Since the European Commission’s (EC’s) Capital Markets Union (CMU) project was first launched six years ago, many would agree that progress has been slow and not without challenges. Fast forward to today: The European Union’s (EU’s) capital markets may have finally reached a turning point. Despite economic challenges brought about by the COVID pandemic, Europe’s capital markets have shown resilience, providing vital funding for businesses and small and medium-sized enterprises (SMEs) at record levels.
While the wave of corporate bankruptcies that was initially feared has so far not materialised, we should not be complacent. It remains to be seen whether this record performance will continue as economic and market conditions normalise following the gradual withdrawal of wide-ranging fiscal, monetary and regulatory support measures. Europe’s capital markets are also still far from reaching their full potential compared to the size of the economy, and significant needs for investment to support growth and sustainable digital transformation lie ahead.
Record financing from capital markets
Over the past year, capital markets have increased the provision of funding for corporates to an extent unseen in recent years. Our recent report tracking the progress of European capital markets showed that the proportion of markets-based funding for EU corporates rose to a record 16.8 percent of total funding in the first half of 2021, up from 11.8 percent in 2020. European SMEs have also benefited from higher levels of equity risk capital. In fact, while absolute levels remain lower than the United States, Europe is the fastest-growing region globally in private-capital investment, with investment in European SMEs having grown by 2.4 times this year.
However, as government support measures are withdrawn post-pandemic, financial pressures are likely to increase for many businesses. According to an Association for Financial Markets in Europe (AFME) report released earlier this year, European businesses need to bridge a gap of €450-to-600 billion in equity to prevent widespread business defaults and job losses, as COVID-19 state support measures are gradually reduced. In this respect, equity markets and hybrid capital instruments can play an important role in providing fresh capital to companies to help mitigate debt burdens or invest in growth and innovation.
Growth in sustainable finance
Sustainable finance has also been a notable area of success for Europe over the past year. Environmental, social and corporate governance (ESG) debt markets have shown remarkable growth, with issuance levels no longer representing a niche market sector but now accounting for a sizeable market segment. In the first half of 2021, ESG issuance increased by 69 percent compared to 2020.
A more granular look at Europe’s ESG performance shows that German issuers supplied the largest volume of green bonds in 2020 and the first half of 2021, partially supported by the successful origination of three green bunds and one green bobl (bundesobligationen) by the German government. Spain, Italy, the United Kingdom and the European Commission (on behalf of the EU) have also issued highly oversubscribed inaugural green sovereign bonds during 2021, and the European Commission’s SURE scheme successfully contributed to the growth of social bonds over the past year.
However, like the provision of funding for corporates, ESG markets need to prove that they can effectively mobilise capital to support the objectives of the European Green Deal. In its new Sustainable Finance Strategy, the Commission estimated that €480 billion investment each year will be needed to meet the 2030 emission-reduction target. While the EU is a world leader in issuing green bonds, it is clear that public funding is insufficient to reach the necessary volumes of financing, and capital markets play an essential role in facilitating the transition towards a carbon-neutral economy.
Sustainable finance policy has the power to enhance the tools banks use to make investment decisions, such as disclosures and ESG ratings, and to attract more participants to ESG markets by increasing integrity and trust in the market. Disclosure rules, in particular, should be developed consistently across the EU and in close cooperation with global standard setters. It is also crucial to have a clear definition of sustainability, which the EU Taxonomy aims to achieve. For many companies, there will be a gradual transition towards more sustainable business models. The taxonomy should, therefore, include not only activities and entities that are already low carbon but also take a forward-looking viewpoint to be inclusive of firms, their assets and their activities that have the commitment and potential for transition within scientifically determined thresholds.
Addressing long-standing issues
Although a positive picture is painted by the growth in markets financing, Europe’s capital markets continue to face long-standing structural challenges. For instance, securitisation issuance has fallen significantly in Europe and continues to be below the levels observed prior to the introduction of the EU’s Simple, Transparent and Standardised (STS) securitisation framework. In contrast to the US, the proportion of EU securitised products and loan disposals relative to total loans outstanding has consistently declined over the last three years, demonstrating the limited capacity of the banking sector to transform loans into tradeable securities. Furthermore, annualised securitisation issuance in the first half of 2021 was 29 percent lower than at the end of 2018. Europe needs a well-functioning securitisation market to allow greater risk transfer from banks to markets, enabling banks to support new lending.
Furthermore, a clear focus on measures that will enhance the attractiveness, efficiency and integration of EU capital markets is also needed. Regarding the health of Europe’s equity markets, listing rules should be reviewed to promote equity finance and attract high-growth SMEs and larger companies to public markets. Europe’s initial public offerings (IPOs) market is still lagging behind the US. Between the first and third quarters of 2021, EU IPO issuance reached €35 billion, compared to the €214.4 billion in the US over the same period. If European IPO issuance is to catch up with the US, European companies need to be incentivised to issue on the continent by creating efficient capital markets.
It is also vital to support a strong and competitive trading and post-trading ecosystem in the EU. In this respect, establishing a consolidated tape (or price-comparison tool) for equity and bond instruments could be a catalyst to expand investor participation and democratise access to European markets. This would provide all investors with a comprehensive and standardised view of the European trading environment. Meanwhile, major inefficiencies remain to be tackled, such as the absence of a common EU-wide system for withholding tax relief at the source. This is an example of friction that significantly negatively impacts financial markets and cross-border investment.
What’s next for the CMU?
In November, the Commission will announce new proposals to “bring CMU back into the light and build some momentum behind it”. These will be important to ensure the positive trends we have seen this year continue under normal market conditions. As Europe comes out of the shadow of the pandemic, it will also be important to effectively start tackling the long-standing barriers we know are there. While the CMU project may have been given a much-needed jumpstart by markets this year, progress cannot be taken for granted.
(In October 2021, AFME published a report in partnership with 10 other organisations that tracks how Europe’s capital markets performed in the first half of 2021. “Capital Markets Union Key Performance Indicators – Fourth Edition European Capital Markets – a turning point.”)