Capital Markets Blog Series – Part II: The mechanisms and key objectives of the Capital Markets Union key building blocks

 

Banking Union and Capital Markets Union: Objectives and state of play

One of the conclusions of the financial crisis from a political and supervisory perspective was that the European banking system requires a uniform supervision across the EU. As part of the Banking Union roadmap, EU institutions agreed to establish a single supervisory mechanism (SSM), a single rulebook for banking regulation (CRD/CRR) and a single resolution mechanism (SRM) for banks. While the SSM and SRM have become an integral part of the prudential banking supervision and are fully operational, the implementation of a single European deposit insurance (EDIS) is still missing in order to complete the Banking Union roadmap. However, the implemented regulatory actions and the enforcement of supervisory expectations have subsequently led to a substantially more resilient banking system evidenced by an improvement of all material regulatory ratios for capital and liquidity as well as for resolvability.[1]

While the Banking Union mainly focuses on regulating banks’ activities (including those on capital markets by the FRTB-framework[2]) and strengthening the resilience of the financial sector by strengthening banks, the Capital Markets Union’s (CMU) overall aim is to complement bank financing by facilitating EU businesses’ direct access to harmonized EU Capital Markets, attracting more investors and fostering capital market growth and enhance its ability to provide capital and liquidity to the real economy. The biggest difference between these two initiatives is that – with regard to the Banking Union – a large part of the implementing regulation is directly applicable by banks based on European law – a prerequisite for the uniform supervision by the European Central Bank (ECB). By contrast, most of the implementing regulation of the CMU legislative framework will remain dependent on national transposition of European regulation, thus creating room for national discretion. The uniform implementation of the CMU will thus depend upon the participating European countries agreeing to implement it in a coordinated and rather similar way by the word. While uniform implementation is valuable in terms of creating a level playing field between the countries, the CMU is less regulatory and supervisory in nature and foresees no uniform supervision like the banking union.

Recognizing the growth potential of EU Capital Markets and the associated positive impact on the real economy, the European Commission adopted the Capital Markets Union action plan in 2015. As part of its mid-term review in 2017, further measures were identified and added to the CMU action plan. The legislative framework implementing the CMU currently comprises 13 key CMU building blocks and 3 sustainable finance initiatives. Furthermore, the Commission is planning to issue another action plan (‘CMU 2.0’), once political uncertainty on Brexit will be reduced. While the Banking Union was mainly geared towards increasing the regulation of bank´s activities and strengthening the resilience of the financial sector by strengthening banks, the Capital Markets Union’s overall aim is to foster growth of EU Capital Markets and provide a broader range of funding and investment alternatives to the real economy and consumers.

The following diagram shows a holistic overview of the key objectives of the key CMU building blocks mapped to the Capital Market participants (as defined in part I of this blog series):

 

 

The Capital Markets Union key building blocks: Overview and intended effects

Overall, the CMU was designed to mobilize and channel capital to EU companies and infrastructure projects, offer additional investment opportunities for savers and investors and make the financial system more resilient.[3] At present, the most important capital market in Europe is the UK capital market which currently offers financial intermediation to all European capital market players. After Brexit, the terms of access to this market will be uncertain. The remaining capital market landscape can be characterized as being fragmented nationally or regionally. Although cross-border investment and financing is legally possible and promoted as part of the Single European Market for goods and services, cross-border financial activity for many market players constitutes more an option than a widely used instrument. There are numerous reasons for this fragmentation, the most important ones being the remaining differences regarding legal frameworks governing national markets, national market supervision (as opposed to the SSM´s European supervisory scope), resulting in a wide range of regulatory/supervisory practices, product types and market specificities.

Under such market conditions transaction costs are high as is information asymmetry between market players. These market inefficiencies make markets thin (characterized by a small number of participants and transactions), slow and therefore inefficient. The individual CMU building blocks address these inefficiencies by (1) standardizing existing or creating new standardized products (such as STS securitizations) and thus reducing information asymmetries, (2) creating harmonized legal frameworks in fields that are not product-specific (such as insolvency procedures) and (3) stabilizing the financial system by ensuring consistent implementation of regulatory measures and achieving a level playing field. The last point also includes the regulation of banks as the predominant players on the European capital markets where this regulation is not yet integrated.

The following table provides an overview over the 13 key CMU measures structured by the underlying mechanism.

Mechanism Policy Description Objective (Factsheet)
(1) Reduce information asymmetry / standardise Covered bonds To provide a source of long-term financing for banks in support to the real economy
Pan-European personal pension product (PEPP) To give citizens more and better options for retirement savings.
Prospectus Regulation To facilitate access to financial markets for companies, particularly small and medium-sized enterprises.
Simple, transparent and standardized securitization To broaden investment opportunities and boost lending to Europe’s households and businesses.
Sustainable finance: Taxonomy To help to reorient private capital flows towards more sustainable investments, such as clean transport, and help finance the transition to a low-carbon, more resource-efficient and circular economy
Sustainable finance: Disclosure
Sustainable finance: Low carbon Benchmarks
(2) Reduce transaction cost / integrate Cross-border distribution of collective investment funds To remove burdensome requirements and harmonize diverging national rules
Crowdfunding To improve access to this innovative form of finance for start-ups, while maintaining investor protection.
European Venture Capital Fund Regulation (EuVECA) and European Social Entrepreneurship Funds Regulation (EuSEF) To stimulate venture capital and social investments in the EU.
Preventive restructuring, second chance and efficiency of procedures To provide honest entrepreneurs with a second chance and facilitate the efficient restructuring of viable companies in financial difficulties.
Promotion of SME Growth Markets To cut red-tape for small and medium-sized enterprises trying to access capital markets.
Third-party effects on assignment of claims To enhance legal certainty about the applicable national law to the effects on third parties where a claim is assigned cross-border.
(3) Stabilize financial system European Supervisory Authorities review including anti-money laundering rules To enhance supervisory convergence and strengthen enforcement, including against money laundering and terrorist financing.
Investment firms review To ensure a level playing field between the large and systemic financial institutions while introducing simpler rules for smaller firms.
European market infrastructure regulation (Supervision) To ensure that the EU supervisory framework effectively anticipates and mitigates risk from EU and non-EU central counterparties servicing EU clients.

 

(1) The following four building blocks are and will be implemented based on measures aiming at reducing information asymmetry and increasing standardization with regard to investments and funding opportunities:

  • Covered bonds: Acknowledging that covered bond markets are very fragmented across the EU, the new rules aim at enhancing market volumes in those Member States with less developed covered bond markets in order to raise overall market efficiency. By providing a common definition of covered bonds, defining the structural features of the instrument and identifying those high-quality assets that can be considered eligible in the pool backing the debt obligations, the EU Commissions aims at introducing standardization to the market and increasing the transparency for investors. The rules also establish a supervision mechanism for covered bonds and sets out rules allowing the use of the ‘European Covered Bonds’ label.
  • Pan-European personal pension product (PEPP)[4]: Based on the low interest rate environment, investment in shares and bonds increases slowly. However, EU households still hold their savings mainly in cash, bank deposits and insurance and pension products although higher returns could be generated by alternative investments. By introducing an EU wide cross-border standardized voluntary scheme for saving for retirements, PEPP aims at complementing existing public and national private pension schemes and therefore offer consumers more investment choices.
  • Prospectus Regulation: The CMU measures aim at increasing the transparency regarding the risks of the investments by introducing new rules that require firms to include multiple thresholds of risks in the prospectus and allowing cross-references to certain existing documents. Lighter disclosure rules which will be applicable by certain SMEs and mid-sized companies, aim at facilitating their access to Capital Markets to companies which currently mainly rely on bank financing.
  • Simple, transparent and standardized securitization (STS)[5]: Assuming the EU securitization market was built up again to the pre-crisis average, it would generate up to EUR 150bn in additional funding for the economy.[6] In order to achieve the aim of fostering the EU securitization market and restoring an important funding channel for the EU economy, the EU Commission has implemented new rules which differentiate between high-quality securitization products and other products which do not satisfy such criteria.
  • Sustainable finance initiatives: By introducing new sustainable finance initiatives the Commission aims at increasing transparency e.g. by creating a common classification system and taxonomy, establishing labels for green financial products and strengthening the transparency of companies on their environmental, social and governance policies (ESG) with the objective of supporting economic growth while reducing pressures on the environment and taking into account social and governance aspects.

(2) Furthermore, six of the CMU key building blocks are based on the idea to foster growth of EU Capital Markets by reducing transaction costs and with that allowing new participants into the market, which so far mainly rely on bank financing and fostering new cross-border investment opportunities:

  • Rules introduced in relation to Cross-border distribution of collective investment funds aim at aligning national marketing requirements and regulatory fees, harmonizing the process and requirements for the verification of marketing material by national competent authorities (NCAs) as well as enabling the European Securities and Markets Authority (ESMA) to better monitor investment funds.
  • Crowdfunding: Acknowledging that the EU market for crowdfunding is underdeveloped as compared to other major world economies[7], the new rules aim at improving access to crowdfunding for small investors and businesses in need of funding, particularly start-ups. Investors will potentially benefit from the new rules relating to a protection regime, information disclosures for project owners and crowdfunding platforms, governance and risk management and supervision.
  • European Venture Capital Fund Regulation (EuVECA) and European Social Entrepreneurship Funds Regulation (EuSEF): By introducing these two types of collective investment funds, the Commission is aiming at making it easier and more attractive for investors (e.g. insurance companies) to invest in unlisted SMEs.
  • Preventive restructuring, second chance and efficiency of procedures: By providing a second chance through debt discharge to businesses and entrepreneurs the Commission’s proposal aims to facilitate the restructuring of companies in financial difficulties with the aim to avoid insolvency and the destruction of going concern value.
  • Promotion of SME Growth Markets: By introducing a new category of trading venue dedicated to small issuers the Commission aims, among other things, at reducing the administrative burden and costs faced by SME growth market issuers while increasing market integrity and investor protection.
  • Third-party effects on assignment of claims: In order to foster cross-border growth of EU Capital Markets, the Commission acknowledges that a common legal framework across the EU is a key success factor. By determining which national law is applicable to the effects on third parties where a claim is assigned cross-border, transaction costs will potentially be reduced.

(3) One of the key CMU objectives is furthermore to stabilize the EU financial system, e.g. by enhancing the supervisory convergence, ensuring a level playing field and strengthening enforcement measures:

  • European Supervisory Authorities review including anti-money laundering rules: While the EU has strong AML rules in place, recent cases involving money laundering in some EU banks have raised concerns that those rules are not always supervised and enforced effectively across the EU. Planned changes regarding the AML directive therefore aims at further improving the level playing field among all firms operating across the Single Market (domestic, EU27-based or operating from third countries). A new specific provision requiring the European Supervisory Authorities (ESAs) to have in place dedicated reporting channels for receiving and handling information provided by a natural or legal person reporting on actual or potential breaches, abuses of or non-application of Union law are expected to increase transparency and contribute to improved rules and their consistent enforcement across the EU27.
  • Investment firms review: The investment firms review divides investment firms into three categories, with the aim to ensure a level playing field between the large and systemic financial institutions while introducing simpler prudential rules for non-systemic investment firms.
  • European market infrastructure regulation (Supervision): A proposal to strengthen the supervision of central counterparties: to ensure that the supervisory framework of the Union is sufficiently robust to anticipate and mitigate risk from Union central counterparties and from systemic third-country central counterparties servicing Union clients.

 

The CMU: First conclusion

In order to achieve the overall objective of fostering growth of EU capital markets, the Commission formulated the key objectives of the CMU action plan. In order to reach these CMU objectives in due course, it is essential that necessary measures are implemented homogeneously across the EU, considering that – in contrast to the Banking Union´s measures – most of the CMU building blocks will require national implementation of European directives. The uniform implementation of the CMU will thus depend on the agreement of participating Member States to implement it in a coordinated way in order to balance the administrative cost originating from it and the benefits of larger, efficient and resilient capital markets for the real economy. Furthermore, taking into account the latest political developments regarding Brexit, it is necessary that additional measures identified as part of the ‘CMU 2.0’ initiative focus more on the development of the EU27 capital markets and how to best minimize disruption regarding financial intermediation currently offered by the UK capital market participants post-Brexit.

 

 

 

Please contact our PwC experts in case of any questions.

Stephan Lutz – Mail: stephan.x.lutz@pwc.com

Ina Alexandra Steiner – Mail: ina-alexandra.steiner@pwc.com

Dr. Philipp Völk – Mail: philipp.voelk@pwc.com

 

 

 

 

 

 

[1] https://www.consilium.europa.eu/media/39698/joint-risk-reduction-monitoring-report-may2019.pdf

[2] https://blogs.pwc.de/regulatory/tag/frtb/

[3] https://ec.europa.eu/info/business-economy-euro/growth-and-investment/capital-markets-union/what-capital-markets-union_en

[4] For more information regarding the PEPP rules, please read our already published blog: https://blogs.pwc.de/insurance/risk-finance/aufsichtsrechtlicher-dialog-genehmigungsverfahren/europaeisches-parlament-hat-dem-vorschlag-ueber-eine-verordnung-fuer-ein-europaweites-privates-altersvorsorgeprodukt-pepp-zugestimmt/2923/

[5] For more information regarding the new STS rules, please read our already published blogs: https://blogs.pwc.de/capital-markets/category/securitization-structured-finance/

[6] https://europa.eu/rapid/press-release_IP-17-1480_en.htm?locale=en

[7] https://ec.europa.eu/info/business-economy-euro/growth-and-investment/financing-investment/crowdfunding_en

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