Bundesbank welcomes the creation of a Capital Markets Union

Flags of the European Union in front of the Berlaymont in Brussels ©Fotosearch.de
The Bundesbank supports the creation of a European CMU. In its response to a Green Paper published by the European Commission, the Bundesbank said that the CMU project provides an opportunity to further develop and integrate Europe's capital markets. The European Commission's Green Papers are designed to encourage debate on individual topics which then often triggers legislative initiatives at European level.

The Bundesbank believes there is a need for action because capital market development and integration in Europe remain incomplete. It points out that corporate finance in Europe is mainly bank-based, whereas US firms' external funding is more market-based. The Bundesbank suggests that this reliance on bank borrowing may have magnified the negative impact of the financial crisis of 2007-09 on economic growth in Europe. More developed and integrated markets for debt and equity could have provided valuable funding alternatives to the real economy when banks reduced their lending.

The Bundesbank notes in its statement that cross-border capital flows picked up in the early 1990s, signalling stronger capital market integration. However, these capital flows were likewise dominated by bank credit, which during the financial crisis showed a sudden reversal to a domestic bias. According to the Bundesbank, the financial crisis contributed to the fragmentation of the financial markets. Although a large proportion of equities in the euro area are held by non-domestic residents, other market segments, such as the market for venture capital, are highly fragmented. Furthermore, cross-border investment is often impeded by institutional barriers.

"Double dividend"

The Bundesbank believes that a Capital Markets Union could generate a "double dividend". A higher share of equity in corporate financing and an increase in cross-border equity capital flows would make the European financial system both more conducive to growth and more resilient to shocks.

The Bundesbank argues that firms’ demand for external equity increases in parallel with their need to finance investment opportunities from research and development (R&D), as, conversely, experience in the United States and Europe shows that a larger supply of external equity financing has a positive impact on innovation and investment. The Bundesbank recommends that the CMU project should pay particular attention to the positive impact of venture capital investment on the innovatory potential of start-ups.

The Bundesbank's statement also discusses the stabilising function of equity capital. It says that since equity provides a buffer against potential losses, firms with a sustainable business model and high equity capital buffers can absorb greater shocks than deeply indebted firms. The Bundesbank statement points out that equity capital can also have a stabilising effect in terms of country risk. Thus if a certain region or country is hit by a local macroeconomic shock, the shareholders of affected enterprises bear the losses. If this equity comes not just from the region concerned, but also from cross-border investors, the result would be cross-border risk-sharing. Losses would then also be shouldered by investors from other EU member states. The Bundesbank explains that this minimises the risk of further imbalances arising from income or consumption effects and reduces the necessity for additional fiscal risk-sharing channels in the EU, which have featured prominently in recent debates.

Three priorities for reform

The Bundesbank sees three priorities for a Capital Markets Union. First, it calls for a reform of national insolvency legislation, which in some member states currently impedes private-sector debt restructuring. Reform could facilitate debt restructurings, while banks would have better options for removing legacy assets from their balance sheets, and funds could once again be used productively, which would aid economic recovery.

Second, the Bundesbank calls for the dismantling of barriers to the development and integration of European capital markets in order to give enterprises easier access to capital. The Bundesbank sees one option in greater harmonisation of the legal framework for securitisations and loan funds. It also argues, however, that the CMU should equally address more ambitious reforms to rules and regulations relating to the structure and integration of the financial markets. These include takeover rules, corporate governance rules, and aspects of tax law and insolvency law.

Third, the Bundesbank cautions that the CMU project should not create additional distortions. For example, creating incentives to invest in certain asset classes (eg through targeted lowering of regulatory standards) could promote an inefficient use of funds or encourage investors to incur excessive risk. In the Bundesbank's view, such developments could foster risks to financial stability.

Thorough analysis of the need for action

In its statement, the Bundesbank points out that full harmonisation of national regulations may not be needed or possible for the CMU. However, it notes that the EU can play an important role by enhancing transparency regarding different national regulations.

The Bundesbank adds that, before taking measures aimed at simplifying the conditions for raising capital, the actual need for action must also be analysed thoroughly. It explains that a lack of funding opportunities is not necessarily the only reason for low levels of investment in some EU member states. Other possible causes are low productivity, too little innovation or a lack of profitable investment opportunities. But such problems require structural reforms going beyond the CMU project, the Bundesbank concludes.