Courtesy of Vincenzo Bavoso
In my recent article published in Convivium, titled Market-Based Finance, Debt and Systemic Risk: A Critique of the EU Capital Markets Union, I addressed the question of whether fully integrated capital markets across the European Union (under the EU Capital Markets Union – CMU) can facilitate economic growth and stability, or whether they are likely to lead to the re-emergence of practices and risks that are reminiscent of pre-crisis years.
The rationale behind integrated capital markets rests on the belief that they represent a more effective platform for private risk sharing. Moreover, capital markets are also regarded as alternative channels of finance to their traditional banking counterparts—at least in continental Europe. This leads to understanding capital markets as market-based finance, with the emphasis being on the disintermediated access to capital, as opposed to the intermediated one that occurs traditionally through banks. It is precisely this disintermediated, market-based character that is assumed to be more efficient in the allocation of finance to small and medium-sized enterprises (SMEs), start-ups, and generally entrepreneurial activities.
The background to this debate, as far as the EU is concerned, is the policy goal to liberate large banks from the burden of having to provide finance to SMEs, thus allowing them to focus on activities and operations that are more cost effective and profitable than SME lending. At the same time, the idea behind the capital markets union is that SMEs would rely on cross-border, alternative channels of finance (market-based of course), facilitated among other things by a streamlined access to the bond market, following the new EU Prospectus Regulation.
While emphasis is increasingly laid on the expansion of alternative market-based financing channels, such as P2P lending and equity crowdfunding, the EU policy to implement a capital markets union is fundamentally grounded on expanded pan-European bond markets (extended as said to SMEs) and on a revived securitization market. This sharp focus on debt capital markets finance—and in particular on securitization—raises a number of questions.
First, as it has been repeatedly pointed out in a number of post-crisis studies (see Turner “Between Debt and the Devil” 2015, for instance), the level of private debt created within financial markets is probably the biggest policy and regulatory challenge today and is in fact yet to be fully addressed both in Europe and in the US. Not only does the EU CMU not seem to recognize this problem, but its focus on securitization and bonds is likely to increase the trend towards private debt creation.
More specific risks emerge from the analysis of the EU CMU, and they all stem from what seems to be the inevitable resurrection of market-based channels of financial intermediation. In the decade before the global financial crisis (GFC) in 2008, market-based finance was identified by the practice of large financial institutions that had progressively shifted their business model. They did so on the asset side by ramping up the trading and lending (and also warehousing) of securities, whereas on the liabilities side, they relied on short-term repo contracts with money market mutual funds.
It is now well documented that this business model gave way to unprecedented levels of risk-taking. In particular, contrary to what had been postulated by most financial economic theories, and what had been predicted by policy-makers and regulators, the business model resulted in uncontrolled increases in leverage, while maintaining an illusion of liquidity. Moreover, the main components of that system of financial intermediation, namely securitization and the repo market, are today recognized as the essence of what, since 2007, we call the shadow banking system.
Beyond analysing the details of how market-based finance increased problems of debt-creation, leverage and liquidity, my article assesses the extent to which a facilitative policy framework, such as the CMU, could represent a key turning point towards the development of a leverage cycle.
Against the backdrop of risks that are likely to materialize in connection with revived market-based channels of finance, the article looks closely into the regulatory framework that is designed under the CMU and its attendant regulations. The specific regulatory measures examined include the EU standardised securitisation (STS) Regulation, which is more directly related to the CMU package and is aimed at restarting a sustainable securitization market in the EU. Central to this analysis is also the regulation of repos, which comprises the EU Securities Financing Transactions Regulation (SFTR), and is complemented by the FSB guidelines on repo haircuts. Lastly, attention is drawn to the new Basel III framework and in particular to the new capital requirements, the leverage ratio, and the liquidity requirements.
Overall, it is fair to say that the result of the above framework is likely to make certain practices more expensive for banks. In particular, the extent to which banks are able to resort to, and rely on, short-term sources of finance – as they did in pre-crisis years – should be curtailed by the new Basel III framework. In principle, the STS Regulation is conceived as a regulatory tool to bring securitization back to the more sustainable practices of the 1980s and early ‘90s.
The more gloomy assessment of the article comes when the attention is turned to the supervisory framework that accompanies the above regulatory infrastructure. Notwithstanding some merits, the overall construction is still built on frail foundations. A chief example of that is Basel III, which still relies on its third pillar of market discipline for the purpose of supervisory processes. Likewise, the STS Regulation, despite being aimed at wholesale pan-EU capital markets, relies on market actors and competent national authorities for the purpose of supervision. The European Securities and Markets Authorities (ESMA), still plays only a marginal coordination role.
In the end, the unconventional thrust of the article is centered on the conclusion that if capital markets are to play a positive role in the real economy, and in society, both the regulatory and supervisory architecture of market-based finance needs to undergo more drastic changes.