More capital How to Deliver a Double Dividend

Europe needs a capital markets union and should pursue harmonization, clear away barriers to stimulate innovation, according to the vice president of Germany's Bundesbank.
Money makes the world go round.

Integration in Europe took a giant leap forward with the creation of the banking union.

Centralized bank monitoring reduces the risk of crises occurring and improves the way distressed banks are handled. This will help Europe to overcome crises more quickly.

Now, the European Commission has unveiled a proposal outlining measures aimed at developing a union of capital markets. In the short term, the proposal calls for a framework to better finance businesses through the capital market, beyond banks.

Are additional reforms really necessary? Is there a need for additional financing channels and thus fewer bank-based financing models?

In general, the answer is “yes.” A properly structured capital markets union can contribute to greater stability and at the same time spark more growth, delivering a double dividend.

Well-developed financial markets foster entrepreneurship, innovation and investment. Venture capital plays a special role in this respect. Entrepreneurs can raise venture capital but can also bring valuable experience to a start-up’s corporate management. For many European companies, however, having external financing means relying on debt, primarily via bank loans.

Are additional reforms really necessary? Is there a need for additional financing channels and thus fewer bank-based financing models? The answer is “yes.”

Economies with larger banking systems grow faster initially. But they reach a tipping point at which further growth in the financial sector no longer drives but instead inhibits economic growth. Some indications exist that such financing through outside capital has grown beyond a healthy amount in Europe. One piece of evidence is the large share of non-performing loans on banks' balance sheets.

Moreover, the structure of financing affects the financial sector’s stability. In the euro zone, borrowing has proved to be significantly more susceptible to cross-border capital flight than financing through equity. One advantage of equity capital is that through the payment of dividends, it performs an important buffer function to cushion economic shocks.

A higher proportion of debt capital, on the other hand, exacerbates economic volatility because companies and households during a downturn try to reduce their degree of indebtedness. Cross-border corporate investments enable a better distribution of risks among countries and would be particularly important in the euro zone, given the lack of a nominal exchange rate to absorb country-specific economic shocks.

In order to facilitate increased growth and stability, the capital markets union should set three priorities.

First, reforms are needed that make it easier to restructure debt and accelerate the removal of bad loans from banks' books. Greater harmonization of basic points of insolvency legislation could make an important contribution.

Second, barriers hindering sustainable growth of capital markets and the integration of European capital markets should be removed. Only a part of capital resources is traded on the stock markets. The larger share is tied up in companies and cannot be traded easily.

International mergers and acquisitions can be a channel for increased capital mobility. Legal and institutional barriers often block such deals. In most countries, the tax deductibility of interest expenditures still tends to give financing through debt an edge over equity financing.

Third, the union of capital markets should not be used as a lever for other policy objectives. What small and mid-sized companies need are open markets and low entry barriers. If the government were to steer investment into certain asset classes, that would encourage the taking of excessive risks and promote the mis-allocation of capital. Doing so would run contrary to the primary goal of creating open markets with sound competitive conditions to promote innovation.


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