buildingaeuropean ... · furthermore,limitingtheroleofbank-basedfinance...

Building a EuropeanCapital MarketsUnion: The Need forLiquidity and FocusGeorges Ugeux*

Banks; EU law; Financial markets; Financialregulation; Harmonisation; Securitisation

AbstractThe European Commission is building a Capital MarketsUnion (CMU) to counteract Europe’s over-reliance onbank funding. As the Commission’s CMU communicationoften refers to peripheral projects and misapprehensionof Europe’s capital markets, this paper aims to contributeby highlighting the main challenges and action points forrealising the CMU.

“The direction to take is clear: to build a singlemarket for capital from the bottom up, identifyingbarriers and knocking them down one by one,creating a sense of momentum, and sparking a

growing confidence for investing in Europe’s future.The free flow of capital was one of the fundamentalprinciples on which the EU was built. More than 50years on from the Treaty of Rome, let us seize thisopportunity to turn that vision into reality.”1

This statement of the Action Plan on building a CapitalMarkets Union (CMU) is powerful. The initiative of theEuropean Commission (the Commission) is to be praisedas it takes the Liikanen Report2 forward and attempts totackle one of the anomalies of European finance: theexcessive importance of the banking sector as a sourceof financing in the EU.

The objectives of the CMUThe Liikanen Report pointed out that the Europeanbanking sector is significantly larger than those in the USand Japan. In 2010, Europe’s banking assets represented349% of its GDP, relative to 78% in the US.3 AlthoughEurope and the US have a similar GDP, the depth of theircapital markets is very different. The Association forFinancial Markets in Europe (AFME) estimates thatEurope’s investable assets is two-thirds of the US’ total.4

The size of the European Bond market is indeed half ofthe US in GDP terms.5 It shows the underdevelopmentof the European bond market, which is largely dominatedby sovereign issuers rather than companies. This chartpublished in 2013, shows that Europe constitutes ananomaly by world standard.6

*This article is a further development to the comment letter the author sent to the European Commission that has been prepared in conjunction with several participants tothe class I am teaching on “European Banking and Finance” at Columbia Law School. The contribution of Christopher McIlwaine and Isabel Verkes has been particularlyhelpful in the elaboration of this paper.1Action Plan on Building a Capital Markets Union (Action Plan) COM(2015) 468 final (30 September 2015), p.6. Available at: http://ec.europa.eu/finance/capital-markets-union/docs/building-cmu-action-plan_en.pdf [Accessed 18 March 2016].2Report of the European Commission’s High-level Expert Group on Bank Structural Reform (Liikanen Report), published in October 2012. Available at: http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/report_en.pdf [Accessed 18 March 2016].3 Liikanen Report (2012), p.12.4AFME& BCG, “Bridging the growth gap” (February 2015). Available at: http://www.icmagroup.org/assets/documents/Regulatory/Private-placements/AFME---Bridging-the-growth-gap---February-2015.pdf [Accessed 18 March 2016].5Sapir &Wolff, “The neglected side of banking union: reshaping Europe’s financial system”, Bruegel policy contribution (14 September 2013). Available at: http://bruegel.org/2013/09/the-neglected-side-of-banking-union-reshaping-europes-financial-system/ [Accessed 18 March 2016].6Tyler Durden, “Spot the Odd Continent Out: Bank Assets as a % of GDP”, Zero Hedge (18 May 2013). Available at: http://www.zerohedge.com/news/2013-05-18/spot-odd-continent-out-total-bank-assets-gdp [Accessed 18 March 2016].

314 Journal of International Banking Law and Regulation

(2016) 31 J.I.B.L.R., Issue 6 © 2016 Thomson Reuters (Professional) UK Limited and Contributors

Total banking assets as % of GDP

On the dichotomy between bank-based and a moremarket-based financial system—as respectivelyrepresented by Europe and the US—there is no conclusiveevidence that one of these systems should prevail.However, a system that heavily relies on a single kind offunding is not optimal. As this continues to be an issuefor Europe, Erkki Liikanen raised the issue of Europe’soverbanking in 2010 and again in 2014. He warned thatthe expansion of bank sizes and bank funding is notmatched with a similar growth in market-based finance.7

Indeed, the EU needs both forms of finance. That iswhy former Governor of the central bank of Switzerland,Philipp Hildebrand, argues that Europe should diversifyits funding channels.8 Also, EU Commissioner JonathanHill recognises this:

“Bank-based funding has many strengths, not leastthe close relationship that some banks have withtheir clients … But the crisis has clearlydemonstrated that there is a risk in having too manyeggs in one basket.”9

Developing market-based finance in Europe wouldstrengthen Europe’s economic growth capacity andimprove its resilience against adverse financialcircumstances resulting in tightened bank lending.However, this requires a fundamental reform of the

European financial system that amounts to variouschallenges, risks and structural changes. An additionalcomplicating factor is the differences in market depthacross the various EUMember States (see graph below).10

7Erkki Liikanen, Keynote Speech at the Alpbach Financial Market Symposium in Alpbach, Austria (28 August 2014). Available at: http://www.bis.org/review/r140905a.htm [Accessed 18 March 2016].8Philipp Hildebrand, “A European capital markets unionmust consider its investors” (16 April 2015), Financial Times. Available at: http://blogs.ft.com/the-exchange/author/philipphildebrand/ [Accessed 18 March 2016].9Commissioner Jonathan Hill, “Refocusing financial integration on growth and jobs”, Speech at the European Financial Integration and Stability Conference (27 April2015). Available at: http://europa.eu/rapid/press-release_SPEECH-15-4861_en.htm [Accessed 18 March 2016].10William Wright and Laurence Bax, “Decoding capital markets union: report on the potential growth in European capital markets” (June 2015), New Financial. Availableat: http://newfinancial.eu/wp-content/uploads/2015/05/Decoding-capital-markets-union-final-0915.pdf [Accessed 18 March 2016].

Building a European Capital Markets Union: The Need for Liquidity and Focus 315


Furthermore, limiting the role of bank-based financewill collide with entrenched and vested interests of bankintermediation. For the purpose of this article, we willtherefore focus on the needs for a disintermediation ofEuropean capital markets in the course of building aCMU.As confirmed byEUCommissioner Jyrki Katainen,the project of the CMU should:

“Increase the overall pie so that everyone benefits:banks, capital markets and, most importantly, firmswho will find more sources of funding. Removingobstacles that prevent our high levels of savingsfrom finding their way to productive use in theeconomy. And it is about giving choice to companieson where and how they want to get financing.”11

However, both the Green Paper12 and the Action Plan13

of the Commission reflect a wide scope of considerationsand are not entirely focussed on the objective of reducingthe over-reliance on bank intermediation. The EUcommunications on the CMU include inputs from otherEU policies, seeking to strengthen the political legitimacyfor the Commission to intervene. Accordingly, theCommission posits some features and effects of the CMUthat are unrealistic deliverables of the project.While applauding the initiative, I want to remain

neutral as to whether or not the Commission will succeedin the development of a CMU. Rather, this article is tryingto look at some of the basic realities andmisunderstandings on capital markets that may resonatefrom the way the CMU is projected in the Green Paperand Action Plan. What are some fundamental reasonswhy this market is less developed in Europe?

Financial stability and diversificationAn important objective that leads the CMU initiative isfinancial stability:

“Integrated financial and capital markets can helpMember States, especially those inside the euro area,share the impact of shocks. By opening up a widerrange of funding sources, it will help to sharefinancial risks and mean that EU citizens andcompanies are less vulnerable to bankingcontractions.”14

Where the existence of a CMU aims to reduce thebalance sheets of financial institutions, it transfers risksof instability but does not necessarily reduce the risk ofinstability.The confusion comes from the notion of diversification:

the CMU aims to offer alternative sources of funding toborrowers. The Commission argues that the growth ofcapital markets will induce stability. Unfortunately,capital markets are by nature more subject to short-termmovements and volatility than to stability. That does notdisqualify the project: it simply requires a realisticapproach to financial stability and what the furtherdevelopment of capital markets will deliver.15 What theCMU will provide is the stability that comes from anon-exclusive reliance on bank balance sheets that, inEurope, remains more vulnerable than in the US.

Capital markets as an alternative to banks“Capital markets are the markets where securitiessuch as shares and bonds are issued to raise mediumto long-term financing, and where the securities aretraded. The securities might be issued by a companywhich could issue shares or bonds to raise money.Bonds could also be issued by other entities in needof long-term cash, such as regional or nationalgovernments. The securities are issued in what isknown as the primary market and traded in thesecondary market. In the primary market a companywould have face-to-face meetings to place itssecurities with investors.”16

This definition from the Financial Times is the generalunderstanding of capital markets. The Commission’sCMU communication does not define “capital markets”,but it focusses on the objective of reducing the size andleverage of European banks and the dependency of theeconomy on bank financing.Europe’s strong dependence on bank-based finance

imposes constraints on growth and comes with risk. Thefinancial crisis showed destabilising consequences ofgrowing on- and off-balance sheet leverages in thebanking sector. Although the banks appeared to havestrong capital ratios, whenmarket forces compelled banksto deleverage, rapidly falling asset prices reduced theiroverall capital and available credit. The build-up ofexcessive leverage and subsequent deleverage processes

11Commissioner Jyrki Katainen, speech at ESBG retail banking conference in Brussels (19 March 2015). Available at: http://ec.europa.eu/commission/2014-2019/katainen/announcements/esbg-retail-banking-conference_en [Accessed 18 March 2016].12Action Plan COM(2015) 468 final (30 September 2015).13Green Paper on Building a Capital Markets Union (Green Plan), COM(2015) 63 final (2 February 2015). Available at: http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=COM:2015:63:FIN&from=EN [Accessed 18 March 2016].14Action Plan (2015), p.4.15Georges Ugeux, International Finance Regulation: the Quest for Financial Stability (Hoboken: Wiley Financial Series, 2014). Available at: http://www.amazon.com/International-Finance-Regulation-Financial-Stability/dp/111882959X [Accessed 18 March 2016].16Financial Times Lexicon available at: http://lexicon.ft.com/Term?term=capital-markets [Accessed 18 March 2016].



damaged the financial system and the economy as awhole. The Basel Committee addressed this issue byintroducing a non-risk based minimum leverage ratio of3% to complement risk-based capital ratios.17

Accordingly, the Commission adopted the Basel IIIleverage ratio as laid out in the Capital RequirementsRegulation (CRR) and Directive (CRD IV).18

Safeguarding sustainable levels of banking leverageremains an important issue to the overall resilience ofbanks. On 6 December 2015, the Bank for InternationalSettlements published a paper inviting regulators to raisethe Basel III leverage ratio for banks from 3% to 5%.19

The Commission assumes that regulatory constraintswill limit the ability of banks to lend, and uses thisrationale to justify the overall CMU project. Therefore,one of the objectives in the CMU Action Plan isleveraging banking capacity to support the widereconomy.20 This seems to be in contradiction with theBasel III regulations and seems to water down thestandards of the CRR and CRD IV. In a similar vein, theCommission tries to reverse a trend by watering down itsown capital criteria when it comes to small andmedium-sized enterprises (SMEs):

“Article 501(1) CRR includes a provision thatreduces the capital requirements for credit risk onexposures to SMEs. This provision was introducedto ensure that the level of capital required in respectof SME loans did not increase as a result of thehigher overall level of capital required under theCRR. Consequently, capital requirements for loansto SMEs have been reduced relative to therequirements for other categories of loan.”21

First, this should be looked at more attentively sinceSME loans generally contain risks associated with lessstable companies. Similar concerns apply to theCommission’s idea on allowing credit unions to operateoutside the EU’s capital requirements framework forbanks.22 Secondly, and more importantly for this article,expanding the capacity of the banking sector should notfall under the scope of a CMU. Strengthening creditunions and SME bank financing are valuable objectives,but these are not directly related to capital markets andthus distract from the actions needed to develop a CMU.Therefore, the extent to which the CMUGreen Paper andAction Plan consist of proposals relating to issues beyondcapital markets raises important questions on the diversityof EU objectives.

Venture capital funds are not traded oncapital marketsThe previous comment also applies to the part where theCMU stresses the importance of venture capital andprivate equity for the European economy, recognisingthe challenges:

“Risk-capital markets can often lack scale; this isthe case not only for the stock exchanges specializedin financing high-growth companies, but also forrisk-capital investment at the start-up or developmentstage of new enterprises or in high-technologycompanies.”23

To tackle this, the Commission proposes to:

“Launch a package of measures to support venturecapital and equity financing in the EU, includingcatalysing private investment using EU resourcesthrough pan-European funds-of-funds, regulatoryreform, and the promotion of best practice on taxincentives.”24

The Commission’s initiative makes a lot of sense, andis worth pursuing. The source of risk capital for SMEs isdefinitely complex, and funds have become a key resourcefor them. However, even in the US, those funds are notlisted and do not raise capital through public markets.Stock exchanges do not list venture capital and privateequity firms because they do not want to be listed. Thenature of their private investments makes valuation verydifficult—they are to be put in the category of privateplacements.It is therefore better to leave private equity and venture

capital out of the scope of building the CMU, as it simplydoes not have a relevant impact on the European CMUproject.

PoliticsAn explanation for the wide-ranged proposals within theCMUproject is the complexity of political agendas withinthe EU. The Commission seems to add some remarks onthe CMU for internal political reasons—to obtain thesupport of the various European constituencies. TheEuropean logomachy and comitology diverts the attentionaway from the core issues such as liquidity anddisintermediation. An example is the referral to Europe’s€315 billion Investment Plan fund.25 This project will not

17The Basel Committee on Banking Supervision developed a global framework to strengthen the regulation, supervision and risk management of the banking sector, referredto as “Basel III”. The Basel III leverage ratio is defined as Tier 1 capital measure divided by the exposure measure (the bank’s average total consolidated assets), expressedas a percentage. Available at: http://www.bis.org/bcbs/basel3.htm [Accessed 18 March 2016].18Regulation 575/2013 on prudential requirements for credit institutions and investment firms and amending Regulation 648/2012 (CRR) [2013] OJ L176/337 and Directive2013/36 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87 and repealingDirectives 2006/48 and 2006/49 (CRD IV) [2013] OJ L176/338. Available at: http://ec.europa.eu/finance/bank/regcapital/legislation-in-force/index_en.htm [Accessed 18March 2016].19 Ingo Fender and Ulf Lewrick, “Calibrating the leverage ratio” (6 December 2015)Available at: http://www.bis.org/publ/qtrpdf/r_qt1512f.htm [Accessed 18 March 2016].20Action Plan (2015), p.21.21DG FISMA Consultation Paper on the possible impact of the CRR and CRD IV on bank financing of the economy (July 2015). Available at: http://ec.europa.eu/finance/consultations/2015/long-term-finance/docs/consultation-document_en.pdf [Accessed 18 March 2016].22Action Plan (2015), p.21.23Green Plan (2015), p.17.24Action Plan (2015), p.5.25Action Plan (2015), p.5.



be financed through capital markets unless it is guaranteedby the EU, in which case it is included in the sovereignborrowing category and not part of the CMU.In a paradoxical way, the Commission’s statements

confirm that infrastructure finance and the other industriesof the Investment Plan cannot be done through capitalmarkets. This “fund” will not be funded by public marketsand will have no liquidity or secondary market. It is oneof the policies included in the CMU project that reflectspolicy intentions rather than capital market considerations.Indeed, it is important to outline the positive impact of

the CMU on other European policies. However, ratherthan providing focussed proposals for the CMUframework, the current proposals under the CMU projectoften look at peripheral issues or benefits. The creationof a European capital market for bonds and equities is ahuge challenge by itself. The complexity of the structures,processes and accountability will need to be addressed.By adding numerous other EU projects in the CMU

documents, the risk of dilution of the efforts beyond itscore purpose is such that it might derail the creation of acapital market and misses its key target. It alsocomplicates the debate concerning the furtherdevelopment of the CMU and the shape thereof.

The CMU and liquidityLiquidity is the most important ingredient of capitalmarkets. It is the main source of confidence for investorswho want to make sure that their investments can be soldin a reasonable timeframe and without major disturbanceof the price of the securities. Philip Hildebrand asks apertinent question on the objective of the CMU:

“Can liquidity be achieved in Europe withoutcross-border opportunities? Realistically, not on thescale that it is available in the US. Yet suchopportunities are now practically non-existent.”.26

Stylised view of capital markets in the broader financial system27

This chart above comes from the Green Paper. Itamplifies the confusion in the liquidity debate as itmisunderstands the distinction between primary andsecondary providers of liquidity.Primary liquidity is provided by investors, retail or

institutional, and is by far the most important source offunds. However, investors will not put their money infinancial assets that are not liquid enough to guaranteethat they will be able to sell their securities in a shortperiod of time without disrupting the price of those assets.This applies in particular under the Solvency II Directivethat harmonises EU insurance regulation.28 Secondaryliquidity is provided by market makers, a combination ofbanks, broker dealers and securities companies. Unlessenough financial resources are allocated tomarket makingby financial intermediaries, a CMU will not be possible.

In the aftermath of the crisis, these financialintermediaries are subject to new rules and regulationsthat affect their market-making capabilities. It is not therole of institutional investors to be market makers orproviders of market liquidity.Improving Europe’s liquidity conditions requires

involvement of the various stakeholders:

“Liquid and efficient capital markets supporteconomic activity, growth, and jobs. It is theresponsibility of market providers, investors, issuersand regulators to ensure that this vital function isnot compromised.”29

Yet, there is no evidence at this stage that the bankingsector is willing to embark on a major initiative that willreduce their balance sheets and allocate equity to

26Hillebrand, “A European capital markets union must consider its investors” (16 April 2015), Financial Times.27Green Plan (2015), p.7.28Directive 2009/138 on the taking-up and pursuit of the business of Insurance and Reinsurance [2009] OJ L335/1.29Martin Scheck, ICMA Chief Executive, commenting on: the Survey Report—Liquidity in the European secondary bond market: perspectives from the market (November2014). Available at: http://www.icmagroup.org/assets/documents/Regulatory/Secondary-markets/The-state-of-the-European-investment-grade-corporate-bond-secondary-market_ICMA-SMPC_Report-251114-Final3.pdf [Accessed 18 March 2016].



corporate debt market making. New capital adequacy andleverage rules might actually constitute a disincentive forbanks to provide the necessary liquidity. However,without such involvement of banks, the CMU projectruns the risk of being stillborn.

Involving the banks: Liquidity CoverageRatioThe Basel Committee developed the Liquidity CoverageRatio (LCR). The LCR is part of the three ratiosdeveloped by the Basel Committee and “aims to ensurethat a bankmaintains an adequate level of unencumbered,high quality assets that can be converted into cash to meetits liquidity needs for a 30-day time horizon”.30

The Green Paper states that the liquidity ratio

“should increase the transparency, consistency andavailability of key information, particularly in thearea of SME loans, and promote the growth ofsecondary markets to facilitate both issuance andinvestments”.31

This statement of the Commission seems to misalignwith the fundamentals of the LCR. Through the LCR,banking regulation is effectively reducing the ability ofbanks to provide liquidity to medium- and long-termsecurities. As such, it will neither increase the availabilityof information in the area of SME loans, nor promote thegrowth of secondary markets per se, as the Commissioninfers. The Basel Committee emphasises the LCR as avital tool to strengthen the banking sector, and evenrecognises the potential impairing impact of a strong LCRon financial markets:

“The Committee remains firmly of the view that theLCR is an essential component of the set of reformsintroduced by Basel III and, when implemented, willhelp deliver a more robust and resilient bankingsystem. However, the Committee has also been

mindful of the implications of the standard forfinancial markets, credit extension and economicgrowth, and of introducing the LCR at a time ofongoing strains in some banking systems. It hastherefore decided to provide for a phasedintroduction of the LCR, in a manner similar to thatof the Basel III capital adequacy requirements.”32

The Commission may assess the impact of the LCR inrelation to its CMU initiative. As market making is anessential activity to the CMU, how to not unduly penalisethem, given the LCR?

Securitisation is a vital CMU componentSecuritisation is a way in which banks should be involvedin the CMU project. Indeed, the EU is trying to revampsecuritisation:

“If EU securitisations could be revived—safely—topre-crisis average issuance levels, banks would beable to provide an additional amount of credit to theprivate sector of more than EUR 100 billion.”33

The need is clear:

“Since the crisis, activity has remained impaired,despite low loss rates in European securitisations.Securitisation issuance in Europe in 2014 amountedto some €216 billion, compared to €594 billion in2007.”34

In the context of the CMU, it is indeed a way to reducebank balance sheets and issue instruments that arecollateralised by financial assets. It should be part of theCMU project.The table hereunder from the International Monetary

Fund shows a drastic decrease of securitisation, both inthe US and in Europe. The challenge seems to be to goback to 2008, when securitisation exceeded over $800billion.

30Basel Committee, “International framework for liquidity risk measurement, standards and monitoring” (final publication of December 2010). Available at: http://www.bis.org/publ/bcbs165.pdf [Accessed 18 March 2016].31Green Plan (2015), pp.10–11.32Basel Committee, “Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools” (January 2013). Available at: http://www.bis.org/publ/bcbs238.pdf[Accessed 18 March 2016].33Action Plan (2015), p.4.34Green Plan (2015), p.10.



Total private European and US securitisation issuance (in billions of US dollars)35

Securitisation is a way for banks to transfer the risk oftheir loans to outside investors. The experience of thefinancial crisis showed that the renegotiation of the termsof the securitised loans requires the approval of theholders of the securitised bonds. The investors’ rigidity,that takes away renegotiation from the hands of thelending bank, is counterproductive in times of loandefaults.The publication by the Commission of A European

Framework for Simple and Transparent Securitisation isan important step in the direction of a revival of thesecuritisation in Europe:

“Soundly structured, securitisation is an importantchannel for diversifying funding sources andenabling a broader distribution of risk by allowingbanks to transfer the risk of some exposures to otherbanks, or long-term investors such as insurancecompanies and asset managers. This allows banksto ‘free’ the part of their capital that was set asideto cover for the risk in the sold exposures, therebyallowing banks to generate new lending.”36

Sources of liquidity: the role of marketmakingThe CMU Green Paper mentions liquidity in the contextof capital market intermediation by banks and their roleas market makers.37 This issue is not further assessed inthe subsequent Action Plan. The concern is that somemarket segments indicate a decreased liquidity level.Cross-market analysis of developments inmarket liquidityis complex. As the Green Paper recognises, some suggestthat liquidity may have been mispriced during thepre-crisis period. Further, liquidity levels may be affectedby stricter regulatory requirements for market makers aswell as an overall lack of market confidence.

However, onemust determinewhere in the EU’s capitalmarkets’ liquidity will come from—or should come from.To address market depth and liquidity, it is necessary tohave a clear view of the existing liquidity enhancingmarket mechanisms and their efficiency. Assessing thesemechanisms enables a more targeted debate on whetherand how the Commission could promote market depthand liquidity in the course of building the CMU. Asfollows, I will address two liquidity-providingmechanisms that can be relevant in this regard: bondliquidity and stock exchanges.

The role of the ECB in bond liquidity: theEurozone initiatives reduce liquidityOne mechanism to address the Eurozone’s liquiditysituation is the open market operations by the ECB. It isa macroprudential initiative, of which the impact oncorporate debt is uncertain. Main Refinancing Operations(MROs) are one-week liquidity-providing operations ineuros. The aim of MROs is directing short-term interestrates and signaling the Eurozone’s monetary policystance. Longer-term Refinancing Operations (LTROs)offer the financial sectors additional longer-termrefinancing. To serve the non-financial sector, TargetedLonger-term Refinancing Operations (TLTROs) seek toimprove bank lending over a two-year window, excludinghouse purchase loans to households.Since 2009, the ECB launched several bond purchase

programs, including its recent quantitative easing program(Public Sector Purchase Programme or PSPP). In general,the purpose of these open market operations is providingmarket liquidity by solving short-term cash issues. TheCommission may want to research the economicaleffectiveness of these individual open market operationsby the ECB in relation to its liquidity management.For the first time, the ECB deemed it to be helpful to

purchase corporate bonds, reducing the liquidity of thecorporate bondmarket. The corporate bondmarket started

35Miguel Segoviano, Bradley Jones, Peter Lindner and Johannes Blankenheim, “Securitization: The Road Ahead”, IMF staff discussion note (January 2015). Available at:https://www.imf.org/external/pubs/ft/sdn/2015/sdn1501.pdf [Accessed 18 March 2016].36European Commission, A European Framework for Simple and Transparent Securitisation (30 December 2015). Available at: http://europa.eu/rapid/press-release_MEMO-15-5733_fr.htm [Accessed 18 March 2016].37Green Plan (2015), p.24.



to feel net impact of the ECB’s first Quantitative Easing(QE I) of €65 billion a month. However, the immediateeffects of the QE is a weakening of the Euro and acontinuation of negative interest rates, instead ofeconomic growth and reduced unemployment. Despitethose observations, on 10March 2016 the ECB increasedthis amount to €80 billion.38

The ECBhad to obtainGerman bonds from the ChineseCentral Bank to reach their quotas.39 The ECB attemptsto increase inflation, but the EU’s low interest rates seeminsufficient to stimulate employment and growth. TheQE I benefited Member States with high public debt,including France. The second tranche of QE (QE II) didnot compensate for the modest positive effects of QEI—which triggered even more aggressive stimulus plansin the spring of 2016. Overall, it will further increase thebalance sheet of the ECB that shrinks its ammunition forfuture crises.In other words, the ECB’s action restricts the liquidity

of the corporate bond market. There was no need for itand it might backfire through the expropriation ofsavings.40

Stock exchanges are important sources ofliquidity for equity marketsThe liquidity of equity markets is in direct correlationwith the market value of the float of the listed companies.Policies cannot change that principle. It explains why,already today, large companies listed on stock exchangesare effectively subsidising smaller ones. Stock exchangesare crucial for medium-sized companies, while smallcompanies have no place on a public market. In that light,non-regulated trading venues operating alongside stockexchanges are interesting for the objectives of the CMU.For example, the German Stock Exchange, Deutsche

Börse Group, uses its Xetra Liquidity Measure (XLM)to indicate the liquidity for a security in the order bookbased on implicit transaction costs. In relation to theGreen Paper’s focus on SMEs, the Eurozone’s openmarkets are worth considering in assessing liquiditymanagement for SMEs. An interesting example is theOpen Market (Freiverkehr) initiative in Frankfurt/Main.

The Open Market and its sub-segment “Entry Standard”aim to create liquidity and facilitate SMEs with raisingfunds at a stock exchange. Compared to a regulatedmarket, the Open Market had fewer access requirementsand lower entry costs.The merger between Deutsche Börse and the London

Stock Exchange announced on 3March 2016 will furtherincrease the liquidity available to European-listedcompanies and make the European markets moreattractive to global investors.41

CMU: the difference between equity andbondsThe providers of funds, the users of funds and thefinancial intermediaries look for different kinds offinancial products. More importantly, even if a bankmakes market in bonds and equity, those two activitiesare distinct and respond to different risk profiles, liquidityand capital commitment.Bonds are left to market makers: there is no such thing

as an exchange for bonds. Banks trade bonds in theirtrading rooms and over-the-counter. There is no regulationof this market, no commitment of resources and when acrisis emerges, it is the first market that shows sign ofweakening, lower liquidity and eventually credit crisis.

The European bond marketCorporate bonds look impressive when they areaggregated. However, a closer look shows that most ofthe bonds are issued by banks rather than corporateissuers. Bank financing through the bond markets doesnot disintermediate, since the proceeds are going to beinvested in assets through the balance sheet of the banks.That does not fulfill the objective of reducing the size ofbank financing.Data from the ECB indicates that, of the outstanding

securities in the EU (€16.6 trillion), only €1 trillion isissued by the non-financial corporate sector against €8trillion issued by financial institutions, who use capitalmarkets to fund their intermediation. An annual issuanceof €48 billion of corporate bonds is very low.

38Claire Jones, “ECB cuts rates to new lows and expands QE” available at: http://www.ft.com/intl/cms/s/0/9a45a960-e6ac-11e5-a09b-1f8b0d268c39.html#axzz42ndEJbpP[Accessed 18 March 2016].39Claire Jones and Gabriel Wildau, “China aids eurozone QE drive with sales of German bonds”, Financial Times, 1 November 2015. Available at: https://next.ft.com/content/302bd274-7f29-11e5-ae43-f6d4a22c5a1a [Accessed 18 March 2016].40Georges Ugeux, “La Banque Centrale Européenne perpétue les taux d’intérêts négatifs et joue avec le feu”, Le Monde, 1 December 2015. Available at: http://finance.blog.lemonde.fr/2015/12/03/la-banque-centrale-europeenne-perpetue-les-taux-dinterets-negatifs-et-joue-avec-le-feu/ [Accessed 18 March 2016].41 “London Stock Exchange backs Deutsche Börse deal as profits rise”, The Guardian, 4 March 2016. Available at: http://www.theguardian.com/business/2016/mar/04/london-stock-exchange-backs-deutsche-borse-deal-as-profits-rise [Accessed 18 March 2016].



Outstanding amounts and transactions of euro-denominated debt securities by country of residence (January 2016)(EUR millions; nominal values)42

It is indispensable to analyse the current Europeancapital market with more details by country and byindustry, and analyse why the European corporate bondmarket is so underdeveloped. The Green Paper isoptimistic in its assessment of the existing EuropeanCapital Market, as a result of which it underestimates thechallenges of its creation.

The dominance of sovereign bonds“Capital markets have expanded in the EU overrecent decades. Total EU stockmarket capitalisation,for example, amounted to €8.4 trillion (around 65%of GDP) by end 2013, compared to €1.3 trillion in1992 (22% of GDP). The total value of outstandingdebt securities exceeded €22.3 trillion (171% ofGDP) in 2013, compared to €4.7 trillion) (74% ofGDP) in 1992.”43

The chart above substantiates the comment above.However, it fails to look at the central issue: most of thecurrent €22.3 trillion of debt securities are sovereignbonds. Europe is dealing with excessive sovereignindebtedness. Many European countries, in particularItaly and France, have an indebtedness that exceeds 100%of their GDP, and each of those two countries have morethan €2 trillion of debt.Over 10% of the outstanding debt securities are in the

balance sheet of European banks. This represents onaverage 100% of their equity. It is the core of the nexusbetween banks and governments. It is one of the mainsources of fragility of the European banks that are heavilyexposed to fluctuations of long-term sovereign bonds

both on the interest rate side and on the credit side.WhileEurope refused to acknowledge that risk in its stress tests,the evidence of a 50% haircut on holding of Greek debtproved that, even if countries cannot go bankrupt,sovereign bond holdings are not risk free.Analysts are also discounting Basel III, when they

accept that sovereign bonds are risk-free and thereforedo not require any equity allocation. In the case of Europewhere countries rank fromB to AAA, refusing to allocateequity to sovereign bonds is systemically dangerous.

42ECB data. See this continuously updated ECB graph available at: https://www.ecb.europa.eu/stats/money/aggregates/bsheets/html/outstanding_amounts_A30.A.U2.0000.en.html [Accessed 18 March 2016].43Green Plan (2015), p.8.



Differentiating credit scoring from bondratingThe EU’s CMU communication calls for work on creditscoring.44 It is useful to take a closer look at this objective.A bank determines a credit score (or credit rating)

when it lends to individuals or a business to assess therisk of the lending. In other words, “a credit rating is acurrent opinion and measure of the risk of an obligor withrespect to a specific financial obligation based on allavailable information”.45 A bank thereby often benefitsfrom confidential information from a centralised pool ofcredit information available only to banks and providedby central banks.The credit scoring is assigned to an entity and not to

an instrument on itself. A credit score assessment is basedon qualitative and quantitative information that can evenbe confidential. Besides, new companies may havedifficulties in having an adequate credit score due to alack of data. Credit scoring is therefore not the way to gofor SMEs.On the other hand, bond rating refers to a grade given

to specific debt securities to indicate their credit quality,based among other information on the credit rating of theissuer but also the specifics of the instrument, such asdebt ranking or collateralisation. It is granted byindependent rating agencies to ensure their objectivityand that they are based only on public information.On another note, the Commission has already explained

that they plan to reduce the reliance on the ratingsprovided by credit rating agencies through theestablishment of the FSB Principles on Reducing Relianceon CRA Ratings, which are visualised as a multilayerapproach that will eventually be adopted by marketparticipants.46 To promote bond financing bymedium-sized corporate issuers, the Commission maywish to further develop, together with rating agencies, aspecific rating system.

Equity—public and privateThe Green Paper addresses private placements as a wayfor companies to raise capital:

“[A]n offering of securities to an individual or smallgroup of investors not on public markets. These canprovide a more cost effective way for firms to raisefunds, and broaden the availability of finance formedium to large companies and potentiallyinfrastructure projects.”47

Let us start by saying that the securities offered withprivate placements are of a different nature than thesecurities that concern the CMU. Private placementspredominantly involve equity issuance. Banks act asbrokers and arrangers between investors and borrowersat the time of issuance. Inherent to their private nature,while private placements disintermediate the banks, theydo not feed the capital market: they are not listed and arecirculated among a handful of buyers. There is nosecondary market infrastructure to facilitate trade in thesesecurities and thus no liquidity.Furthermore, the Commission’s statement that private

placements are cost-effective needs to be questioned.Since they are not liquid instruments, the conditions ofthe issuance are affected by what is known as anilliquidity discount. They are structurally more expensivethan public issues.Concerning equities, there is no shortage of buyers or

sellers of shares of private companies. Depending on thelevel of development of the company, it is angel investors(startups), venture capital (small enterprises) and privateequity (SMEs). Furthermore, as Europe’s largest privateplacement market, the products on Germany’sSchuldschein market are not considered securities underGerman law. The need for internationalisation of thismarket and other private investments is relevant, but notwithin the actual scope of building the CMU. Rather thangetting more deeply into the issue of private placementsin the development of the CMU, it might be preferableto refer to the International Capital Markets Association(ICMA) task force that tries to improve this market.48

Private placements apply only to equity issuanceoutside of CMU.

InfrastructureThere seems to be some confusion on the role of capitalmarkets in infrastructure finance. Infrastructure projectsare generally not part of the development of capitalmarkets. It only affects capital markets through theindirect financing of lending institutions. As such,infrastructure finance is therefore not part of the CMU.Infrastructure projects do not finance themselves directlythrough capital market transactions.The nature of infrastructure finance is such that they

are unlikely to use capital markets directly. They mightcontinue to drive their funding through the balance sheetsand guarantees of the EIB, the European Investment Fundand its specific programs.

44Green Plan (2015), p.10.45ESME, “Role of Credit Rating Agencies, report to the European Commission” (June 2008). Available at: http://ec.europa.eu/finance/securities/docs/agencies/report_040608_en.pdf [Accessed 18 March 2016].46DG Internal Market and Services available at: http://ec.europa.eu/finance/rating-agencies/docs/140512-fsb-eu-response_en.pdf [Accessed 18 March 2016]; and ICMA,“The current state and future evolution of the European investment grade corporate bond secondary market: perspectives from the market” (November 2014). Available at:http://www.financialstabilityboard.org/publications/r_101027.pdf [Accessed 18 March 2016].47Green Plan (2015), p.11.48 ICMA, “Pan-European Corporate Private Placement Market Guide” (February 2015). Available at: http://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/Primary-Markets/private-placements/the-pan-european-corporate-private-placement-market-guide/ [Accessed 18 March 2016].



Infrastructure finance requiresdifferentiation between debt and equityThe Green Paper stresses the need for new infrastructureinvestment in the EU:

“to maintain its competitiveness. The flow of fundsto such projects is, however, restricted byshort-termism, regulatory barriers and other factors.Also, many infrastructure projects displaycharacteristics of public goods, implying that privatefinancing alone may not be appropriate to deliverthe optimal level of investment.”49

The importance of infrastructure financing cannot beunderestimated. It is a source of employment andeconomic activity. However, the funds for those projectshave a twofold nature of debt and equity, which is notwell-distinguished in the CMU project. This distinctionis essential if the Commission is going to adequatelyaddress infrastructure financing.Financing major infrastructure projects usually entails

both debt and equity financing. Many infrastructureprojects are today funded through project financewherebycorporate sponsors providemuch of the equity financing.These infrastructure projects are often done within specialpurpose vehicles (SPVs), outside the legal entity of thecorporate sponsors.Through the creation of SPVs, promoters and

beneficiaries of the infrastructure project are the providersof equity that is never publicly placed. The sole purposeof the SPV is to carry out the project. This enables thecorporate sponsors to shield themselves from many ofthe liabilities that could arise if the project fails. In projectfinance, the only assets that a lender can seize are thosebelonging to the SPV. In this context, there is a strongincentive for equity stakeholders to increase the debt toequity ratio. They have little to lose and a lot to gain bycreating highly leveraged SPVs. Government guaranteesalso enable a SPV to build up more debt than it mightunder normal circumstances as projects with governmentbacking appear to be more credible to other borrowers.Involving capital markets in infrastructure finance is

problematic. Governments and promoters can keep theseliabilities off their balance sheets. This means that theycan increase their liabilities while not reducing theirability to borrow money otherwise. The problem is thatgovernments and shareholders still have those liabilities.Thus, infrastructure financing can disguise massiveliabilities. Due to the fact that the only collateral ininfrastructure finance is in the SPV, infrastructure isextremely risky. Lenders depend on the success of along-term project to get paid back. These conditionsshould have great effects on how the Commissionregulates debt and equity in infrastructure finance. Forthis reason, neither the equity nor the debt of SPVs islisted or public.

The Commission should be cautious regarding projectsfunded with more debt. Allowing more debt wouldincrease the amount of projects and provide a short-termstimulus to the European economy. However, the stimuluswould be ephemeral as an economic downturn could havean extremely deleterious effect on infrastructure finance.It could negatively affect government finances inparticular. Liabilities that are hidden during periods ofeconomic stability would burst forward when theeconomy suffers a downturn. Government action to ensurethat the debt to equity ratio remains manageable must betaken because natural incentives do not encourage fiscallyprudent conduct in infrastructure finance.Private financing may not be enough to deliver the

optimal level of investment. However, governmentsupport will not improve the situation. It could make itworse. The Commission should find ways to encouragesound equity financing. It should also encouragetransparency in infrastructure finance. If the Commissionand Member State governments do ultimately decide tobecome more involved in infrastructure finance, theyshould establish ring-fenced funds that would enablegovernments to support infrastructure projects thatencounter financial difficulties.There is a need for a special task force looking at

infrastructure finance, but it is not part of the CMU.

Leveraging the powerful role of theEuropean Investment BankThe infrastructure considerations of the Green Paper seemto ignore the role of the EIB Group50 in infrastructurefinance. The EIB Group is composed of the EuropeanInvestment Bank and the European Investment Fund,which latter is more focussed on providing SME riskfinance. It does have a balance sheet of €542 billion.The EIB Group defines itself as the only bank owned

by and representing the interests of the 28 EU MemberStates and the largest multilateral borrower and lenderby volume. It aims at financing projects in strategicinfrastructures, in renewable energies, environmental andurban development, in education and finally in helpingSME’s financing.As the EIB is directly owned by the EUMember States,

it can enjoy the lowest interest rates and provides the bestquality of sovereign bonds. EIB issues euro benchmarkbonds under its Euro Area Reference Notes (EARNs)program. There are great ranges of liquidity and maturityfor those products, which have outperformed AAA-ratedsovereign bonds. Thus, the EIBGroup is already proactivewith probably an unbeatable access to low cost funds.The Green Paper suggests a restriction of funds for

infrastructure projects because of short-termism,regulatory barriers and other factors, while the EIBalready has a long-term outlook. Moreover, it makes apoint of insisting on SMEs and infrastructure projects,which are the two focusses of the EIB. In its

49Green Plan (2015), p.14.50Available at: http://www.eib.org [Accessed 18 March 2016].



recommendation, the Commission seems to ignore thisexisting structure and it is difficult to imagine what couldbe more efficient. The independency and the exceptionalaccess to funds of EIB might be the best way we have tofund economic growth. We should encourage it morethan to compete with it—or try to redo its work.

Medium enterprises at the centre of theCMUIn recent studies of the ECB on access to finance ofSMEs, it appeared clearly that access to finance is adeclining preoccupation for SMEs, and the least importantfor the moment. The chart hereunder quantifies thatanalysis.51

This table should be a humbling moment for the CMUprotagonists. Using capital markets does face companieswith serious challenges, even though their appetite forother sources of financing is also uncertain.It would be helpful in this debate if the Commission

distinguishes small companies and start-ups frommedium-sized companies.

Priority on medium-sized companies isessential to the CMUThe Commission’s CMU Green Paper states:

“SMEs can raise financing as easily as largecompanies; costs of investing and access toinvestment products converge across the EU;obtaining finance through capital markets isincreasingly straightforward; and seeking fundingin another Member State is not impeded byunnecessary legal or supervisory barriers.”52

Medium-sized companiesOne could agree with the previous statement of theCommission if it applied only tomedium-sized companiesinstead of all SMEs. Following the definition of SMEs,medium-sized companies have a turnover of ≤ €50million

or ≤ €43 million on their accounts. Furthermore, EUpolicy on funding opportunities for micro or smallercompanies may be a divergence from the EU principleof subsidiarity. Financing smaller companies is mostly anational issue, if not regional or local. It would beessential to consider a policy that looks at themedium-sized enterprises who, are squeezed and ignoredbetween the big and the smaller companies (i.e. with aturnover or balance sheet of ≤ €10 million).Medium-sized companies are significant to the overall

economy as part of the group of SMEs that constitute99% of all businesses in the EU. The example of Germanyand the importance of its Middlestand has been the coreof job creation, competitiveness and technology.53 Morespecifically, the size of medium-sized companies (andsmall mid-cap)54 is sufficient to allow capital marketfinancing, while the small enterprises can only benefitfrom the markets indirectly, i.e. through financialintermediaries such as banks and venture capitalists.The development of a corporate bond market that

would incorporatemedium-sized companies would enrichthe European capital market. However, it also raises withmore acuity the question of liquidity. For a medium-sizedcompany issuing €50 million—a minimum for any formof liquid securities issue—this is a very large amount with

51ECB, “Survey on access to finance of small and medium enterprises” (December 2015). Available at: https://www.ecb.europa.eu/pub/pdf/other/accesstofinancesmallmediumsizedenterprises201512.en.pdf?2c146594df6fe424c7adb001e1306c73 [Accessed 18 March 2016].52Green Plan (2015), p.4.53EIF, “Investment and Investment Finance in Europe” (2015). Available at: http://www.eif.org/news_centre/research/investment_and_investment_finance_in_europe_2015_en.pdf [Accessed 18 March 2016].54Mid-cap companies are defined in arts 3, 4, 5 and 6 of the Title I of the Annex of the Commission Recommendation 2003/361 concerning the definition of micro, smalland medium-sized enterprises [2003] OJ L124/36.



limited flexibility. Creating liquidity for a €50 millionissue will require a very specific commitment of publicand private financial institutions.

Smaller-sized companiesMoreover, there are organisations addressing the needsof SMEs. For example, the European Investment Fund(EIF) has been very active by providing bank guaranteesand investing in private equity funds, and is an addedvalue for SMEs.55 However, this is not through capitalmarkets, but due to loan guarantees granted by the EIFor the banking sector. It is a risk sharing and creditenhancement mechanism. Further, the majority of SMEswill continue to rely on bank funding, and not be directlybenefited from or even be impacted by CMU.56 Indeed,the CMU communication expresses a recurrent themecoming from the European authorities; banks need to beassisted to make loans:

“In Europe, most SMEs only approach banks whenseeking finance. Although almost 13% of theseapplications are rejected, it is often because they donot meet the banks’ desired risk profiles, even ifthey are viable.”57

The assumption is that companies need funding, andeven more, cheap funding. This idea is not confirmed bythe observations. According to the Survey on the Accessto Finance of Enterprises in the euro area, SMEs find thatthe willingness of banks to provide credit is increasedacross countries.58 According to this survey, bank relatedproducts are the most relevant source of finance for euroarea SMEs. Notwithstanding, every EU country hasshown different SME dependency on this source offunding.The survey shows that banks are willing to continue

and even increase lending for SMEs, especially forcompanies other thanmicro-sized companies. The ECB’sloan survey shows that banks eased their credit standardsfor corporate loans even further during early 2016.Accordingly, the rejection rates for loans to enterprisesdecreased. Nonetheless, microenterprises remain highlychallenged to access the banking system.The lesson to draw from this is that small

companies—as defined by the EU—need to be dealt withlocally, not at the European level. Where Europe can behelpful is the policy-making and structural support tomedium-sized companies. Capital markets cannotaccommodate companies who borrow less than €50million at a time.

The amalgamation of small and medium-sizedcompanies is not attributable to the Commission. If onetries to find the definition of “medium enterprises”, onlyresources on SMEs are available. In terms of availabledata and EU policy, the three different business sizesincluded in the SME definition—micro, smaller andmedium-sized—are glued together. This can beproblematic for regulatory purposes and adequatepolicy-making. To ensure the feasibility of a capitalmarkets financing, medium enterprises should issuesufficient bonds or equity to meet the necessary liquiditylevel. This, implicitly, means that what is called a“medium enterprise” has to havemore assets for the CMUpurpose.

The Prospectus Directive59 and the need forinformationDistinguishing small from medium-sized companieswould help with another proposal under the CMUproject:reforming the current prospectus regime. This wouldindeed make “it easier for companies (including SMEs)to raise capital throughout the EU and to boost the take-upof SME Growth Markets”.60

Since the introduction of EU’s Prospectus Directive in2005, the access of SMEs to public equity fell due to thecost of producing a long and complex document subjectto the approval of the competent national authorities. Thecurrent prospectus regime will likely not be very usefulfor SMEs, because SMEs do not resort to the prospectuseson a regular basis and the investors will anyway operatetheir assessment on their independent assessment.Instead, the Commission must create a separate and

simplified disclosure regime for SMEs, applicable onlyto medium-sized companies who raise capital publicly.This is relevant to institutional and private investors. TheQuoted Companies Alliance advices:

“Exemption from vetting by a national competentauthority; the limitation to a closed set of mandatorydisclosures; and the possibility to incorporateinformation by reference to what [is] alreadyavailable to the public.”61

Simplification and clearer documents would decreasethe time and costs of producing a prospectus.

55Available at: http://www.eif.org [Accessed 18 March 2016].56Nicolas Véron and Guntram B. Wolff, “Capital Markets Union: a vision for the long term”, Bruegel Policy Contribution (23 April 2015). Available at: http://www.bruegel.org/publications/publication-detail/publication/878-capital-markets-union-a-vision-for-the-long-term/ [Accessed 18 March 2016].57Green Plan (2015), p.14.58ECB, “Survey on the Access to Finance of Enterprises in the euro area” (April 2016). Available at: https://www.ecb.europa.eu/stats/pdf/blssurvey_201604.pdf?62706d1f446edb3d029bf00251b7a665 [Accessed 20 April 2016].59Directive 2003/71 on the prospectus to be published when securities are offered to the public or admitted to trading. Available at:http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32003L0071&from=EN [Accessed 6 May 2016].60Green Plan (2015), p.10.61Quoted Companies Alliance, “Proposals to amend the Prospectus Directive” (February 2015), p.4.



Should issuers apply a common accountinglike IFRS?Harmonising accounting standards have been a subjectof debate for a long time, and are addressed by the CMUproposals:

“[T]he development of a simplified, common, andhigh quality accounting standard tailored to thecompanies listed on certain trading venues could bea step forward in terms of transparency andcomparability, and if applied proportionally, couldhelp those companies seeking cross-border investorsto be more attractive to them.”62

Most users of International Financial ReportingStandards (IFRS) probably do not consider the IFRS assimple. Furthermore, oppositions from some countriesmake its European application disparate. For example,on an enforcement level, the US has a problem with thelack of statutory rights of the European accounting bodieswho can accept exceptions under political (European ornational) pressure. However, Kara Stein, an SECcommissioner, described IFRS as an “aspirational goal”.63

In November 2015, the SEC’s chief accountant, JamesSchnurr advocated the use of global accounting rules byUS companies in order to complement their financialstatements considered under US regulations.64 Recently,China also seemed to explore further use of IFRS.65

On 10March 2015, Insurance Europe published a jointletter with the European Insurance CFO Forum to theEuropean Financial Reporting Advisory Group(EFRAG).66 The Maystadt Recommendations are key tothis thinking process.67

Today, the Commission is on a collision course withpolicymakers over its obligation to launch a full reviewinto the legality of international accounting rules and howthe body responsible for setting them is run. It seems toassume that SMEs should apply a common accountinglike IFRS.The EU has not adopted the current IFRS for SMEs

because it was assessed to be incompatible with the EUAccounting Directives. However, the EU has made anallowance thatMember States can adopt it if they modifyit to comply with the Accounting Directive from 2013.68

The latest Accounting Directive aims at reducing theadministrative burden for SMEs by simplifying thepreparation of financial statements and reducing thefinancial information SMEs are required to report. TheDirective will apply to all EU Member States.The fact that IFRS for SMEs has not been implemented

across the EU suggests that applying a commonaccounting standard for SMEs across the EU is unrealisticand a better goal would be to simplify reporting in babysteps as initiated by the Directive noted above:

“The IFRS for SMEs is a self-contained Standard(less than 300 pages); designed to meet the needsand capabilities of small and medium-sized entities(SMEs), which are estimated to account for over 95per cent of all companies around the world.”69

Regulation could become an obstacleto CMUThe European regulatory framework tries to protecttaxpayers from having to bail out financial institutions.Yet, it does not aim at developing new markets, let aloneinciting banks and insurance companies to become criticalplayers in this initiative.The Commission’s Action Plan acknowledges the

potential negative impacts of new regulation on long-terminvestments:

“Institutional investors, in particular life insurancecompanies and pension funds, are natural long terminvestors. However, in recent years they have beenretrenching from investment in long term projectsand companies … At present, they typically hold alarge share of their portfolio in a relatively narrowrange of assets. The EU should support institutionalinvestors to allow their exposure to long-term assetsand SMEs, while maintaining sound and prudentasset-liability management. Prudential regulationaffects the appetite of institutional investors to investin specific assets through the calibration of capitalcharges.”70

There is something perplexing in seeing regulatoryinitiatives that were aiming at the financial stability andresolution of crisis re-emerge in the context of capitalmarkets. While obviously regulation is interconnected topolicy, the success of the CMU project will be affectedby regulatory considerations.

62Green Plan (2015), p.14.63Sara Lynch, “SEC’s Stein calls for ending debate over dueling accounting rules” (26March 2015). Available at: http://www.reuters.com/article/2015/03/26/sec-accounting-stein-idUSL2N0WS1LJ20150326 [Accessed 18 March 2016].64Michael Rapoport, “Top SEC Accountant Urges Supplemental Use of Global Rules for US Companies” (17 November 2015). Available at: http://www.wsj.com/articles/top-sec-accountant-urges-supplemental-use-of-global-rules-for-u-s-companies-1447780897 [Accessed 18 March 2016].65Richard Crump, “China to explore further use of IFRS” (25 November 2015). Available at: http://www.accountancyage.com/aa/news/2436407/china-to-explore-further-use-of-ifrs [Accessed 18 March 2016].66Available at: http://www.insuranceeurope.eu/sites/default/files/attachments/Joint%20letter%20to%20EFRAG%20on%20IFRS%209%20endorsement.pdf [Accessed 6May 2016].67EFRAG, Implementation of the Maystadt Recommendations (31 October 2014). Available at: http://ec.europa.eu/finance/accounting/docs/governance/reform/131112_report_en.pdf [Accessed 6 May 2016].68Directive 2013/34 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings. Available at: http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32013L0034&from=EN [Accessed 6 May].69 IFRS, 2015 Amendments to the IFRS for SMEs (May 2015). Available at: http://www.ifrs.org/IFRS-for-SMEs/Documents/IFRS%20for%20SMEs%20May%202015/2015_Amendments%20to%20IFRS%20for%20SMEs_Standard.pdf [Accessed 6 May 2016].70Action Plan (2015), p.20.



Solvency II penalises long-term investmentsLong-term investors are the great absents of the GreenPaper. It is assumed that they will have an interest andbe incited to acquire such assets. It is important to lookat the terms and conditions at which they might play therole of primary liquidity provider. Without their interest,banks will not play the role of secondary liquidityproviders. How can long-term investment funds becomean instrument that will activate capital markets? TheGreen Paper refers to the Solvency II Directive, statingthat it

“will allow companies to invest more in long-termassets by removing national restrictions on thecomposition of their asset portfolio”.71

While this paper will not express an opinion on themerits and/or weakness of the Solvency II Directive forthe European markets, Solvency II will not encouragelong-term financing within the context of a more robustcapital market in Europe as the Green Paper presumes.Currently, the Solvency II regime is effective since 1January 2016—three years prior to the goal set out for afully functioning European CMU by 2019.The Solvency II Directive has a series of rules that

discourage long-term investments. Most notably,Solvency II utilises a market value framework to ensurethat the balance sheets of insurance companies haveenough capital buffers to deal with any large marketdisruptions. In doing so, the market value of traditionallysafe assets will increase while the values of otherlong-term assets classes (like infrastructure and realestate) will decrease and insurance companies will seemlike they are in a weak capital position, even though theirliabilities are due in a distant future and may be able towithstand temporary market volatility. Insurancecompanies will no longer have as much incentive to holdlong-term investments because of the way the marketvalue framework interprets the balance sheets, and willinstead turn to assets with shorter maturities and safeassets traditionally not impacted by market volatility.Right now, insurance companies are the largest

institutional investors in Europe. If Solvency II isimpacting the ability of insurance companies to makelong-term investments, this will in turn impact theircontribution of liquidity to the European CapitalMarkets.72 The Director-General of Insurance Europe,Maria Koller, made a comment that is illustrative of thispoint:

“While the industry welcomes the move to arisk-based regulatory regime and recognises that thefinal version of Solvency II was improved to avoid

a huge negative impact on long-term investments,aspects of the directive and how it is implementedwill still require insurers to hold inappropriately highamounts of capital against their long-terminvestments. This will make it more expensive forinsurers to invest in long-term government andcorporate bonds, as well as growth-stimulatingactivities, such as infrastructure projects.”73

In fact, the Commission wrote an open letter74 to theEuropean Insurance andOccupational Pensions Authority(EIOPA) regarding insurance companies concerning theirrole as long-term investors, and later a Green Paper75

concerned with the range of factors that may impactlong-term financing in Europe. In terms of Solvency II,the Green paper on Long-Term Financing of the EuropeanEconomy said:

“Institutional investors such as insurance companiesare suitable providers of long-term funding. Whileinvestment by institutional investors in less liquidassets such as infrastructure assets has been limited,the search for higher yields in a low interest rateenvironment is increasing their appetite for suchassets.Solvency II, applicable since 1 January 2016, will

repeal certain investment obstacles, particularly forless liquid asset classes, which currently exist inMember States. Insurers will be free to invest in anytype of asset subject to the prudent person principle,whereby they should be able to ‘properly identify,measure, monitor, manage, control and report’ therisks associated with such assets.It is argued that strengthening capital requirements

to capture all quantifiable risks, including marketrisk (which was not considered in the previous legalregime, Solvency I) may influence the investmentbehavior and long-term outlook of insurers asinstitutional investors. For this reason, theCommission asked the European Insurance andOccupational Pensions Authority (EIOPA) inSeptember 2012 to examine whether the calibrationand design of capital requirements necessitates anyadjustment, without jeopardizing the prudentialeffectiveness of the regime, particularly forinvestments in infrastructure, SMEs and socialbusinesses (including securitisation of debt servingthese purposes). EIOPA’s analysis was provided inDecember 2013. It recommends criteria to define

71Green Plan (2015), p.17.72Georges Ugeux, “Could Solvency II Threaten the Financial Stability of European Insurance?” (25 September 2015), Columbia Law School, Blue Sky Blog. Available at:http://clsbluesky.law.columbia.edu/author/georges-ugeux/ [Accessed 18 March 2016].73Maria Koller quoted by Judith Ugwumadu, “Insurers issue Solvency II investment warning” (1 September 2014). Available at: http://www.theactuary.com/news/2014/09/insurers-issue-solvency-ii-investment-warning/ [Accessed 18 March 2016].74European Commission, Letter to the EIOPA on Solvency II Publication (26 September 2012). Available at: http://ec.europa.eu/internal_market/insurance/docs/solvency/20120926-letter-faull_en.pdf [Accessed 18 March 2016].75European Commission, Green Paper on Long-Term Financing of the European Economy COM(2014/168) final (27March 2014). Available at: http://ec.europa.eu/internal_market/finances/docs/financing-growth/long-term/140327-communication_en.pdf [Accessed 18 March 2016].



high-quality securitisation and designs a morefavorable treatment for such instruments, bylowering the corresponding stress factors.”76

In response, EIOPA concluded that there is nojustification for lowering the proposed Solvency II marketrisk charges in relation to certain long-term investments.The EIOPA rejected extension of differential treatmentto infrastructure financing and securitisations of SMEdebt.77

If the Commission wants to encourage long-terminvestments in areas like infrastructure, it must be doneby amending the marking-to-market rules of SolvencyII. It cannot merely assume that the Solvency II Directivewill in fact strengthen long-term investments or this willimpact another area that capital markets can get liquidityfrom. One option would be to encourage collaborationand resource pooling in order to create institutions thatare large enough to make more long-term investmentswith a risk management system that addresses long-termrisks. The CMU project must also find ways to addressthe pro-cyclical behavior of insurance companies sellingassets too quickly and not serving as long-term investors.My main concern is the imbedded volatility to whichsolvency ratios might be subject.

The way ahead for the CMU: focus oncapital markets for medium-sizedcompaniesWithout questioning the intentions of the Commission,it seems that the definition of capital markets was dilutedby other policies of the EU to benefit from thisopportunity. In order for the CMU to succeed, it isessential that a specific focus be granted for the creationof pan-European equity and corporate bond markets,sensu stricto. It is by itself a substantive undertaking thatrequires clear priorities.This project clearly corresponds to Schumpeter’s

creative destruction of a continent that has entirely reliedon bank financing over the past centuries as the Medicidid in the 15th century in Venice. Building the CMU ishugely complex and challenging, but it needs to be doneif Europe wants, as the Commission does, to dispose ofmodern sources of diversified channels of financing.I would therefore recommend that the Commission

focusses its ambitions on what this is actually about: thedevelopment of stronger capital markets in Europe forthe benefit of all parties involved. Medium-sizedcompanies are in serious need for alternative investments.They are also the providers of jobs and the source ofgrowth. Capital markets are not accessible to small

companies and start-ups for structural reasons anywherein the world. The following issues should be the corefocus.

• Liquidity is not something the Europeanauthorities can activate by themselveswithout a massive co-operation of financialinstitutions. It will be important tounderstand the providers of primaryliquidity (investors) and secondary liquidity(market makers) to look at the opportunitiesand challenges of developing the embryoniccorporate bond market in Europe. It is aconditio sine qua non to the existence of aEuropean CMU.

• The potential role of insurance companiesrequires an honest assessment regardingthe consequences that Solvency II has onthe long-term end of their portfolios. Thecurrent application of Solvency II will tellif a revision of the marking-to-market oftheir securities should be on the reformagenda to avoid undue volatility ofinsurance companies’ solvency ratios.Long-term investment should be part of theCMU.

• Credit Ratings are a matter for discussionwith the existing credit agencies. Howcould they extend their services tomedium-sized companies in a way thatreduces the complexity and the costsassociated to this rating? The answer is notat the rating agencies, nor at theCommission. Institutional investors willhave to guide the Commission efforts onthe prospectus and the information availableat a level that make it reasonable for themto invest.

• Regulated stock exchanges do have theability to list and trade equities issued bymedium and large corporations. Theplatform for large capitalisations is alreadyin place and effective, together with theMiFID and MiFID II regulations.78 Whatdo they need to activate a market formedium-sized companies in a way thatprovides an orderly and transparent pricediscovery?

• The securitisation of financial assets isalready the object of considerable workwithin the Commission. It will be importantto create a climate that makes such assetssufficiently liquid to create investors’

76European Commission, Green Paper on Long-Term Financing of the European Economy (27 March 2014), p.5. Available at: http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52013DC0150 [Accessed 18 March 2016].77EIOPA, “Discussion Paper on Standard Formula Design and Calibration for Certain Long-Term Investments” (8 April 2013). Available at: https://eiopa.europa.eu/Publications/Discussion%20paper/Discussion_Paper_on_Standard_Formula_Design_and_Calibration_for_Certain_Long-Term_Investments_20130408.pdf [Accessed18 March 2016].78Directive 2004/39 on markets in financial instruments amending Directives 85/611 and 93/6 and Directive 2000/12 of the European Parliament and of the Council andrepealing Directive 93/22 [2004] OJ L145/1 (MIFID) and Directive 2014/65 on markets in financial instruments and amending Directive 2002/92 and Directive 2011/61[2014] OJ L173/349 (MiFID II).



confidence. It does however raise thequestion: what is the nature of the ultimateinvestors in securitised assets? The ECB’sattempts seem difficult to implement.79

• Involving London is essential to this effortto provide visibility of the European CMUbeyond continental borders. The city is akey factor in the world of global markets.In the context of the British referendum, itis a delicate but positive exercise. “It’s thegame of a lifetime between the UnitedKingdom and the EuropeanUnion but someof the City of London’s biggest players aresitting on the sidelines.”80

• Work with the EIB in the field ofinfrastructure finance. With over half atrillion of assets, the EIB is by far the mostpowerful tool that the EU disposes of toprovide infrastructure finance.

• Look at the regulatory obstacles to theCMU, whether it is Solvency II, Liquidityratios, CRR and CRD IV, or the prospectusdirectives; but not by increasing leverageor leading to a capital adequacy that createsan incentive to take additional risks.

In order to address these challenges, the Commissionneeds to distinguish between equity and bond markets.There are fundamental reasons why those markets haveevolved in a way that puts bonds into an over-the-counterstructure and equities in regulated exchanges.While bothwill need liquidity support, they are of a substantiallydifferent nature.That process requires the active co-operation of the

primary liquidity providers (the insurance companies andother categories of institutional investors), the secondaryliquidity providers (banks and other market makers) andthe equity markets (stock exchanges and large tradingplatforms). It is time to create this forum in order toensure that the key ingredients are available to providethe necessary liquidity and trading environment that canmake it a success.The following topics, as important as they are, would

only delay andmake unnecessarily complex this initiativeand should be involved at a later stage or in a differentforum:

• The ELTIF, the “fund”, needs to bediscussed in a forum that recognises theleadership of the EIB and its unique accessto the sovereign bond market with an AAArating. Infrastructure finance does notderive from capital markets.

• The dialogue on venture capital isimportant, but it is not new and is notfinanced through capital markets. However,it addresses small companies that, bydefinition, do not have access to capitalmarket financing. The notion that the CMUcould help start-ups is utopia. It is not thecase on the US market and venture capitalis financed outside of the public markets.

• The same applies to private placementswhich do not, by definition, include tradedsecurities and are specifically addressingneeds of equity.

• Bank loans are by definition not part ofcapital markets. Examining the reasons forEurope’s stagnant loan market is useful:interpretations on the lack of bank loansare speculative, at best.

• Infrastructure finance is a topic by itself.While the CMU might provide indirectsupport to the Commission’s initiatives,this financing requires a level of flexibilitythat is not compatible with securitiesfinancing. Also, the US markets do notfinance infrastructure through publicmarkets.

We cannot ignore that sovereign bonds, that representa large share of the equity of European banks, benefitfrom an unjustifiable privilege. They do not require anyform of capital adequacy and, in a negative interest ratepolicy of the ECB, provide profitable carry-trade profitsfor banks. Central banks protect banks that invest inGovernment securities. The Bermuda Triangle of thebanking sector, central banks and governments needs tobe broken if the Commission really wants to create aEuropean CMU. It is therefore against the formidablepressure of banks and sovereign issuers that this initiativeconflicts. It is the EU governance that will be challenged:the CMU is a task of historic dimension.

79Christopher Whittall, “ECB’s Attempt to Breathe New Life Into Securitization Market Falls Flat” (1 February 2016), Wall Street Journal. Available at: http://www.wsj.com/articles/ecbs-attempt-to-breathe-new-life-into-securitization-market-falls-flat-1454315616 [Accessed 18 March 2016].80 Francesco Guerrera, “City goes silent on Brexit” (1 January 2016)Politico. Available at: http://www.politico.eu/article/the-city-bickers-over-brexit-united-kingdom-european-union-membership/ [Accessed 18 March 2016].

