Can a European Capital Market Survive Brexit?

LONDON – On September 30, 2015, in those far-off days when the United Kingdom was a fully-fledged member of the European Union, then-European Commissioner Jonathan Hill announced the launch of a new initiative called the “capital markets union.” Almost 60 years of European construction had still not created anything approaching a single market for investment, and in many EU countries capital markets remained weak and underdeveloped. The worthy aim, Hill wrote, was “to identify the barriers to the cross-border flow of investment,” and “work out how to overcome them step by step.”

Much liquidity has flowed under the bridge since then, and Hill is now drawing his euro-pension. But it is hard to see that a great deal of progress has been made. Indeed, the project may even have gone into reverse, as Brexit threatens to disrupt and divide the one well-functioning capital market Europe now possesses: London, which accounts for the majority of the market finance raised for European companies.

That likely split is highly unfortunate, to the extent that it worsens the real problem the European Commission identified. By comparison with the US, Europe relies heavily on bank finance. In the US, the corporate bond market is the source of almost three-quarters of finance for companies, with bank lending supplying the remaining quarter. In the 27 remaining EU countries, the proportions are almost exactly reversed. In the UK, it is about half and half: as is often the case, Britain is positioned somewhere in the middle of the Atlantic Ocean.

There are structural and historical reasons for the different role played by EU banks, and one should not expect European capital markets precisely to follow the pattern of their North American counterparts. In the so-called Rhineland model, banks are often very close to their corporate clients, and sometimes own stakes in them. But the aftermath of the financial crisis showed the importance of diversified funding sources for companies.

Total funding of EU companies fell from 112% of GDP in 2006 to 106% in 2016, owing to a sharp reduction in bank lending, which dropped by a fifth in real terms. Bank lending fell a little in the US, too, as banks sought to restore their balance sheets and rebuild their capital strength. Tighter bank regulation made that inevitable, and a considerable proportion of the post-crisis improvement in capital ratios was driven by a reduction in lending. But in the US, the capital markets were able to take up the slack, and total funding available to companies has risen, powering a more robust economic recovery.

In Europe, capital markets have not played that vital role of absorbing the shock of credit rationing by banks. The European Central Bank has done its best to help, with special schemes that fund banks to lend to small and medium-size enterprises. These have been successful, up to a point. The latest scheme had a take-up of €740 billion ($888 billion) – money that is to be repaid within the next three years. But such programs impose a burden on the ECB and constrain its ability to withdraw unconventional funding and normalize monetary policy. It would be far better if European capital markets were more flexible and open to a wider range of companies.

There are now some modest signs that a shift to market-based financing is under way. The banks themselves have been able to raise new equity capital, which helps. And Europe has taken baby steps toward promoting greater standardization of market practices. The European Commission is encouraging the rebirth of a European securitization market, for example, and the powers of the European Securities and Markets Authority are being strengthened. Member states that hitherto were reluctant to cede control over their markets to a pan-European authority are coming to understand that something closer to a European Securities and Exchange Commission is needed to ensure common standards.

But progress is slow, and Brexit is a further obstacle. The largest pools of European liquidity and capital remain located on the banks of the Thames, and no one yet knows how UK withdrawal from the EU will affect them. Investors and bankers warn that dividing these pools by imposing controls on cross-border activity between the UK and the EU will set back the cause of capital markets union and make financing more costly for EU companies. But, for now, the politics of Brexit – on both sides of the English Channel – are standing in the way of a market-friendly solution.

The UK, understandably, is trying to maintain as much market access as possible for London-based firms. Michel Barnier, Europe’s Brexit negotiator, is insisting that, as the UK makes its transition to “third country” status, only limited regulatory equivalence is possible. And that, says Barnier, will restrict cross-channel financial transactions.

As signs of an incipient slowdown in the European economy begin to multiply – coincident indicators suggest that industrial production has slowed sharply in 2018 – the case for agreeing on a Brexit deal and refocusing attention on capital markets union is becoming more powerful and more urgent. The commissioner now responsible, Valdis Dombrovskis, said in London in late April that the “building blocks” will be in place early next year, to “help our companies to better cope with the departure of Europe’s largest financial center from the single market.” That is a laudable goal, but it could well be too little, too late.

Howard Davies is Chairman of the Royal Bank of Scotland.

Copyright: Project Syndicate, 2018.
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