Can the EU come to an agreement on the capital markets union?

The concept of a union between the capital markets of EU member states is an idea few would dare dismiss. Promising to bring growth across the region, EU commissioner for financial services Lord Jonathan Hill’s plan to create a capital markets union (CMU) is widely accepted to be a good idea, and even long overdue. When looking at the details of such a union, however, some issues are likely to cause disaccord – and potentially even challenge the EU's structure.

Since Mr Hill published plans for the CMU in February 2015, evidence of its worth has been recognised across the board.

“This project is an excellent example of the sort of policy-making and reform Europe should be doing,” Harriet Baldwin, economic secretary to the UK's HM Treasury, said at think-tank Bruegel’s 10th anniversary event, held in London in October, which focused on the topic of the CMU. “It will have a very positive impact on businesses and investors across all 28 member states, including here in the UK. It will stimulate investment and growth, improve European competitiveness, and help deliver jobs and growth across the whole of the EU.”

Whereas alternative finance providers, such as asset managers and private equity funds, finance some 80% of the economy in the US, the figure is far less in Europe, where bank lending takes centre stage. While this is not necessarily a bad thing, the need to make more funding available within the EU requires alternative sources of funding, which could relieve banks and free up funds for clients that are less able to access capital markets.

So what does the CMU proposal actually entail? 

Low-hanging fruit

A comprehensive package, delivered on a step-by-step basis, the European Commission is looking to implement CMU initiatives by 2019, with the European Parliament pushing to achieve a fully integrated single EU capital market no later than 2018. 

Left, right and centre, there has been criticism that the initial action plan by Mr Hill, which was tabled in late September 2015, was not ambitious or fast enough. Indeed, the proposal includes some elements that have already met with consensus among the concerned parties and should therefore be easy to push through.

“If you look at the CMU proposal that is on the table now, it is not ambitious and concrete enough,” says Cora van Nieuwenhuizen, a member of the European Parliament (MEP) for the Alliance for Liberals and Democrats for Europe (ALDE) and member of the Economic and Monetary Affairs Committee (ECON).

In this context, plans for a new prospectus directive – which would make the process of accessing capital markets simpler, by cutting down on documentation and cutting the high cost and complexity of drawing up a prospectus and getting it approved by national regulators – is “low-hanging fruit”, according to Ms van Nieuwenhuizen. “We had already planned to revise the old [prospectus directive], so that is not controversial at all,” she says.

The European Commission’s latest prospectus regulation proposal was published on November 30, 2015. Among other things, it calls for the introduction of a free and searchable online database, as well as initiatives such as shelf-registration of disclosure documents, which would cut down on the paperwork and timeline associated with a securities issue.

Law firm Norton Rose Fulbright pointed out one aspect that is “controversial” – an aspect that calls for the application of a single disclosure regime to all securities, and with it the removal of the €100,000 denomination distinction for disclosure purposes. Currently, wholesale bond issues, mainly aimed at institutional investors and issued in minimum denominations of €100,000, require a lower level of disclosure than retail bond issues. But this is not expected to disrupt the implementation of the prospectus directive review.

Easy pickings?

Apart from the prospectus directive and regulation on European long-term investment funds, which was adopted in April 2015, the European Commission’s action plan, introduced in late September, includes consultations on covered bonds and venture capital funds in the near term. The commission wants to produce legislative proposals for venture capital funds and consult on cross-border fund investments in 2016.

Dörte Höppner, chief executive at Invest Europe, an association representing Europe’s private equity, venture capital and infrastructure sectors, explains that while Invest Europe member companies have invested in about 5100 companies per year over the past five years, funds are still lacking scale. “You need to be able to raise at least €150m per fund if you want to attract the large institutional investors with deeper pockets,” she says. “By matching private capital with money from the EU budget or the European Fund for Strategic Investments to create larger funds of funds, this would bring more global institutional investors to venture capital and support more of Europe’s growing companies.”

It is widely agreed that it has to be made easier for smaller companies to access financing outside the bank market. This could be done by encouraging equity investment, and the role venture capital and private equity could play in this is often cited. However, there are still significant national barriers to investment, according to Ms Höppner. “At the moment, some member states impose additional fees, charges or requirements on EU fund managers seeking to market their funds in [their] jurisdiction, so one of the most important steps the commission could take is to prevent this practice,” she says. 

A consultation on the cross-border marketing of funds represents a first step in the quest to determine where these 'national barriers' are – but there are no plans yet on how to tackle them.

Meanwhile, the ongoing consultation on the impact of existing financial regulation is another initiative establishing a consensus throughout industry, as well as most of the EU. But meaningful results of the regulatory review could be hard to come by, according to one member of the European Parliament’s ECON committee, given that most of Mr Hill’s staff are from the old guard of previous commissioner, Michel Barnier, under whom most of the existing regulatory framework was authored.

Good, but good enough?

Another immediate measure that could cause friction is the new draft regulation on European securitisation.

Securitisations have a poor image on both sides of the Atlantic, largely due to their role in the 2008 financial crisis. But, while in Europe securitisations of mortgages and other assets were not as commonplace pre-crisis as in the US, where residential mortgage-backed securitisations were the root of the Lehman Brothers’ collapse and subsequent bank bailouts, it is in the US that such products are again flourishing.

Now, Europe hopes to renew interest in the product, with a proposal allowing securitisations that adhere to the principles of being simple, transparent and standardised (STS). The idea is that by allowing banks to securitise assets, more cash can be freed up on their balance sheets, which, in turn, can be invested into the economy. But the topic is not without controversy, and STS securitisation proposals are not convincing all parties.

Some MEPs remain sceptical, such as Molly Scott Cato, a member of the European Free Alliance, Green Party and ECON committee, who described securitisations as “an attempt to pretend that hiding risk is really reducing risk”. In a debate on the CMU in the plenum of the European Parliament on October 8, she said that new securitisations should not to be allowed to “involve the tranching of assets with varying levels of risk" and proposed "that we do not allow the return of credit default swaps”.

Others recognise the need for a re-introduction of the product, but remain cautious and await further clarification on the details of the proposal, such as MEP for the European People’s Party [EPP] and ECON Committee vice-chair Markus Ferber. “When Mr Hill presented the Green Paper in the ECON committee, he said he doesn't want to have the bad loans securitised, he wants to have the good loans securitised,” says Mr Ferber. “But by only securitising the top loans, you make it harder for banks to give out loans because of the banks’ capital requirements.

“I understand that there is a need for some banks to optimise their balance sheet, but you will not create trust and confidence in European securitisation markets if you start with the bad loans. I have a feeling that we are scratching on the wrong part of the problem.”

Securitisation proposal insufficient?

Meanwhile, some industry experts deem the current proposal insufficient to re-launch securitisation in Europe.

According to Eric Litvack, head of regulatory strategy at Société Générale's global banking and investor solutions operations, the starting point for the new securitisations “is such an unfavourable capital treatment that the landing point is still a significant disincentive to securitise”.

He explains that, typically, it can be more cost efficient to keep the assets qualifying to be packaged into securitisations on the balance sheet or to sell them off altogether.

“Banks would have to hold a minimum proportion of the securitised assets on their books – the skin in the game – but quite often they don’t even get down to the minimum 5% because you can’t necessarily distribute everything you securitise,” he says. “That surcharge is a drag on securitisation. It is very possible that the outcome would still be more covered bonds than securitised assets as you move towards what is least penalised.”

Another problem lies in the practicalities of the proposal. STS securitisations require 57 different criteria to be met, by both the issuer and investor. ALDE’s Ms van Nieuwenhuizen is calling for the criteria to be cut – a step that would be welcomed by both the buy-side and sell-side.

Alexander Schindler, head of the European Fund and Asset Management Association, says that investors will be willing to buy securitisations, but there is a need to establish certain technical standards, such as prospectuses and ratings, so that institutional investors will be able to invest. Then it would be “in a position to really develop a deep and liquid market”, he says. “I think these instruments could be interesting, in particular given the current zero-interest-rate environment, at least in the euro context.”

But not only are there differences in opinion between the industry and legislators, political camps in the European Parliament are even more divided over the securitisation issue.

“The left-right split is obvious and you need to find the balance in the middle to make sure you get a majority of political support,” says Kay Swinburne, MEP for the European Conservatives and Reformists Group, and a member of the ECON committee. “Lobbyists are already trying to push the envelope as far as possible – but the more complicated it gets, the less political support you get across the board.” She says that, in future, there could still be scope for implementing more advanced securitisation products.

The complexity of the issues that one single proposal within the CMU framework – such as securitisations – causes, gives a taste of the scale of the friction that could be caused by implementing the wider CMU idea.

Provoking controversy

More controversial initiatives include cross-border tax changes and a harmonisation of insolvency schemes, both of which have been envisaged for implementation in 2018 or 2019. However, such issues of national competencies are likely to prove difficult, if not impossible to push through. Yet, there are good reasons to tackle these issues as they will further support the workings of a genuine CMU. And the call for it exists. “[For investors,] a greater degree of harmonisation is always better, and easier than to invest cross-border,” says Mr Schindler, adding that all institutions would appreciate a reduction in obstacles.

The differences between insolvency regimes in the EU's 28 member states are enormous, according to Ms van Nieuwenhuizen. She suggests that discussions about coordinating insolvency regimes should be started, as this would “allow countries to share best practices and maybe, on a voluntary basis, countries could move in the same direction”.

Still, the odds of reaching an agreement on a common insolvency scheme are not good. “The insolvency schemes are too deeply rooted in national legislation and national frameworks,” says Mr Litvack. “Getting to a common scheme would be a very significant lift – I am not sure that there is a political desire to go there today, as it is not yet clear to what extent this would be a significant liberator of financing channels.”

Creating problems?

One critical voice is EPP’s Mr Ferber, who says that he “will not raise [his] hand for a proposal, which will result in a full harmonisation of civil law”, reasoning that it would create more problems than it might solve in the area of financial markets.

Mr Schindler says: “There is a lot of national gold-plating with regards to the implementation of EU regulation, and we have to get rid of these differences. Ultimately, you aim at harmonising the European capital market, and currently there are a number of tax barriers preventing investors to invest cross-border.”

He adds that a pan-European personal pension product, while equally difficult to implement, should also be targeted. He believes that it would bring additional benefits, such as boosting retail saving flows into the capital market, which would contribute to providing longer term funding to EU economies.

“While CMU is a project that has to move step by step, it probably requires even stronger integration – for instance, in the case of internal supervision,” says Roberto Gualtieri, chair of the ECON committee and MEP for the Group of the Progressive Alliance of Socialists and Democrats in the European Parliament. “We need to start working on supervisory convergences. I know that we can’t do the same integration we did with the banking union by tomorrow, but we have to go into the direction of a real, strong supervisory convergence and integration.”

The idea of creating a banking union-style single supervisor for the CMU is a suggestion that provokes strong disapproval from the UK. “There are those who consider that the creation of a new single supervisor is necessary for achieving the objectives of CMU, and it has been suggested that the UK is holding the process back,” Ms Baldwin said at Bruegel’s CMU event in October. “I want to be very clear on this issue: capital markets across member states are of very different shapes and sizes, with different risks and opportunities. In breaking down barriers between them, it’s essential that the local knowledge and expertise of national regulators is preserved and utilised. That will ensure reforms are as effective as they can be.”

The CMU taboo

With countries such as the UK not likely to agree to allow the CMU to tackle issues of national competencies, the oft-quoted option of a 'Europe of two paces' could well return to the fore. This would see the creation of two groups within the EU: those willing to further co-operate and harmonise, and those unwilling. This would likely see a split along the lines of eurozone and non-eurozone member states.

A eurozone CMU could bring some benefits to the single currency area, too, as it already is the broadest and deepest funding currency within the EU. “The CMU is a pan-European project – and it is important to look at a Europe of 28 – but that shouldn’t prevent you from also strengthening the eurozone,” says Mr Litvack. “The euro would benefit from initiatives at the sub-regional level. But this is an area where the commission has to tread carefully.”

Yet, with the UK’s referendum on EU membership scheduled for late 2017, before the most contentious CMU topics are set to be tackled in 2018, the future look of the CMU is still up in the air either way. Issues such as insolvency regimes and tax harmonisation are a matter of political negotiation. And while a blanket handover of national competencies to the EU is unlikely, in some instances there might be scope for compromises.

“Regarding national tax treaties, a compromise could be [a ruling saying] that you can always benefit from the most positive tax treatment for any specific investment,” Mr Schindler suggests. “As long as we don’t have a fiscal union, we will not have a harmonised tax system – that is unrealistic.”

With so many degrees of harmonisation possible, it will be years until the final shape of a CMU is known – and what its impact on the structure of the EU will be.