Capital Markets Union

Overview

The Capital Markets Union (CMU) is an economic policy initiative launched by the former president of the European Commission, Jean-Claude Juncker in the initial exposition of his policy agenda on 15 July 2014. The main target was to create a single market for capital in the whole territory of the EU by the end of 2019. The reasoning behind the idea was to address the issue that corporate finance relies on debt (i.e. bank loans) and the fact that capital markets in Europe were not sufficiently integrated so as to protect the EU and especially the Eurozone from future crisis. The Five Presidents Report of June 2015 proposed the CMU in order to complement the Banking union of the European Union and eventually finish the Economic and Monetary Union (EMU) project. The CMU is supposed to attract 2 trillion euros more on the European capital markets, in the long term. The CMU was considered as the "New frontier of Europe's single market" by the Commission aiming at tackling the different problems surrounding capital markets in Europe such as: the reduction of market fragmentation, diversification of financial sources, cross-border capital flows with a special attention for Small and Medium-sized enterprises (SMEs). The project was also seen as the final step for the completion of the Economic and Monetary Union as it was complementary to the Banking union of the European Union that had been the stage for intense legislative activity since its launching in 2012. The CMU project meant centralisation and delegation of powers at the supranational level with the field of macroeconomic governance and banking supervision being the most affected. In order to address the goals and the objectives decided at the creation of the project, an Action Plan subject to a mid-term review was proposed consisting in several priority actions along with legislative proposals to harmonise rules and non-legislative proposals aiming at ensuring good practices between market operators and financial firms. The new European Commission under the leadership of Ursula von der Leyen has committed to take ahead and finalise the project started by its predecessor by working on a new long-term strategy and to address the problems the project has had in recent times following the mid-term review and the UK's exit from the EU. This is also highlighted in her bid for the presidency of the European Commission during the process of election as the main economic motto of her campaign was "An economy that works for people". Its successor is the Savings and Investments Union.

History of the EU financial integration

Capital Markets Union is, by nature, a step in the history of the European Union financial integration, whose dynamic is to lead to freer movement of capital. The Treaty of Rome, establishing the European Economic Community in 1957, already expressed the necessity to instaure free movement of capital in between the member states. Then, the directive of 1988 implemented it by preventing any restriction on free capital flow. In 1999 the financial services action plan was created, the first step in creating a single market for capital, and in 2011 the European Supervisory Authority, in order to insure the European financial markets stability. Only four years later, is the CMU project presented by Jean-Claude Juncker.

Characteristics of the EU financial system

The EU economy remains bank-oriented, especially when compared to the United States. It means that corporations usually prefer to borrow money from the banking sector instead of financing their investments through financial markets. According to the OECD analysis, this is partly due to the fiscal bias: in most European countries, firms benefit from tax advantages if they have to reimburse a bank loan, but that is not the case if they emitted obligations on the capital markets. Therefore, there is a strong financial incentive for European companies to favour the banking sector. This high reliance on the banking system implies less stability for the European economy, hence the position of the European Commission, which advocates for a diversification of financing sources. SMEs, which have particular difficulties in integrating the financial markets but which represent a good share in the created value of the European firms, largely contribute to this tendency. The second characteristic is part of the bank-based nature of the EU economy : it is the European saving patterns. Whereas the United States population choose to invest in long-maturity-assets through pension funds or life insurances, European savers prefer easily accessible financial instruments, such as deposits or short-maturity-assets. This economic behaviour generates a lack of financial profitability of the EU and accentuate the importance of banks as the main funding providers of the European economy. The third characteristic of the European financial system is that capital invested stay usually in the national market : it is the home bias. Even if before 2011, there was a positive trend for cross-border investments, most of the capital flow was remaining within the national frontiers of the member states and European financial integration is still limited. This lack of cross-border investments prevent high-growth-potential companies from getting the financial resources they need to develop innovations and become more competitive. In fact, shareholders prefer buying shares from their national companies, creating an important hindrance to European financial integration, because they have to face regulation barriers if they want to invest in another country of the EU.

Impact of the 2011 crisis

The 2008 financial crisis had two main consequences on the financial integration of the European Union:

It showed the instability induced by an excessive reliance on banks' loans: When there is uncertainty, the offer of credit is reduced, impacting negatively all the economic activities depending on it. It is especially the case for Europe, whose SMEs mainly get financed by the banking system. Dealing with the aftermaths of the 2011 crisis, the dependency of the EU economy on banks made it harder for growth and employment, according to the former President of the European Commission. It increased the fragmentation of the European capital markets by increasing the domestic bias: There was a sensible reduction of cross-border investments after 2011. because the previous financial integration was led by banks investing on international financial markets. Once affected by the crisis, their withdrawal drove the European financial system to more fragmentation than before.

Impact of Brexit

Most of the financial power of the European Union was located in the City of London prior to Brexit. Some British firms moved to continental Europe implying a loss of financial expertise in the EU. In spite of that, the European Commission asserted the consistency of the Capital Markets Union action plan, already launched at the time, and accelerated the efforts to implement it.

Economic goals

The European Commission designed 3 different levels of objectives for the Capital Markets Union, from the global economic goals to the more concrete necessity for the construction of an integrated financial system. These economic objectives frame the six intervention areas encompassed by the action plan.

Overarching objectives

Facilitating the financing of both private and public sector on the financial markets The Capital Markets Union aims to ease the access of firms and states to financing, which has become more difficult since the 2008 financial crisis. The creation of a single market for capital would send an incentive to private and institutional actors to invest the capital available, by creating new possibilities of cross-border attractive investments. This renewed possibility of financing may help the economic agents to come back to the level of growth they had before the crisis, impacting positively the employment rate. It is especially true for SMEs which might need more financing than what the banking system can offer them and therefore, would benefit from more accessible capital markets. CMU would also make the institutional investments in infrastructures way easier.

Ensuring the stability and the sustainability of the European financial system through integration Economic stability depends on the diversification of the source of financing. When encountering a crisis hitting a particular source of financing, such as the banks in 2010, it is important to be able to get capital otherwise, both for the states and the companies. That is why giving and incentive to get financing through capital markets with the CMU would make the economy more shock-resistant, because it would depend less on the banking system. On the investors side, stability is ensured by the portfolio and the geographical diversification of the assets. It reduces the loss of value if a specific economic area is hit by a negative shock when you have invested in several types of activities and it reduces the loss if a specific country is touched when you have invested in several countries. Hence, the risk-sharing influence of the CMU may strengthen the European economic stability. Regarding sustainability, the increased access to capital is considered as a mean to finance environment-friendly economic projects and to encourage sustainable development.

Strategic objectives

Improving the competitiveness and the efficiency of the European capital markets, to fight against the "market fatigue" By increasing the range of investments opportunities, a CMU objective is to improve the capital markets effectiveness. This means improving the allocation of capital, leading it to the most efficient economic actors among the European firms, because a single market for capital would have given the possibility to do so. The efficiency of capital markets deals with the competition between the European financial institution : making them gather in a common capital market would give the financial institution the incentive to become even more efficient. Competition would also lead to more diversification in terms of liabilities and assets. Market fatigue is the discredit from which asset and security exchanges suffered after the 2008 financial crisis. It reduces the capital flow on the capital markets and has a negative impact on the economic activity.

Pursuing a stable financial integration, to fight against the "integration fatigue" The improved integration of the capital markets with the CMU is meant to increase cross-border risk-sharing and to reduce the home-bias of the investments. Currently, there are still some hindrances, as the regulation differences among the member-states persuade investors to invest in their home-country. Actually, the diversity of European rules regarding insolvency, restructuring or taxation represents a lack of legal security for investors. As the main point of a single market for capital is to remove the barriers of free capital flow in-between the member-states, the objective is to attract the savings of the richer countries towards the poorer ones. Removing the barriers preventing European exchanges, to act like a unified territory, is the very sense of integration. It counters the "integration fatigue" : the increasing difficulty for the European leaders to pursue the European integration. It is an incentive to invest abroad, therefore reducing the home-bias. Moreover, investing in another country leads to a geographical diversification of the assets possessed, which has a positive impact on the economic stability, as explained previously. Furthermore, investments in emerging economies can yield higher returns than advanced economies, as the idiosyncratic risk is higher.

Increasing cohesion within the European Union to fight against the "eroding consensus" The "eroding consensus" is the increasing difficulty to get the support of the European population for the European institutions' decisions. The erosion is illustrated by the negative response of France and the Netherlands to the European referendum on the constitution of the EU. The Capital Markets Union's goal is to represent a part of the solution to this issue, by improving the cohesion in Europe. Firstly, it is a project encompassing different currencies, therefore encompassing countries outside the eurozone area. Secondly, it involves few changes in the way European institutions work, preventing any opposition to a total overhaul. Finally, it does not require risk-sharing from the member-states, which could have made the population reluctant to the CMU. Its main contribution to the European cohesion is its goal: to equally provide financing on capital markets, across the European territory, and to provide this access on the basis of the economic actors' merit.

Operational objectives

Improving data availability across European countries Investors on the capital markets don't always have the necessary means to gather the needed information in order to invest, while financing institutions do. However, incertitude about their investments may prevent them from investing as much as they could have if they had had the adequate information. The latter would have allowed them to evaluate the worth of an asset and juge if its price corresponds, or not, to its value. Therefore, the first operational objective of the CMU is to increase the information flow to make the price setting on the capital markets more precise.

Facilitating the access to markets As it might be complicated for a small firm to produce the information necessary to enter the capital markets, the CMU's purpose is to set up the required execution infrastructures to ease their access. This means reducing the regulatory obstacles stopping SMEs and start-up to finance themselves through capital markets, so that every economic actor could have an equal access to the capital needed. Concretely, it leads to a simplification of the rules regarding the information production for small issuers.

Strengthening the implementation of the regulation protecting the investors Because of the lack of confidence in the regulatory structures protecting the investors, the amount of capital invested might be reduced. Consequently, the third operational objective of the CMU is to give more strength to the contracts and the rules protecting the capital providers so that they regain confidence on the capital markets. The idea of the project is that legal certainty that they are no going to loose suddenly the wealth they have invested will encourage the use of capital markets as a good mean to yield a profit from the savings rather than keeping it on a bank account.

Actors targeted

The Capital Market Union action plan aims at affecting positively 4 types of economic actors:

Citizens : improving the profitability on savings for retirement and the opportunities of investments If citizens had the possibility to access capital markets in an easy way, they could use their savings to invest instead of keeping them on their bank account. They would do so because of the wider range of possible investments. It may be more profitable for them and increase the money they have for their retirement.

Companies : extending the possibilities to be financed differently than by a bank loan Firms, and especially SMEs which still face difficulties entering capital markets, would get access to European capital in an easier way on a single capital market where the information regulation would have been adapted to their situation. This is particularly true for the start-ups experiencing high growth and in need of a quicker financing to sustain their development.

Investors : reducing the hindrance to invest in another member state As explained previously, the harmonisation of the regulation across the European Union would allow investors to enter other member-state's capital market more easily. In fact, it would reduce their cost of adaptation to the national regulation : the financial regulation of a country would be the one of every member-state. If investing in your home capital market is as simple as investing in another, it would increase the investments opportunities for the investors.

Banks: extending the lending opportunities and encourage sane balance-sheets Because risky investments opportunities would go towards capital markets, a bigger portion of the banks' balance-sheets would be dedicated to the real economy. This is a way for the European Commission to prevent the 2008 financial crisis, when the banks's balance-sheets were composed of too many subprime assets, from happening again.

Action plan

The Commission put forward an action plan for the CMU in September 2015 followed by two legislative proposals concerning securitization. The action plan was launched encompassing mainly 6 areas of intervention with a total of 20 objectives to be achieved through 33 actions. As set out by the commission, these actions would be subject to a mid-term review in 2017 where 9 other priority actions were adopted having regard to what had been achieved and the different challenges that the EU was facing, as for instance Brexit. The original action plan from 2015 entails 6 priority axis, namely: 1) Financing for innovation, start-ups and non-listed companies; 2) Making it easier for companies to enter and raise capital on public markets; 3) Investing for the long term, infrastructure and sustainable investment; 4) Fostering retail investment; 5) Strengthening banking capacity to support the wider economy and; 6) Facilitating cross-border investment.

Financing for innovation, start-ups and non-listed companies

The first priority axis entails actions aiming at supporting venture capital and equity finance through the creation of a pan-European venture capital fund-of-funds with a total amount of €2.1 billion to boost venture capital and start-up financing; proposing the revision of the EuVECA and EuSEF and also implementing action in the field of tax incentives for venture capital and business in general. Furthermore, it aims at overcoming information barriers to SMEs investment as in the first Green Paper launched by the Commission on the CMU, the Commissioner for Financial Stability, Financial Services and Capital Markets Union at the time recognised the importance of facilitating access to finance by SMEs. This translated into 2 main actions, the first aiming at strengthening feedback given by banks declining SME credit applications and the second by mapping existing local or national support and advisory capacities across the EU to promote best practices. Last but not least, the Commission wants to promote innovative forms of corporate finance through the studying of crowdfunding possibilities, the development of a coordinated approach to loan origination by funds and assessing the case for a future EU framework and the promotion of private placements.