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Symposium 2015

Solution for Capital market union - How Should it be Designed to Solve the European Growth Problem?

The Challenge

The basis idea of a capital market union is simple: Capital should flow from surplus countries to deficit countries. In South European economies there is a general lack of capital. Most firms, especia ...

The basis idea of a capital market union is simple: Capital should flow from surplus countries to deficit countries. In South European economies there is a general lack of capital. Most firms, especially those oriented to the domestic market, have trouble to get finance from their banks and from the capital market. On the other hand, investors in Germany and other parts of Northern Europe suffer from low yields and a lack of investment alternatives. It looks as if there is a straight forward solution to this problem: Let those people from northern Europe looking for investment alternatives finance those firms in southern Europe, which are seeking capital and which are willing to offer higher rates than their peers in the north. These investments should be done through the capital market and/or the banking market. It would be win win situation as investors would get higher yields and broader diversification while companies lacking capital would be enabled to do more business. The result would be more real investment and higher growth rates throughout Europe.

Financial Regulation and Stabilization

The financial market crisis has shown that the financial integration in Europe is far from being complete even though on paper free flow of capital is granted. Instead, the fragmentation of the financial landscape became obvious, with capital fleeing to so-called safe havens instead of flowing to those places where capital was lacking. This has impeded the recovery of the euro area. Thus, to foster economic growth sustainable financial integration has to be deepened. In this respect optimal allocation of capital and diversification are the main channels to improve growth conditions in Europe.

Allocation of capital

The optimal allocation of capital means that capital flows to those companies which use capital in the most productive way. For example, if a Portuguese company has found a way to desalinate seawater with less energy costs than its competitors, capital should flow into this company instead of going to a firm which is ailing in the textile sector or so. In addition, in a financially integrated Europe this money can and should come not only from domestic urces but also from other European investors.

The optimal allocation of capital can, however, only happen, if investors are enabled to concentrate mostly on firm specific factors to compare alternative investment projects. During the crisis, the firm specific characteristics were completely masked by systemic factors like the convertibility risk, the crisis of the domestic banking sector and the sovereign risk. An optimal allocation of capital has not been possible. Instead, capital flows were mainly driven by safe haven aspects, meaning that investors in the core countries remained in their local sphere while investors of the so called peripheral states withdrew their money mainly to the core countries (Coeuré, 2015). Some solutions to these problems are underway. Especially, the nexus between banks and the sovereign is in the process of being diminished with the bank resolution mechanism in place since the start of 2015. In addition, the rescue packages for overindebted sovereigns as well as the ECB’s monetary measures provided for less convertibility risk.

Nonetheless, even without these factors (which have not been abolished completely and could resurface) there are other issues which feed the financial fragmentation. At the forefront of this are the very heterogeneous insolvency laws as well as different tax laws in the national jurisdictions. An example may illustrate this: if a German bank is willing to finance a flat in Hamburg or Munich, but not in Madrid due to legal uncertainty about the chance to realize the corresponding mortgage, the allocation of capital is certainly not optimal.

In the past, divergent interpretations of regulatory rules have also contributed to sub-optimal allocation of capital, as the bubble in the Irish banking sector has shown. The newly established single supervisory mechanism for banks is an important factor to provide for a level playing field.


Deeper financial integration would also be advantageous for investors and for the stability of the economy.

Deeper financial integration means that a broader range of assets, be it capital market products, real estate, bank products, etc. are available to investors enabling them to diversify their portfolios in a much better way than as they concentrated mainly on their home turf, as it is mostly the case, currently. The reasons for the strong home bias are not completely clear. Yet, it looks as if different tax laws as well as different transactions play an important role (Philips et al, 2012). With respect to bank products the lack of having a cross-border depositor insurance institution let people shy away from putting their money on current accounts of banks abroad, even if the interest rate is much higher than in local banks.

If there was higher diversification this would also lead to higher shock absorbing capacity in the single euro member countries (European Commission, 2015a). If, for example, the German stock market was hit by a dramatic fall in the demand for German cars, investors who had a well-diversified portfolio across euro area would experience less income losses and wealth losses than investors fully concentrated on the German stock market. Swings in consumer demand would be less volatile, stabilizing the internal demand and the GDP growth rate. Having in mind that shocks will not be absorbed by fiscal mechanisms in the European Union in the near future due to political resistance this diversification effect is especially important.

Connection between capital markets union and banking union

Many steps have been taken since the eruption of the financial market crisis. In this respect first measures towards a European capital markets union have been announced by EU-Commissioner Jonathan Hill. At the same time, another project is underway, the European banking union. In the public discussion both projects are often discussed as separate issues. However, the capital markets union and banking union are interdependent. The one does not work without the other and both projects are impacted by common factors. For example, in the case of securitization of loans (a project which is top on the agenda of the EU commission (European Commission, 2015b)) banks structure loans in the form of securitization to then sell these structures on the capital market and make room in the balance sheet for new loans. Against this backdrop, many measures proposed for a better integration of capital markets cannot and should not be isolated from the issue of deepening the integration of the banking market.


The focus is laid on some of the most pressing issues with respect to the capital market project as well as some new ideas which are underrepresented in the public discussion.

Reforming the insolvency laws in the European Union

Developing markets literature about the problems to get credit flowing identify mostly ill-designed insolvency laws and/or complicated and time consuming enforcement proceedings (Freedman, Reid, 2006). Given that, for example, in Italy resolving insolvency takes 1.8 years on average, while in Belgium it takes half the time, according to the World Bank doing business indicator (World Bank Group, 2015), it is little wonder that an Italian company has difficulties in getting capital from a non-domestic bank which is less familiar with the insolvency law than the local institutions. This, in addition to the higher costs which are to be considered in the calculation of the loan conditions, leads to higher interest rates for Italian companies, in comparison to peer companies from other European Union countries with a better designed insolvency law. This impediment to financial integration also applies to other financial market products, as for example, private placements as well as securitizations (especially if the latter bundle loans from different jurisdictions).

The most ambitious approach to tackle the above described problem would be to harmonize the insolvency law and the proceedings to resolve the insolvency. Such a project will certainly be confronted with huge legal and political difficulties given the complexity of the insolvency law and the heterogeneity of the insolvency laws in different countries.

Having said that and given the fact that the appropriate design of the insolvency law are of such a great importance for cross border loans as well as cross border bond issues and the like, politics should aim for this ambitious approach, without losing time.

In the meantime, second best solutions are desirable, with a complementary character to a comprehensive approach.

One second best solution could be to implement a so called 29th regime, as proposed by Brühl et al. (2015). This would be a special European regime for the restructuring of corporate bonds outside an insolvency proceeding. It would have to be a European legislation and it would have the advantage of resolving repayment problems much quicker than in a formal insolvency procedure.

Another complementary second best solution could be to require legislators of the EU member countries to modify their insolvency laws and their proceedings guaranteeing that a determined time cap is not surpassed with respect to the time needed to resolve an insolvency. Such a requirement would lead to a certain harmonization without the time consuming difficulties to change the whole law structure (which would most probably be necessary in the case of the harmonization of the insolvency law).

Secondary market for non-performing loans

Banks are playing and will play a key role in both, the lending and the capital markets. The burden of non-performing loans in countries like Italy, Portugal and Spain implies that banks are less able to fulfill their role as lender and as arranger of capital market deals. That is given that a bank usually provides part of its balance sheet for such deals. Clean balance sheets are the best starting position to build up a fully integrated financial market. Thus, it is necessary to find effective ways to put banks in this position.

In the context of the building up of a capital markets union it looks reasonable to build up a secondary market for non-performing loans (Jassaud, Kang, 2015). This could be fostered by different measures, amongst them:

  • Adapt the regulation to enable the securitization of non-performing loans. The current action plan of the European Commission plans to foster the market for securitization focusing on SME-loans. This paper proposes to add a securitization scheme for non-performing loans, which could have a huge potential given that the sum of all of these loans in the euro area amount to approximately 1 trillion Euros.
  • Setting up NPL asset management companies to foster liquidity in the market for non-performing loans, partly through securitization structures.
  • Tax reform: Allow provisions and write offs to be fully deductible to incentivize the selling of bad loan portfolios.


A capital markets union for banks

If a regional bank in a peripheral country has a sound balance sheet and good knowledge of the local market the bank should be able to get the funding also outside the country to extend loans to local companies. The funding could come from other banks and/or the capital markets. The basic idea is that in this way banks from abroad must only look into the management capacities and the balance sheet of the corresponding bank instead of trying to evaluate various SME’s of a far distant market.

Prior to the crisis this concept seemed to work. However, the design was not sustainable. While banks where indeed able to get funding from abroad, they used these funds only partly for the financing of SME’s but mostly to buy other capital market instruments from other financial institutions. When the interbank market stopped being available for financing, the whole concept collapsed. However, the reason for this was not too much financial integration as some market participants claim, but an ill-regulated integration.

To get the above described concept going, regulations must be adjusted. Partly, this has happened, partly not. The banking union must be completed in the sense that banks are supervised by the same standards, whatever the banks home country is. This includes also a single resolution mechanism as well as a unified deposit insurance. Significant progress has been made in this respect, but we must not stop here.

Given the experience of the financial crisis, which spread around the world due to a freeze of the interbank market, some new regulations have been introduced, of which one of the most important is that the maturity structure of the liabilities must fit to the maturity structure of the assets in some way. Basel III attempts to go this way through the requirement of a certain liquidity ratio as well as new monitoring tools.

In addition—and this measure is not part of the current regulation projects—banks should be required to hold a well-defined share of loans to non-financial institutions. Such a ratio should be in the area of 50 to 60 percent of the balance sheet instead of 20 to 30% as it is currently the case in many banks. This would limit the interconnectedness between banks and avoid the misuse of the capital markets as a gambling field.



Brühl, V., Gründl, H.,Hackethal, A., Kotz, H.-H., Krahnen J. P. and Tröger, T. (2015), Comments on the EU Commission’s Capital Markets Union Project, White Paper No. 27, Safe Policy Center.

Coeuré, B. (2015), Completing the single market in capital, in: Banque de France, Financial Stability Review, No. 19, April 2015.

European Commission (2015a), Building a capital markets union, Green Paper, Brussels, 18.2.2015.

European Commission (2015b), Action plan on building a capital markets union, Communication from the commission the European parliament, the council, the European economic and social committee and the committee of the regions, Brussels, 30.9.2015.

Freedman, P.L. and Reid, W. C. (2006), Banks that don’t lend? Unlocking credit to spur growth in developing countries, in: Development Policy Review, 2006, 24 (3), pp. 279 – 302.

Jassaud, N, Kenneth Kang, K. (2015), A Strategy for Developing a Market for Nonperforming Loans in Italy, IMF working paper WP/15/24, February 2015.
Philips, C.B., Francis M. Kinniry, F. M., Donaldson. S. J. (2012), The role of home bias in global asset allocation decisions, Vanguard Research, June 2012.

World Bank Group (2015), Doing business, on website of World bank ( exploreeconomies/italy/#resolving-insolvency).