BY-SA 2.0)
