Capital Market Union, a prerequisite to restore ECB transmission

The Capital Markets Union (CMU) is the unloved little sister of the Banking Union (BU). Born as it is to the crisis, it is now being blamed for being too blurred, too conceptual and unsuitable to generate the concrete measures that would effectively create a unified market for financial products and investors in order to allocate the abundant savings of the Europeans to the appropriate regions and sectors of the continent.

But now the ECB shall soon – even if very prudently – start normalising its monetary policy stance, can the European Monetary Union afford to live “with BU but without CMU”? Not really if the ECB wants to count on all transmission channels for its monetary policy actions. And we know that some of those transmission channels, notably through bank balance sheets, are still clogged in many countries.

Although still somewhat nebulous, the interim review of the CMU published at the end of May by the European Commission allows for some degree of optimism. It has been bred by a public consultation that provided a fairly comprehensive menu of priority areas of work. If four were to be chosen, what would they be?

First area of work: venture capital. So as to correct an uncontested market failure in the corporate finance chain. The "scale-ups", these start-ups growing, lack dedicated venture capital. The European legislator has already reached an agreement in principle to facilitate the life of venture capital funds and other social entrepreneurship funds with a European dimension. A systematization and harmonization of tax incentives at their address could support their development further, which would be good for growth and innovation.

Second specific action: enable banks to manage risk and leverage more effectively. It is no secret that the European economy is embarking on a long period of deleveraging which, depending on the frequency of financial cycles, should imply a reduction in banking leverage well beyond the business cycle horizon. In order to allow banks to accomplish this transition without jeopardizing credit and therefore economic growth, they will need sooner rather than later safer and more transparent markets for securitization. On this front, news is encouraging, in particular now that the agreement in principle on the STS has been reached.

But initiatives on other parts of bank balance sheets should be pursued, such as the specific treatment of SME loan portfolios and, on the liabilities side, that of guaranteed bonds issued by banks to finance themselves.

The third key effort should concentrate on non-bank financial intermediaries and long-term investors. They should become fully able to carry risk, to invest in infrastructure as well as in the equity of the non-financial sector - notably, but not only in the area of low-carbon and social investment where the needs are important and a long term orientation of investment decisions is warranted. Here again, progress has been made in the framework of the Solvency II Regulation, but it is possible to go further, in particular on risk weighting and capital requirements for infrastructure investments.

A final area is common to all: the right to a second chance. We know that bankruptcy law must be reworked in Europe. Insolvency proceedings must be faster and more predictable. Authorities are working on it, but they must not stop on the way.

Of course, the urgency of these specific actions varies from one country to another. Countries where financial markets are the least developed would also be the main beneficiaries of targeted measures to improve access to finance for SMEs. Core European countries, on the other hand, need to create and renew financial instruments for their pensioners. They might therefore need a pan-European savings and financial product for private pension systems. Some countries are the champions of specific financial products, such as covered bonds in Denmark. Finally, banking systems in many countries are still fighting with non-performing loan portfolios and more lies ahead in that field.

Yet, beyond these immediate disparities, all Member States have a common objective: to promote the stability, sustainability and integration of the financial system. This is a prerequisite to make sure that savings are employed to improve collective well-being and maximize potential growth. But financial stability, sustainability and integration are also key to euro area member states because they will greatly facilitate the life of the ECB. As things stand, the transmission channels of monetary policy have become hazardous. With a diversified financial ecosystem, the distribution of risk within the financial system will be more robust, non-banking players will fully assume their role in financing the economy and their sensitivity to the adjustment of the various monetary policy tools – interest rates and yield curve management, liquidity, quantitative actions, risk and collateral standards - will be fully taken into account.

This post is based on notes prepared for the @francestratégie Conference on the Future of EMU in Paris on 13 July 2017. The views exressed are the author’s own.

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