CMU 3.0: time for a paradigm change?

In the last decade the EU has become increasingly aware that, in the face of ever-growing challenges, it will only be able to successfully compete with other major jurisdictions and implement the Twin Transitions if its capital markets become larger and more integrated. Certainly, evidence confirms that EU capital markets remain significantly smaller[1] than those in other comparable jurisdictions, such as the US, and the level of integration still appears unsatisfactory.[2] While in the past the City of London operated in several respects as a de-facto single capital market, Brexit radically changed the situation.

Just in time for the tenth anniversary of the first CMU Action Plan, there have been attempts to revive the initiative, including a joint editorial by the French and German Ministers of Finance, an editorial by the Commissioner for Financial Services and a statement by the Eurogroup as well as one by the ECB Governing Council. But how do we actually get there, beyond declarations of intent and lists of action points? In the following there are some thoughts, both on the need to strengthen capital markets at the national and (even more) European levels and how to get there.

The why question

First, drawing parallels between the banking union and the capital market union is counterproductive. The banking union (or at least what has been put in place) was the result of a crisis and focuses on banking stability. It has clear elements (SSM, SRM and EDIS) and there is a broad consensus on what has to be done, although not as much political willingness to also take the final steps. The Capital markets union, on the other hand, is a much broader project focusing on a variety of markets and institutions, and on the sustainable development of different segments of the financial system, through both legislation and regulation.

Second, Europe urgently needs to diversify away from a bank-based or bank-biased financial system towards giving non-banks and capital markets a stronger role. This includes both public equity and bond markets, but also non-bank intermediaries such as venture capitalists and equity funds. There is sufficient evidence that a bank-based (or bank-biased) financial system is not only bad for growth but also for stability (given the more procyclical nature of bank lending).

Third, rebalancing the financial system towards non-bank segments of the financial system is also needed for innovation and the green transition. In a recently published paper, Beck et al. show that liquidity creation by banks is growth-enhancing through the channel of tangible, but not intangible, investment, with the aggregate growth effect of bank liquidity creation becoming insignificant in economies with a larger share of sectors relying on intangible rather than tangible assets. Ralph De Haas and Alex Popov show that market-based, rather than bank-based, financial systems are better positioned to fund the transition to net zero. Why? Banks generally do not fund innovation and intangible assets as they rely on tangible assets for collateral and the track records of companies (which innovative start-ups might not have). They are also reluctant to fund the green transition as it might hurt their legacy borrowers.

The above constitutes a general argument for fostering non-bank segments at the country level, but why at the European level? Economies of scale matter in finance and even more in capital markets, where network externalities are also important (as is discussed and empirically shown in this paper). Larger countries have bigger and more liquid capital markets (as is shown here, where we compare nascent stock exchanges – the most extreme contrast is between the stock exchanges of China and Swaziland, which were established in the same year). There is also the issue of path dependence, as a vibrant financial centre also relies on many ancillary services (legal, accounting, auditing etc.), a reason why London continues to be one of the global financial centres. Therefore, moving towards a European Capital Markets Union to benefit from such scale and network externalities is critical. Does this mean that financial service providers have to be concentrated in one location? Not necessarily, but it requires close interconnections, mergers of back offices etc.

The how question

How to make EU capital markets larger and more integrated has been at the core of Capital Markets Union discussions and policy initiatives that have taken place in two main iterations since 2015. This has been a bottom-up approach as a result of which a number of barriers have been removed to better match the demand and supply of capital, especially at the cross-border level. Policy initiatives have spanned from ones aimed at facilitating retail investor participation to others focusing on diversifying sources of capital for European businesses or on strengthening market infrastructure.

Some CMU policy initiatives, especially some of those proposed under the 2020 Action Plan, have certainly been ambitious. For example, the set-up of the European Single Access Point (ESAP) and the Consolidated Tape Provider (CTP), and actions under the Listing Act have been important steps in the right direction that should not be underestimated. However, none of these are silver bullets and several bottlenecks still hamper the (cross-border) matching of demand and supply of capital. Deep-rooted issues persist, for example in insolvency frameworks, securities law, consumer protection, financial literacy, pension systems and taxation. Last but not least, the consistent implementation of legislation and regulation via common supervision remains the elephant in the room, which begs the important question of who can drive this process. We think there is a clear need for a champion on the technocratic side – ESMA would certainly be in a good position. Upgrading ESMA’s position as supervisor across more segments of the financial system in the EU could also help in this context. One important impediment are clearly national political interests, as has also been pointed out by Commissioner McGuiness.

With a new legislature upcoming, the question of whether to address such difficult challenges requires a paradigm change, namely a renewed and more ambitious top-down approach, has been raised by the ECB Chair.[3] Certainly, the history of European integration tells us that, while bottom-up processes are often successful in progressively picking low-hanging fruit, top-down shifts (including institution-building) are more difficult to achieve and can be hard to agree on at the EU level. Here, a key point to ponder in the CMU debate is whether there will be a need for a coalition of the willing to move first and break the status quo, leaving the door open for others to opt in at a later stage. Certain EU countries seem prepared to move in this direction. Alternatively, the idea has been floated that it could be left up to market players to opt for a so-called 28^th regime, i.e. a fully-fledged single framework of CMU rules and supervision that sits alongside national regimes.

Finally, it should not be forgotten that EU public policy is by no means the only tool to make an authentic CMU come true, and difficult EU discussion should be no excuse for other players to delay action. In particular, national legislators and the private sector can be active parts of the transformational changes that are needed. On the one hand, while certain CMU issues can only be effectively addressed at the level of the Union, there are some for which national legislators can do a lot, for example when it comes to incentivising and supporting household investments in capital markets. On the other hand, while public policy may be an extremely effective tool to set the appropriate incentives for market players, one should not forget that the CMU is first of all a market integration project. As such, economic actors should contribute to the success of the CMU by making efforts in the direction of increasing consolidation and integration at the cross-border level. This is the case especially in the area of market infrastructure, where efficiency gains for large groups (leveraging e.g. on network externalities) can be significant.

If you want to learn more, we are having a half-day workshop on the topic in Florence (and online) on 14 May in the context of the EMU Lab. More information will be available shortly.

[1] See ECMI (2023), Statistical Package link

[2] See ECB (2022), Biennial report on financial integration and structure in the euro area link

[3] See Lagarde (2023), A Kantian shift for the capital markets union link