September 10, 2019/IMFBlog
When savers and firms invest and borrow beyond their national borders, they enjoy opportunities to diversify their portfolios and lower their funding costs, respectively. In Europe, this idea—of an integrated financial system that offers a richness of financing choice—remains an elusive goal: capital markets are far from integrated.
Our recent research finds that European finance is still sharply segmented along national lines, with savers and investors depending heavily on national banking systems. Although the landscape is dotted with many different types of investors and intermediaries, their focus is mostly domestic—“home bias” is pervasive.
An unlevel playing field
This is a problem because it results in an uneven playing field: the financing costs companies pay depend hugely on their country of incorporation, collateral-constrained startups find it hard to get any funding at all, and consumption is not shielded from local economic shocks.
Lowering barriers to a European Capital Markets Union offers the prospect of powerful macroeconomic benefits.
Firms in, say, Greece, pay a 2.5 percent higher rate of interest on their debt than similar firms in the same industry in France; Italian firms pay 0.8 percent higher interest on debt than comparable firms in Belgium. And Greek and Italian firms are not alone in fighting this uphill battle on funding costs—there is no level playing field.
In addition, firms with limited plants and machinery to offer as collateral—think of an IT start-up—face hurdles accessing bank loans. Such companies grow significantly faster in more developed capital markets, where venture capital funds with diversified portfolios thrive and are more willing to take the risk of providing unsecured financing to innovative players.
Finally, private cross-border risk sharing is severely limited, with local consumption being four times more sensitive to local shocks in the 28 EU countries than in the 50 US states. For every 1 percentage point drop in national GDP growth, consumption drops by 80 basis points, on average, if the country is in the EU, compared to only 18 basis points for the average US state.
Obstacles to capital market integration
Our study included a survey of national market regulators and some of the largest institutional investors in the EU, which identified important obstacles to greater capital market integration in Europe.
Responses flagged shortcomings in information on both listed and unlisted firms, in insolvency practices, and to a slightly lesser extent, in capital market regulation. Some countries were also seen to have weak audit quality, overly complex procedures for retrieving withholding taxes on investments in other countries, and unduly high tax rates.
Some of the benefits of lowering such barriers can be quantified. Using publicly available data, and guided by the survey results, we found that lowering identified barriers offers the prospect of powerful macroeconomic benefits: lower funding costs for firms, larger intra-EU portfolio capital flows, and more risk sharing across borders.
If Italy, for example, were to improve its insolvency practices to best-in-class standards, it could reduce its firms’ average debt funding cost by some 0.25 percentage points. Similarly, Estonia and Greece could see interest cost reductions of some 0.50 percentage points.
Bilateral portfolio asset holdings would double if insolvency regimes and regulatory quality in destination countries were to improve by 1 standard deviation—this is equivalent to Portugal improving its insolvency practices to the UK standard and improving its regulatory quality to that seen in Belgium.
Such improvements in regulatory quality and insolvency regimes would improve individual countries’ shock-absorption, halving the sensitivity of local consumption to local shocks.
Three targeted initiatives
Based on these findings—and building on the achievements of the EU’s Capital Market Union Action Plan—we would urge European policymakers to consider three targeted sets of initiatives in pursuit of greater capital market integration.
To improve transparency and disclosure, we propose introducing centralized, standardized, and compulsory electronic reporting for all issuers of bonds and equities, irrespective of size, on an ongoing basis. This would be a major change to the European reporting framework. And digital technologies can be used to streamline cross-border withholding tax procedures.
To contain systemic risk and improve investor protection where it lags, we propose a series of actions to sharpen regulatory quality, guided by a principle of proportionality. First, systemic entities such as central clearinghouses and large investment firms should be brought under centralized oversight. Second, the European Securities and Markets Authority can and should be strengthened by introducing independent board members. Third, the new pan-European pension product could be pepped-up with design changes to enhance portability and cost-efficiency. Fourth, recognizing the global nature of capital markets, the EU should aim for maximum regulatory cooperation with non-EU countries.
To upgrade insolvency regimes, the European Commission should, first, carefully collect data in an area where the existing information is unreliable; second, develop a code of good standards for corporate insolvency and debt enforcement processes; and, third, systematically follow up on EU member states’ progress toward observing such standards.
Larger intra-EU portfolio flows would help move the EU toward realizing its full economic potential. The relatively technical steps we recommend for removing identified barriers to such flows should be feasible without high-level political deliberations.