How to Achieve a Functioning Capital Markets Union
With growth being on top of Europe's political agenda, a properly devised Capital Markets Union – including the EU's partner countries such as Switzerland – is a priority, as it develops the continent's undersized capital markets.
The European Union (EU) has since the launch of its Single Market in 1992 made considerable progress when it comes to financial market integration. The EU's total market capitalization, for instance, has increased from 1.3 trillion euros in 1992 to 8.4 trillion euros in 2013. The recent establishment of a Banking Union (BU) has been particularly important, but a lot remains to be done in order to facilitate the crucial role of the financial sector in supporting economic growth. (See box for additional information). Some of Europe's capital market segments remain heavily regulated and underdeveloped. As a consequence, the EU's capital markets are much smaller than those of its largest trading partner, the US. A functioning Capital Markets Union (CMU), as devised by the new European Commission, offers the opportunity to open up new sources of funding and increase Europe's resilience to external shocks. Furthermore, financial markets do not stop at the EU's borders.
The Swiss Finance Council (SFC), an organization founded by Credit Suisse Group AG and UBS AG in 2013 that represents the interest of internationally active Swiss financial institutions, in a recently released discussion paper highlights that "conceiving, developing and implementing both the BU and CMU in conjunction with key partner countries − as interlocutors, contributors, and partners − would be of great mutual benefit. (See box below for additional information about the SFC)
Banks Lend to European Firms, Capital Markets to US Firms
A major difference between Europe and the US is that the majority of corporate funding stems from the banking system in Europe, while it stems from the capital markets in the US. Companies tend to face fewer obstacles and have an easier access to capital markets in the US than in Europe. The US example demonstrates that not only large firms can use securities such as bonds or equities for their funding, but small and medium-sized enterprises (SMEs) too. "The heavy reliance on bank funding is causing severe economic damage in Europe, especially for SMEs, which contribute to almost 60 percent of value added and two-thirds of its employment," the SFC states. While the provision of credit to European firms is still dominated by EU financial institutions, non-EU institutions provide a significant proportion of the total – a share likely to continue to grow (see adjacent figure).
Market Fragmentation Weighs on Growth, Leads to Higher Costs
"Europe's challenge involves more than creating alternatives to bank lending… It needs to make the structure of the financial system more competitive and efficient – and ultimately more growth-friendly," the SFC stresses. National differences in contract law, insolvency law, taxation, consumer protection, and payments and security settlement systems, are often cited as factors hindering a further integration of the EU's financial market. A truly integrated European capital market has a very large potential, which one could imagine when looking at the US. The issuance of corporate bonds represents nearly a quarter of total debt in the US and only an eighth in Europe. US capital markets are not only larger, but also more liquid, ultimately leading to cheaper funding for US companies – a further disadvantage for the competitiveness of European firms.
European Capital Market Could Be Double its Size
Also, US equity market capitalization stands much higher: at 92 percent of GDP compared to 42 percent of GDP in the euro area. The initial public offering market is generally much more active in the US than in Europe. Had European capital markets issuance been similar to that of the US as a proportion of GDP between 2009 and 2014, the market would have been more than double its actual size: 9 trillion euros rather than 4 trillion euros (see adjacent figure). The leveraged-loan segment, investment grade bonds and high yield bond markets are estimated to have the biggest growth potential.
Making the Right Choice
Europe currently stands at a critical juncture. "No country in Europe, in or outside the EU, can afford to turn its back on open markets and cross-border engagement. … Rather, Europe can actively seek to prosper by taking a more expansive, multilateral approach, keeping markets open, and engaging particularly with major partners," the SFC concludes. The inclusion of partner countries, such as Switzerland, in the CMU could enhance capital market depth and decisively strengthen Europe's economic and financial system.