The Draghi Report and the Quest for EU Capital Markets: Some Critical Reflections

Since 2015, the European Commission has pursued a policy aimed at fully implementing the integration of pan-EU capital markets, a policy project that has taken the brand name of Capital Markets Union (CMU). This was accompanied from an early stage by a package comprising various regulatory instruments intended to advance the harmonisation of key segments of capital markets. As I have argued in an earlier article on the CMU, in 2018, the Commission’s priority seemed from the outset focused on the development of debt segments of capital markets, and particularly securitisation and bonds. An EU Regulation on securitisation was, in fact, the first building block of the CMU, and this was aimed at resurrecting the post-2008 European market, around a more advantageous prudential framework (what is commonly referred to as Simple, Transparent and Standardised -STS- framework). While I critiqued this regulatory design on several occasions, the resurgence of securitisation in Europe has not met the expectations of policy-makers, and the CMU as a whole has failed to gain momentum.

The perennial struggle for growth that engulfs European economies, particularly at present given the geopolitical instabilities lingering at their borders, has led to a renewed focus on achieving a capital markets union, which is also at the heart of a policy document titled The Future of European Competitiveness, also referred to as the Draghi Report. This Report reiterates some fundamental and long-standing beliefs, and particularly: a) the urgency to channel financial resources in the EU towards research and innovation; b) the excessive regulatory burdens that hinder EU entrepreneurs, particularly start-ups and SMEs; and c) the fragmentation of European financial markets, which is seen as the main factor impeding the success of the CMU. The Report effectively emphasises the importance of fully implementing the CMU, arguing that this would represent the catalyst for growth that the EU is so desperately trying to achieve. And, worth stressing here, EU policy-makers have remained keen on the mantra that most of their policy goals (from the ‘Green’ transition, to research and innovation) are better pursued by mobilising financial resources via market-based channels of intermediation. Banks, in other words, despite representing the traditional source of finance in European economies, are to be relieved of this encumbrance and left free to pursue more cost-effective business—indeed via capital markets. Moreover, for banks to be able to extend loans, they should be able to rely on a securitisation market that allows them to repackage and trade those loans.

In a recent policy brief I have, again, criticised this policy stance on four main grounds.  The first criticism relates to the relentless comparison that EU policy-makers draw between US and EU capital markets. It is well known that the federal status of the US is not replicated in the EU, and this leads precisely to the different legal, regulatory and enforcement regimes that still maintain EU financial markets fragmented. From a conceptual point of view, parallels with the US are also flawed as they fail to take under due consideration different historical, political and institutional preconditions that have shaped the structure of US securities markets.

The second criticism is more foundational: it disputes the centrality that the Commission places on capital markets as engines of economic growth. The EU policy stance has traditionally downplayed the importance that banks have played across European economies while overstating what capital markets might achieve. There are, instead, valid arguments contending that developments in capital markets over the past thirty years (such as evolutions in structured finance and derivatives) have not had tangible effects on the real economy. Capital markets, in other words, have not been associated with growth-oriented projects, but rather with the acquisition of already existing assets, primarily in finance and real estate. These are developments that have also led to asset bubbles, alarming levels of private debt at the global level, and inevitable fears of systemic instability.

A third concern I raise is related to the narrative that the Commission has construed on the merits and flaws of European banks. Falling into such a generalisation is again quite naïve because the structure of European banking is historically not homogeneous. What is fairly safe to observe is that the fragility of banking organisations is rooted in their shifts in business model since the 1990s, which led in turn to the proliferation of large megabanks, and their greater interplay with capital markets on both sides of their balance sheets. This type of expansion led to the shifting of banks from more traditional deposit-taking and lending, towards capital markets intermediation, which eventually contributed to sharp increases in interconnectedness and systemic risks.

The incapacity of European banks to extend credit to the real economy, as is repeatedly invoked by the Commission, needs to be understood in the light of the above shifts and also as a result of the regulatory costs flowing from the capital requirements under Basel III.  Still, to fully appreciate the potential of the banking ecosystem across Europe (and its heterogeneity), one needs to remember that small cooperative banks play a key role in some European economies, particularly with respect to start-ups and SMEs. This transpires, for instance, in Germany, where the Bundesbank has put emphasis on the business model of different types of banks, indicating that domestic business loans represented in 2016 only 8% of total assets in big banks, whereas they accounted for 28% of total assets for cooperative banks. Similarly, it has also been illustrated that German cooperative banks increased their lending to the real economy between 2008 and 2011 by 14%.

A fourth point of criticism is the failure of the Draghi report to show sufficient cognisance of the repeated red flags that have been raised by global policy-makers (most prominently the IMF) about the rising levels of private debt in the financial system. For a number of years, the IMF has warned of the alarming indebtedness in the corporate and financial sectors and the limited capacity of economic agents to meet payment obligations under their debt contracts. The IMF has been representing, in other words, the descending stage of a leverage cycle and the inevitable prospect of financial instability, as hypothesised by Minsky.

The above dynamic is important to note particularly because of the emphasis that the Draghi Report, and the CMU package before, lay on securitisation. So much so that the Commission recently launched a targeted consultation on the functioning of securitisation in the EU, aimed at deregulating this market for the purpose of spurring its resurgence and the growth of capital markets. While this could be the topic of an entire second blog post, suffice here to remember that securitisation was widely recognised in the post-2008 years as one of the chief causes of the crisis. The crux of the problem is its capacity to create layers of leverage and interconnectedness in the financial system outside of what regulators can monitor.

The overall suitability of capital markets to be engines of economic and social advancement appears rather overstated in the EU Commission’s narrative. Part of my recent monograph (titled Debt Capital Markets: Law, Regulation and Policy) addresses some of these long-standing questions, particularly with respect to 1) the inherent capacity of capital markets to lead to financial instability and crises, and 2) the potential of new regulatory frameworks to prevent them.      

The author’s policy brief, ‘The Quest for European Competitiveness, the Draghi Report, and the Chimera of EU-wide Capital Markets’, can be found here.

Vincenzo Bavoso is a Professor of Commercial Law at the University of Manchester.