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This paper has explained how CMU can support economic growth and stability. It has shown how better matching of savers and borrowers leads to greater allocative efficiency and thereby supports economic growth. It has also illustrated how increasing private-sector risk sharing could lead to lower volatility of incomes and consumption, thereby supporting economic stability. The key channels by which this occurs are improving access to funding by borrowers, better matching of investors to financial risk, and more flows of investments across borders. In combination these are the channels through which the financial diversification and integration envisaged under CMU can help to support economic growth and stability.
Better matching of savers and borrowers will require a change in the structure of the EU financial system. Presently, banks dominate the EU financial system while the scale of market-based finance in the EU is much smaller, especially when compared to the United States. The US financial structure developed partly as a result of restrictions on banks — including the Glass-Steagall Act, Regulation Q and state restrictions — and a key question is therefore to what extent initiatives under CMU can (or may wish to) achieve similar outcomes through different means.
Improved private-sector risk sharing will require an increase in cross-border investments so that the correlation between domestic incomes and consumption can be reduced. Consumption volatility picked up sharply during the crisis.
And past empirical studies suggest that private-sector risk sharing in the euro area and the EU has generally been less effective than within countries with a federal structure. Both indicate that there are potential risk-sharing benefits to be harnessed through CMU.
Reflecting this analysis the paper highlights two major reform areas:
Bringing borrowers to the market. This essentially entails establishing mechanisms allowing households and firms to access financing from market-based structures. At the general level, there are two potential dimensions to this: direct forms of market-based finance such as equity and corporate bonds, in which banks do not provide the financing extended to borrowers; and indirect forms where banks and markets act together. Direct forms of finance could be helped through support for public platforms aimed at smaller companies and private financing for medium-sized companies.
Indirect forms of finance could be supported through measures such as those already set out by the Bank of England and the ECB to revive the securitisation market. But it is also worth exploring whether there are other ways in which banking sector expertise could be harnessed while sharing risks with the non-bank sector. More generally, research is needed to understand why, although the leverage of EU and US companies are broadly similar, those in the EU have less quoted equity and more bank loans.
Bringing investors to the market. If more borrowers are to come to the market, then more funds will need to be made available to them. Bringing investors to the market has two key dimensions: directing more household and corporate-sector savings towards vehicles that will invest via capital markets; and encouraging more investors to allocate capital across the European markets as a whole.
In the case of developing investment vehicles, an important consideration should be the diversity of the investor base, which should include varied funding profiles, trading horizons and risk preferences if the risk of liquidity drying up is to be minimised. As for cross-border investments, an influential factor is the extent to which investors exhibit home bias. Reforms should therefore focus on reducing transaction costs, standardisation of investment products and benchmarks, and efficient post-trade arrangements.
The paper has also explained that although the primary motivation for CMU is to support economic growth and stability it is also likely to have implications for financial stability. It has illustrated how benefits from better matching of savers and borrowers, and private-sector risk sharing could make the EU economy and financial system more stable, but that there is a risk of capital flight from national economies during stressed conditions. Experience from the crisis suggests that fixed income assets covering both loans and bonds proved vulnerable to redenomination risk and capital flight. Other assets, notably equities, proved less vulnerable to this risk, as might be expected given they are a claim on a real, rather than a nominal, asset. This suggests that the overall design of CMU should be assessed for its implications for financial stability in the light of recent experience.
In summary, there are a number of paths along which savings can be transferred to borrowers. Diverting funds, particularly from retail savers, away from banks and towards mutual, and other, investment funds and equity instruments would improve the chances of the EU reaping the benefits of capital markets. In economic jargon, these benefits include more allocative efficiency and private-sector risk sharing. But a range of reforms will be needed to achieve these benefits. These are likely to include targeting both investors and borrowers, where reforms across these areas are likely to be mutually reinforcing. This paper has provided an overview of some of the issues related to a European CMU but there is clearly a lot more work to be done to understand impediments, flesh out options, fill data gaps and assess priorities.
Full Financial Stability Paper