A decade after the financial crisis, Europe’s financial markets are at a critical juncture.
A concerted global programme of regulatory and systemic change means significant progress has been made on building a stable and resilient financial system. The EU’s latest banking reform package: the Risk Reduction Measures (RRM) marks an important step towards completing such efforts.
At the same time, the EU is also pursuing an ambitious agenda for Europe’s capital markets to develop and flourish. Its Capital Markets Union (CMU) initiative is crucial for boosting growth and channelling investment into the real economy.
However, as AFME’s latest report, The links between the Risk Reduction package and the development of Europe’s capital markets highlights, ongoing banking reforms need to be considered in the light of how they are likely to impact the wider economy. Without a more granular understanding of the impact of some of the proposals on day-to-day commercial activities there is a significant risk that businesses, investors and governments will find it more difficult to access essential capital markets services.
Real economy access to capital markets
To take one example, European manufacturers – particularly exporters to international markets –are exposed to many different cost variations, such as exchange rate changes or fluctuations in the underlying cost of energy or raw materials. Being able to hedge such risks is essential for them to manage their business. Therefore, it is important that policymakers ensure that capital and liquidity requirements applied to derivatives, used to assist these hedging activities, are proportionate to the risk they involve. Punitive treatment of derivatives could end up indirectly harming exporters by limiting the availability of vital instruments or increasing their cost.
For pensions funds, efficient and easy access to equities markets is a key priority. Over the long term, returns on equities exceed those available on other major asset classes, making them a core holding in many pension funds with 46% of pension assets globally invested in equities. Pension funds often invest in equity markets via “equity swaps” – a contract with a bank where the fund receives a return linked to the performance of an individual stock, or basket of stocks. This is often more efficient than investing directly in individual stocks or indices and allows funds to access a wider range of markets, achieve greater diversification and potentially higher returns. Appropriate regulatory treatment of these transactions in the new funding rules is crucial for ensuring access to good investment opportunities and to promote deeper and liquid equity markets.
Let’s also not forget how much is at stake for EU governments. Public spending (on health, education, infrastructure, etc.) relies on well-functioning and liquid government bonds markets. Government bonds also play an important role in financial markets - as a safe investment for investors to diversify risks and for use as collateral to support borrowing. For the market to function well, it is essential that banks’ activities (as primary dealers and market-makers for such instruments) are not treated punitively and dis-incentivised. There is a danger that requirements in the Risk Reduction Measures – as currently drafted – could result in lower liquidity levels and ultimately higher funding costs for all EU governments.
Striking the right balance on financial stability and capital markets growth
Clearly, the success of further developing Europe’s capital markets will depend, in part, on the fair and proportionate application of banking reforms. The final rules must ensure financial stability while also enabling the banking sector to support the economy
To be clear, the industry fully supports the post-crisis regulatory repair programme and its key objectives. However, we need to strike the right balance. Regulation must not prevent the financial sector from providing the liquidity and investment needed to drive Europe’s economic growth.