Describing it as potentially “key to securing a long-term, sustainable economic recovery”, the House of Lords’ EU economic and financial affairs sub-committee published its formal response to the European Commission’s green paper consultation on capital markets union (CMU) back in March.
In his speech on 17 April Lord Jonathan Hill, the member of the European Commission responsible for the Capital Markets Union, quoted the committee’s conclusion that CMU is “a golden opportunity for the UK… a means to demonstrate afresh that the City of London, and the financial sector which is centred there, is an asset not only to the UK economy but to the EU as a whole”.
The Capital Markets Union is a flagship initiative of the European; it is a key part of the Investment Plan announced by Jean-Claude Juncker, the president of the Commission, in November 2014. The aim is to put in place the building blocks of a well regulated and fully functioning CMU in the EU by 2019 – creating a single market for capital for all 28 member states by removing barriers to cross-border investment and to lower costs of funding within the EU.
The objective of CMU
Following the 2008 financial crisis, economic recovery across the EU has been relatively weak. The corporate sector has suffered from restricted financing, with less bank finance available and a loss of confidence in securitisation and other capital markets.
European capital markets still lag behind the US. The Bridging the growth gap report, co-authored by the Boston Consulting Group and the Association for Financial Markets in Europe, highlights the disparity: Europe’s capital markets are under-developed and there is a smaller pool of funding available than in the US.
EU businesses remain heavily reliant on bank finance (by way of example, banks provide around 80 per cent. of European businesses’ external finance, whereas the reverse is true in the US). Such reliance on bank finance makes economies vulnerable to a tightening of bank lending, as happened during the 2008 financial crisis.
Although all advanced economies suffered a sharp down turn following the 2008 financial crisis, the fragmentation of the EU market during the sovereign crisis that followed further intensified the recession due to the close relationship European banks have with sovereigns.
This lack of market depth and liquidity in EU capital markets is compounded by market fragmentation along national lines, home bias and divergent tax and legal rules between member states.
The purpose of CMU is to create deep, well-integrated and regulated capital markets across the EU. There is a strong single market objective behind CMU which aims to reduce barriers to cross border investment and realise the free movement of capital principle in the EU treaty by placing it at the heart of the single market.
CMU would thus boost non-bank finance for small and medium-sized enterprises (SMEs) and larger corporates, as well as removing the barriers to cross-border investment for retail and institutional investors. The CMU consultation is designed to prompt a range of non-legislative measures as well as specific reforms to EU regulation.
While the House of Lords' EU economic and financial affairs sub-committee consider the CMU consultation to be a helpful starting point, they cautioned that the sheer quantity of proposals the consultation sets out is so broad that it creates a danger of a lack of focus.
Certainly CMU remains a somewhat aspirational concept at this stage; the means to realise CMU are still to be worked out and in many areas the current consultation does not put forward specific proposals for reform. Lord Hill, the European commissioner for financial stability, financial services and capital markets union, has described the approach as “bottom-up” with each barrier being addressed in turn rather than a sweeping approach.
In essence, CMU is an overarching label for a number of EU-wide initiatives. There are five areas where the commission has more advanced plans or where more detailed consultations are under way.
1. Consultation on high quality securitisation
This consultation looks at ways to develop the EU securitisation market, including changes to the regulatory regime. In a strikingly different tone to announcements immediately post crisis, the commission’s objective is now to develop a “safe, deep, liquid and robust market for securitisation”.
The commission is concerned that the securitisation market in the EU has not recovered post crisis (in contrast to the position in the US although this is in part due to the fact that a significant proportion of securitisation instruments in the US benefit from public guarantees from US government sponsored entities like Fannie Mae and Freddy Mac).
The securitisation market had not been too problematic in the EU but had nevertheless suffered from reputational damage because of the US subprime crisis. Indeed it points to the growth in covered bonds, whereas the securitisation market may have suffered from regulatory uncertainty. Greater securitisation would free up the balance sheet of EU banks which would increase their lending capacity to smaller businesses.
The general policy now seems to be to attempt to differentiate between: a) bad securitisations (i.e. ‘highly complex, opaque and risky securitisations’), such as those pre-crisis that were driven by the ‘originate to distribute’ model for assets such as US sub-prime mortgages; and b) good or ‘high-quality’ securitisations (i.e. ‘simple, transparent and comparable/standardised’ securitisations).
Post-crisis, the EU adopted a variety of regulatory reforms (directed at ‘bad securitisations’) including disclosure, due diligence, supervisory reporting, risk retention and capital/leverage requirements. It is now at pains to point out that it has started to adopt a differentiated approach (in delegated acts under Solvency II for insurers and under the Liquidity Coverage Ratio for banks). This approach is already being discussed more broadly in international/European consultations.
In essence the commission is now consulting on ways to develop the securitisation market through legislative reform and by other means. The former includes:
- an EU framework for high-quality securitisations – including their definition/identification- a harmonised EU structure for securitisation
- standardisation, transparency and information disclosure
- changes to the CRR capital requirements
- facilitating insurance sector and SME securitisation
2. Consultation reviewing the prospectus directive
This consultation looks at potential reform of the prospectus regime to reduce burdens on issuers and make it easier and more affordable for EU companies, particularly SMEs, to raise funds. It reflects concern that:
- the approval of a prospectus, which is required when a public offer of securities is made or when a company is seeking admission of securities to trading on a regulated market, is often perceived to be an expensive, complex and time-consuming process; and
- despite harmonisation under the prospectus directive, local practices and the requirements for drawing up a prospectus vary from one member state to another
There are concerns that the drafting of a prospectus is costly and administratively burdensome for companies (particularly SMEs), often requiring a large amount of information to be included which can be confusing for investors to digest. The House of Lords report stressed that there needs to be a common rulebook approach to simplifying the EU prospectus rules and that although there is an overarching need to protect investors, this should not result in the creation of an onerous regime that deterred issuers from entering the market.
The consultation raises a broad range of questions relating to:
- when a prospectus is required (i.e. the thresholds for when a prospectus is required when making a public offer and when a private placement can be made without a prospectus being necessary)
- the information a prospectus should contain
- the prospectus approval process and harmonising such processes across member states
3. Developing private placement markets
The commission has set this as one of its priorities for early action and presents this as a discrete objective from its review of the prospectus directive. The prospectus directive contains thresholds for when an offering of securities can be made to an individual or small group of investors (rather than a public offer of securities) without a prospectus. Such offerings can provide a more cost effective way for firms to raise funds, broaden the availability of finance for medium to large companies and act as a source of diversification for larger scale investors.
There are concerns that barriers to development of private placement markets include difference in national insolvency laws and a lack of standardised processes, documentation and information on the creditworthiness of issuers.
The commission focuses on industry led initiatives and, in particular, the recently launched ‘Pan-European Corporate Private Placement Market Guide’ (published by the Pan-European Private Placement Working Group, led by the International Capital Market Association).
This sets out a voluntary framework for common market standards and best practices for the development of a pan-European private placement market (including through the standardisation of documents). The consultation asks whether action by the EU is needed to support the development of private placement markets beyond supporting market-led agreements on common standards.
4. The European long-term investment funds regulation
The European long-term investment funds (ELTIFs) regulation was proposed long before the idea of CMU. It has now been ratified by the European parliament and just awaits formal adoption. The ELTIFs regulation will provide a new collective investment structure for long-term capital investment. It will be available to managers authorised under the Alternative Investment Fund Managers Directive (AIFMD).
The purpose of the ELTIFs regulation is to stimulate non-bank finance in the EU, particularly for infrastructure projects such as transport/energy and schools/hospitals and social housing by bringing together investors who want to invest in companies and projects for the long-term with enterprises in need of ‘patient’ long-term financing.
Although ELTIFs will enjoy a pan-EU passport, there are concerns that ELTIFs will not have the same ability as UCITS funds to deploy raised capital cross-border, and that there may be barriers at a national banking level, as well as insolvency laws and tax regimes.
Investment may be available to both institutional and retail investors (although the funds will not qualify as UCITs). Marketing will be subject to MiFID rules and, in the case of retail investors, to a key information document under PRIIP rules.
5. SMEs – credit scoring and accounting
The commission is concerned about the lack of finance available to SMEs. It has two proposals relating to SME credit information and accounting standards.
In essence the first plan is to develop more standardised credit information – through a common credit scoring process – to help SME’s gain access to wider sources of finance, including non-bank funding. The commission is concerned that, at present, credit information on SMEs is often limited and only held by banks and, therefore, some SMEs struggle to reach a broader investment base of non-bank investors who might suit their funding needs.
Therefore, the development of a common minimum set of comparable information standards for credit reporting and assessment could help attract funding to SMEs. In addition, the commission believes that standardised credit quality information could help the development of financial instruments to refinance SME loans (including SME securitisations).
The second issue is whether current accounting standards are a barrier to SME financing. In particular, the idea is that a new ‘simplified’ accounting standard might be developed for companies listed on junior trading venues, such as SME Growth Markets which will be facilitated by MiFID II from 2017.
Timeline and next steps
The three consultations (on CMU, the prospectus directive and securitisation) closed on 13 May 2015. Proposed amendments to the prospectus directive are due by early 2016. After the consultations and a conference in the summer of 2015, the commission will publish an action plan in late 2015 setting out the steps to achieve CMU by 2019.
Jason Harding and Michael Cavers are partners at law firm CMS. The views expressed above are their own and should not be taken as investment advice.
