03 February 2016

CEPS: Europe’s Untapped Capital Market: Rethinking integration after the great financial crisis

I. Building Europe’s capital market: Guidelines for an action plan

- This report builds upon an intensive year-long research effort, enriched and guided by discussions within a group of experts, the European Capital Markets Expert Group (ECMEG), composed of stakeholders, academics, policy-makers and industry experts. The aim of this report is to contribute to the debate at the EU and international level on what kind of Capital Markets Union (CMU) Europe needs.

- The report offers a comprehensive overview of the current state of financial integration in Europe and an assessment of major barriers to further capital market integration.

- More integrated European capital markets have been a long-awaited outcome of European policies, to ensure greater financial stability and sufficient funding for EU firms competing in a global economy. Financial integration stimulates further financial development, which can ultimately advance economic development and thus produce more growth and jobs.

- The lack of cross-sectional risk sharing in Europe is the main source of the recent retrenchment of capital flows due to the crisis, after flooding with credit southern European countries in past years. Financial fragmentation is now an important contributor to the growing funding gap for companies at an early stage of development that are in need of fast liquidity injections, and for mid-sized fast-growing companies that are looking for cheap and stable (equity or debt) funding opportunities to expand their business activity.

- Improving the quality of the financial integration process is a core aim of the Capital Markets Union project, which should thus promote the removal of legal and economic barriers to the free movement of capital and financial services in order to create a complementary EU-wide, crossborder private risk sharing mechanism to support the public ones.

- While CMU and Banking Union aim at more private risk sharing, they differ in some respects. In particular, CMU may not necessarily require the creation of new institutions and public risk sharing mechanisms, such as a common fiscal backstop for bank deposits. The CMU plan should entail a set of reforms to reorganise and strengthen the current institutional framework and to remove major economic and legal barriers, so to leave to the single market the decision if Europe needs 28 equity markets. Unlike Banking Union, there is no emergency in the financial system that requires an immediate policy answer. CMU can be spread over the years, but with a detailed and firm timeline, as well as measurable objectives, to ensure certainty.

Methodology for the barrier removal test

- Due to the nature of a financial claim in a market environment (with dispersed monitoring), the legal system (calibrated for investor protection) is a cornerstone of the financial system for public and private remedies, which supports a solid financial integration process. A weak legal system does not yield deep capital markets.

- Indeed, as financial sophistication increases, there is a pressing need for a more effective system of rules and an informational infrastructure (disclosure rules) in order for market mechanisms to 12 complement bank lending and create a financial ecosystem that is conducive to a more diversified resource allocation (private risk sharing).

- Nonetheless, both financial institutions and markets face specification costs (ex ante) and monitoring costs (ex post), due to the inability to write the ‘perfect contract’ or to opportunism.

- To deal with the information asymmetry that creates moral hazard and contract incompleteness, financial contracting in market-based systems requires public information collected and reelaborated by third parties, on top of private information. This can happen alternatively via contracting or renegotiation. ‘Contracting’ is the process leading the investor to enter a financial transaction after using all the information available to price the product and the credit risk of the counterparty (pre-investment). ‘Renegotiation’ is the process of redefining the terms of a financial contract, via contractual negotiation, or exiting a financial transaction, via a sale in the secondary market, before the end of the contract (post-investment).

- The financial contracting approach is used in this report to identify and classify barriers on the basis of their harm to cross-border trading. This approach reduces discretionary actions and increases measurability against well-defined objectives. It also helps to draw a line between measures that require harmonisation and areas that can be left to regulatory competition among member states.

- Contracting and renegotiation take place via three key components: price discovery, execution and enforcement.

o Price discovery is the process of ‘discovering’ the market price that is the closest approximation to the reserve value of the investor, considering his/her assessment of counterparty risk or of the value of the underlying asset at that moment in time.

o Execution is the set of procedures that are involved in the execution of financial transactions taking place with the contracting or renegotiation phase. This includes market entry and exit requirements.

o Enforcement is the process of ensuring the smooth performance or renegotiation of a financial contract, i.e. the enforcement of private contracts, including minority shareholders, retail investors and creditors’ rights.

- A ‘barrier’ can be defined as any domestic or European rule (law), (market and supervisory) practice or procedure that impedes data comparability (price discovery), fairness of procedures (execution) and legal certainty (enforcement) in the contracting or renegotiation phases of a financial transaction. Barriers can be artificial (exogenous to the transaction) or structural (embedded in the transaction), as well as domestic or cross-border (or both). 

- Barriers are most harmful when they make the costs of a financial transaction unpredictable. The more unpredictable costs become, the more negative the impact will these barriers have on financial contracting. In effect, at the core of every market-based financial transaction is the ability to discount future cash flows. The less is the information about direct and indirect costs of the transaction that may affect future cash flows, the lower is the ability to discount future scenarios. Once discounting is impaired, the financial transaction will most likely not take place.

Measurability

- Measurability of objectives plays an important role for the success of a financial integration plan like CMU, as it ensures accountability. With no accountability, the political support to achieve the objectives of this complex project would most likely fade away. As a consequence, we can identify three measurable objectives:

a. Improving data comparability about underlying assets and financial instruments;

b. Reducing discrimination in market entry and exit; and

c. Increasing leg

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