As Prepared for Delivery
June 15, 2023
IMF Background Note on CMU for Eurogroup
Colleagues, we continue! My thanks to Paschal for inviting me to speak on European capital markets. Definitely a topic close to the IMF’s heart.
Let me put the bottom line at the top: Europe absolutely needs capital market union. To create more choices for savers and real investors. To mobilize funding for innovation. To drive a convergence in the cost of funds across the union. To enhance resilience through greater private cross-border risk sharing. And, quite frankly, to catch up with the US on productivity and growth.
Nowhere is the need greater than in the Green Transition. This is existential: either we invest in economic change and slash our emissions, or—quite literally—life on Earth will eventually boil. The challenge calls for resolve, a willingness to take risks on new technologies, and—yes—money. A lot of money.
The European Commission estimates Europe’s investment needs related to the Green Transition at about four trillion euros by 2030. Four trillion euros! You are finance ministers. You make budgets. You understand that fiscal space is a real thing. You know, therefore, that the public sector cannot finance this alone. Moreover, many of the investments will be in areas in the natural domain of the private sector. Most of the total will have to come from banks and capital markets.
Paschal has asked me to be strategic. I want to focus on the narrative. Unlike banking union, where the logic is clear, CMU is often seen as a stack of technical files without a unifying story. Today, as I speak from Luxembourg, a small country that is a giant of the capital markets, I want to focus on how it all fits together.
Let me begin with some context. How do the European capital markets compare?
Let’s start by looking at how companies finance themselves. In the euro area, only about 25 percent of companies’ liabilities comprise tradable instruments—debt securities and listed equity. The rest are bank loans, loans from nonbanks, and a large chunk of unlisted equity. A lot of this reflects the important role played by small and midsized enterprises in Europe: I think of companies that prefer funds from family and friends to the effort of listing on a stock exchange.
As I will explain, this focus on relationships comes at a cost. In the US, 70 percent of firms’ liabilities comprise tradable debt and equity. In Japan, the tradable segment is 50 percent. In the UK, 40 percent. Even if we don’t want to go all the way to the US model, Europe has some catching up to do.
Second, a brief look at the financial system. In the euro area, total financial sector assets amount to some 60 trillion euros, about the same as in China, and not far short of the United States’ 80 trillion euros. Europe and China remain bank dominated, with banks holding about two-thirds of financial sector assets in the euro area, and an even higher share in China. In the United States, in contrast, only one-third of the total is held by banks.
Staff has also documented how European capital markets are fragmented along national lines. For example, European institutional investors exhibit significant home bias at the member state level.
Finally, let me turn to households. The EU is wealthy. For retirement income, it is also much more reliant on social security and public pensions than the US. As a result, the EU’s stock of household financial assets amounts to 2.3 times GDP, versus over 5 times GDP in the US, where people rely more on private savings and pensions. About 30 percent of these assets are held in cash and bank deposits in the EU, versus only 13 percent in the US. Less than half are invested in private pension and investment funds in the EU, versus over three-quarters in the US.
In general, we see less risk-taking in Europe.
Key message: Europe can benefit from more risk-taking. Let me elaborate.
First, innovation. Many creative companies begin life without physical assets. Their assets are their ideas, and ideas are intangible. But banks want tangible collateral, something you can touch. No collateral, no loan.
Europe has venture capital providers, but they tend to be better at funding early-stage research and less good at financing growth. One anecdote I hear often is about creative European companies migrating to America once they reach a certain size. IMF research finds that, even within Europe, collateral-constrained firms tend to grow faster where capital markets are deeper.
Second, cost of funds. IMF research identifies a wide disparity in financing costs across the EU. A firm in Spain or Italy will pay more for its funding than a firm in Germany or France. These are identical companies: same size, profitability, leverage, and fixed-asset endowment, in the same sector, differentiated only by national domicile. We need a more level playing field in Europe. And we need a more level playing field across the Atlantic.
Third, risk sharing. Again, this is intuitive. If I am a Slovak firm selling my equity to investors in Portugal, then if my share price falls the hit is taken in Portugal, not Slovakia. Similarly, if I perform well while the Portuguese economy slumps, the Portuguese investors are cushioned. IMF staff estimates that this “consumption smoothing” effect is four times stronger in the US than in the EU.
Europe needs more of this cross-border private risk sharing. This is about the ‘U’ in CMU: ‘U’ for union. We need to make it easier for a firm in Vilnius to issue a bond in Frankfurt, for a saver in Paris to buy shares in a company in Bucharest.
Let me now move to the tough part: how?
I want to start by giving credit. You have done a lot. Back in 2019 we at the Fund made a number of policy suggestions. I am happy to note that a lot of what we counseled is being done.
In crafting our advice, we noted that one difference between banks and capital markets has to do with risk. If you are a small saver and you want safety: insured bank deposit. If you want a better rate of return: investment fund. But with higher returns come higher risks: mutual fund shares can go down in value as well as up. The capital markets are a place for loss as well as profit.
Bottom line: we need animal spirits, tamed by market discipline.
Market discipline requires transparency. Whereas banks guard their data, the capital markets revolve around public information. Companies publish audited financial statements and prospectuses. Investors read them. The middleman is cut out. Overheads are reduced. These are the basics of market finance.
I want to applaud you for the European Single Access Point for corporate information. I hope it can be taken to completion swiftly. And, in the years ahead, I urge you to take financial disclosures to a whole new level, using every new technology at your disposal.
Let me turn briefly to oversight.
First, consumer protection. Auditors and regulators ensure that disclosures are full, clear, and truthful. This is the essence of protecting the retail investor. We at the IMF understand that a lot of the best regulatory expertise in Europe sits at the national level. But we have also noted that standards can vary across countries. That is why we advise you to take steps to strengthen supervisory convergence.
Second, prudential supervision. Here, I am focusing on two specific types of systemic nonbank financial intermediary: large complex investment firms and central counterparties, or “CCPs.”
Large investment firms engage in leveraged maturity transformation, just like banks. CCPs reduce risks and raise efficiency, but they also concentrate tail risk in a few key nodes. If some banks are too big to fail, I would say some CCPs need to be “impossible to fail.” For years, we at the IMF have argued that such key intermediaries should be supervised just as intensively as large banks.
Next, a word on corporate insolvency. We know that this is an area deeply steeped in national legal tradition, and mostly under the remit of justice ministers rather than the Eurogroup. But the fact remains that there is a strong case for more harmonization of national insolvency frameworks across the EU. I commend the Commission for having made meaningful progress. But, if we are talking here about “Next Generation CMU,” should we not try to go further?
What do I mean? I have in mind an example that you set in banking. There too, 15 years ago, Europe had only national insolvency. In the heat of crisis, you forged the Bank Recovery and Resolution Directive. The BRRD, in essence, is a carveout from national insolvency for failing large banks. So, let me put this to you as a question: could you imagine a BRRD for the corporate sector? Something to think about!
Two parting thoughts, one on the nexus between banking and capital markets, the other on the role of financial centers.
First, banking: sorry if not all of you want to hear this, but fast-tracking CMU will require movement on banking union. Why? Because banks are gateways to the capital markets. Even in the US this is true: banks may own only one-third of US financial sector assets, but their influence stretches much further, into financial product design, underwriting, distribution, market making, asset management, and much more.
If a midsized Estonian firm wants to issue a bond for the first time, where does it go? To an investment bank. If a Dutch retiree wants to diversify out of bank deposits, where does she go? To her bank. Colleagues, my point is that legislative change can only facilitate. At the end of the day, someone has to build the capital markets. In many areas, that will be the large cross-border investment banks.
So, if we cannot make progress on banking union, if we cannot build home-host trust so that cross-border banking can be a reality in Europe, then CMU is unlikely to achieve its full potential. Agreeing with Paschal and his efforts, I urge you to make progress on all fronts.
My last thought, on financial centers. We all know that capital markets rely on clusters of expertise. That is why we have New York for equity and debt, and London for interest rate derivatives and foreign exchange. Within the EU, too, we have hubs in Paris, Frankfurt, Dublin, here in Luxembourg, and elsewhere. CMU is not an effort to create 27 financial hubs in Europe! No! CMU is about creating networks.
As these networks are built, my advice would be to maximize cooperation with financial centers outside the EU. I do not underestimate the risks and challenges of financially integrating with countries outside the EU. But still, the regulatory equivalence process should be exploited to the maximum. And, as regards the UK, we can hope that having the Windsor framework in place creates a basis to build a new and mutually beneficial capital markets relationship.
Colleagues, someone with a good sense of humor recently said to me, the CMU is like the Yeti: “everyone talks about it, but no one has seen it.” Please, go build the CMU! With these words, I wish you a fruitful brainstorming in the months ahead. I very much look forward to seeing the new strategic priorities for the European capital markets that you will set out as guidance for the next political cycle!
Thank you!
Source – IMF