28 September 2020

Goldschmid: Capital Markets Union New Action Plan “Errare humanum est – perseverare diabolicum”

The European Commission published a Communication entitled “A Capital Markets Union for people and businesses-new action plan”. This is the fourth iteration of a process initiated in the early 2000’s under the name of the Financial Services Action Plan (FSAP).

 It received a vigorous impulse at the outset of Commission President Junker’s mandate in 2015 with the proposal to create a “Capital Markets Union” (CMU) among the then EU 28 Member States; it was further updated in a 2017 review.
 
If over the last 20 years progress has been made, mainly in attempts to harmonize or at least coordinate rules implemented by national regulators under a shared rule book, one must nevertheless accept that the fundamental aims of achieving CMU are still a long way off, as the recent new Action Plan admits in its own conclusions.

The reasons are imbedded flaws in the initial concept which, for political reasons, aimed at anchoring the City of London and therefore the UK to the EU in a futile attempt to influence the outcome of the British people’s vote on EU membership, recklessly promised by David Cameron in his party’s manifesto prior to winning an unexpected parliamentary majority in 2014. These flaws were detailed in an article that I wrote in March 2015 entitled “Creating a European “Capital Markets Union” - An ambitious initiative - poorly conceived!”⁽²⁾ and further developed on October 5^th 2015 under the headline “Further considerations on “C.M.U.” and “Brexit” ⁽³⁾.

Unfortunately, all the arguments put forward remain valid to this day; some additional recent developments render the latest proposals of the Commission’s Action Plan even more questionable as to the likelihood of their eventual implementation. For the sake of brevity I will concentrate my remarks hereunder on these new developments while referring the reader to the hypertext links at the end of this paper for those interested in more background.
 
The first remark concerns Brexit. It is rather ironic that, while the initial aim of CMU was to ensure that the continent’s access to the EU’s main financial center – the City – remained unimpaired, the new version of the plan insists (quite rightly) that Brexit makes the need for CMU even more relevant. The Plan fails, however, to draw the appropriate consequences of loosing jurisdiction over the Union’s main developed “national and international financial market”; it appears to wish to postpone consideration of this matter – referred to as “equivalence” – in the current trade negotiations despite the subject being at the heart of EU sovereignty, its financial stability and the regulatory framework of its financial markets.
 
Rather than considering – as the Action Plan states - that CMU will contribute to reinforcing the international role of the €, it is precisely the reverse that is true insofar as completing EMU and extending it to the EU 27 is a precondition to creating an unified EU capital market. Indeed, removing any lingering possibility of a dismantling of the Eurozone and the attendant “redenomination risk”, is a necessary step to foster a vibrant and EU wide investment area in which intra EU-FX considerations will have been eliminated, exceeding by far the benefits of (necessary) regulatory and supervisory harmonization. In addition such an extension is a Treaty obligation the non-enforcement of which by the Commission (guardian of the treaties) constitutes a flagrant violation of “international law” which is so vehemently being upheld in the context of the Brexit Withdrawal Agreement!

The extension of the Eurozone to coincide with the territory of the EU – which is a necessary corollary to the advances made by the adoption last July of the €750 billion “green, digital, inclusive and resilient economic recovery plan” – would constitute a major step towards revitalizing the geopolitical relevance of the EU. Its implementation transcends the importance of building a continent-wide vibrant financial market and should be considered as being a key element in the shaping of other major EU policies, including foreign affairs, defense, trade (in particular Brexit), ensuring that the EU’s financial stability is no longer dependent on the knowhow of the City (for trading derivatives and clearing € denominated securities) or on the goodwill of the US Federal Reserve Bank (to provide USD liquidity to the Eurozone banking system).

A second aspect of the new Action Plan is that it correctly defines the aim as being: building a “single market” with multiple decentralized access points. This objective usefully replaces the earlier (flawed) ambition of creating a “union of distinct national capital markets”. The feasibility of such an architecture has already been partially validated during the unfortunate experience of the coronavirus pandemic which has dramatically increased reliance on distance-working. This bodes well for the further “virtual” integration of the EU’s financial markets by reducing the need of physical proximity for a growing number of operations. Proof of this potential is demonstrated by the record amount of bond issuing having taken place during the pandemic. However, significant problems of internal and external security and supervision will have to be dealt with to provide all market participants with the necessary operational safeguards to protect the market’s integrity in the new digitalized world. This latter crucial constraint has been hardly touched upon in the 16 specific proposals put forward by the Commission.

But it is a third aspect that should be of greatest concern in assessing the relevance of the Action Plan: nowhere in the text is there any mention of the dramatic changes that have taken place since the 2008 financial crisis, in market structures and the respective roles of its main participants. How can one explain the absence of a single reference to the key role that Central Banks have been playing when every major financial institution is hanging on their every word to the point where their influence is translated directly to fixed income, equity and FX markets? Not only do Central Banks seek to give “guidance” on the direction of monetary policy to manage expectations but they must also anticipate the market reactions to avoid disruptions (for example the “taper tantrum” when the FED suggested reducing the size of its “quantitative easing” program or the reaction to ECB’s President Lagarde's unguarded comments on Italian debt).

The action Plan seems to address mostly yesterday’s problems, identified already in the FSAP of the early 2000’s. At the time, a decade’s old basic mantra regarding portfolio diversification, varying around a 60/40 balance between fixed income and equity investments prevailed, and had proved to provide a measure of stability over the longer term. The 2008 crisis saw the start of a long term downward shift in interest rates (delivering over time huge capital gains especially for institutional bond holders); it has culminated today in a zero% - if not negative - rate environment. In parallel, equity markets benefitted from lower rates as investors looked for higher returns. Today the old equilibrium of a 60/40 balanced portfolio has become obsolete and no longer delivers the anticipated protection; risiing interest rates would induce large (unsustainable) capital losses (for insurers and pension funds in particular) at the same time as equity markets would come under increased pressure as companies are, for that same reason, unable to meet their financial commitments.

The economic hit induced by the coronavirus pandemic has only increased the conundrum facing Central Bankers (and Governments). The simultaneous rapid increase of an already excessively high rate of public and corporate indebtedness and a stock market debased by excess liquidity chasing evermore risky higher returns in equities (abetted by buybacks and dividend distributions financed by additional cheap debt) creates a situation that is clearly unsustainable. 

While this theme deserves ample further development, one should first address, in the specific context of the Action Plan, the question as to whether present times are suitable for advocating increased participation of retail investors in providing equity capital to the economy. Rather, though the need of more risk capital is undeniable to achieve the economic recovery and the green and digital agendas, attention should focus more on creating or growing collective investment instruments (UCITS, Insurance Companies, Pension Funds, Private Equity, Public Funds…). Indeed, only institutions professionally managed will be able to access the sophisticated tools (derivatives…) that are needed to give a measure of protection in the new economic and financial environment.  
 
Conclusions:

The regulatory, fiscal and legislative environment necessary to develop the activities of professional managers, collecting and deploying the substantial retail savings available, seems to be – at least partially - at odds with the well-meaning aims developed in the Action Plan.

In the present circumstances – regardless of the implementation of the Action Plan’s proposals aimed in part at protecting individual retail investors – it is likely that this most vulnerable segment of the market will be the first victim of any financial debacle. In the prevailing mood of distrust towards public authorities, disappointed investors are likely to vent their anger far more forcefully than previously against those who promoted their appetite for equities and become permanently discouraged from participating in the market. 

As already mentioned, however, the creation of a single “€” denominated EU-wide financial market should become the EU’s key objective. It will help to preserve its citizen’s high standard of living, provide them with the protection they deserve and above all ensure the perpetuation of the cultural and spiritual values that underpin Europe’s unique contribution to peace among men of goodwill.

© Paul Goldschmidt