Capital Markets, Debt Finance and the EU Capital Markets Union: A Law and Finance Critique
Modern, globalised financial markets are the offspring of a process of liberalisation of capital that started with the collapse of Bretton Woods in the 1970s and culminated with the deregulation policies of the late 1990s. As a result, financial markets have grown dramatically and become increasingly integrated at global level. Much of the growth and innovation that occurred over the past decade has taken place in the realm of capital markets finance, and in particular in the context of debt finance, where new transactional models and products have been engineered since the 1980s.
In this paper I contend that, contrary to conventional wisdom, the excessive development of capital markets finance has been one of the catalysts behind the crises that exploded over the past fifteen years. In particular, the use of innovative debt transactions was instrumental to the creation of excessive levels of risk-taking and leverage. These had catastrophic consequences, both at firm and systemic level.
While much regulation has been enacted in the aftermath of the crises that exploded over the past fifteen years, the way in which debt transactions in capital markets are designed and entered into remains largely unregulated. Moreover, regulators have so far neglected the role that leverage and debt creation have in the economy, and the consequences that these phenomena have on the wider social context. On the contrary, the recent policy design in the EU is promoting a renewed implementation of an old design, the Capital Markets Union (CMU). This revolves around disintermediated, market-based forms of financing, which should represent an alternative to the traditionally predominant (in Europe) bank-based financing channel. In this paper I propose an alternative perspective, suggesting that the European policy design fails to appreciate the risks associated with capital markets finance and its ensuing debt creation effects.
These arguments are grounded on a preliminary reconceptualisation of the key policy and economics claims behind the two main channels of financing, namely bank finance and capital markets finance, which are discussed critically in the context of the EU policy agenda. As said, this paper identifies a number of problems that recur in connection with the development of capital markets channels of finance. These problems are firstly introduced through a discussion of the role that debt, leverage and liquidity have in the financial system. They are then further expounded through a contextual illustration of the development of market-based finance in the pre-crisis years, into what is referred to as securitised banking model. This revolved in particular around two main segments of financial markets, namely the securitisation and the repo markets. The regulatory and policy challenges emerging from this model of financial intermediation are explained by looking at the effects of the leverage cycle on the financial system and its ensuing instability.
The critique of the EU project is completed by looking at the regulatory framework of market-based finance under the CMU. Attention here is drawn mainly (but not solely) to two pieces of regulation. Firstly, the Simple, Transparent and Standardised (STS) Securitisation, which is a central part of the CMU project (and on which I have written more specifically elsewhere); and secondly, the combination of the EU Securities Financing Transactions Regulation, together with the FSB framework for the regulation of haircuts in repo-type transactions.
In this paper I argue that, despite some regulatory efforts, a suitable architecture for the regulation of disintermediated capital markets is still missing.
Vincenzo Bavoso is a Lecturer in Commercial Law at The University of Manchester.
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