The Capital Markets Union Must Consider Conditions in the Banking Sector

What is the status of European financial market integration? After passing legislation to create a banking union in 2014, the European Commission is now planning to establish the foundation for a capital markets union by 2019, in order to create a true single market for capital. This effort to increase the integration of Europe’s financial markets has the goal of stabilising economic growth while also making Europe more resilient to crisis. But what is the current state of play? In this Q&A, Karolin Kirschenmann, a financial economist at ZEW, sees a need for improvement in various areas, including how policymakers deal with insolvent banks, and how to vitalize securitisation markets.

What are the benefits of greater financial market integration?

The European financial and sovereign debt crises have shown that an institutional framework is needed to address the systemic effects of such crises. The banking, fiscal and capital market unions are three distinct but related policy efforts that have the common goal of stabilising the Eurozone and synchronising the economic growth of individual Member States. The promotion of cross-border diversification is a key aspect of the capital markets union. It aims to diversify financing opportunities, particularly for SMEs, while also bolstering securitisation markets, thus easing the distribution of risk beyond national boundaries. This should improve the ability of markets to absorb economic shocks that emanate from specific countries or sectors, thus minimising risk of a systemic crisis. One example of this is the bursting of the dotcom bubble, which did not lead to a major economic crisis since many investors suffered only a comparatively small shock that they were able to cushion.

For the capital markets union to work, don’t we first need stricter banking regulations, including more comprehensive measures for recapitalising financial institutions?

The capital markets union cannot work without considering current conditions in the banking sector. While the capitalisation of European banks has considerably improved, the rate of non-performing loans remains extremely high, particularly in Southern Europe. The problem is not a lack of new regulations. Rather, there is an absence of political will in Europe to recapitalise or unwind ailing banks. Unwinding a financial institution is difficult during an acute crisis, as this can have negative impacts on the economy and savers, and may ultimately trigger a bank run. In the US, the government systematically recapitalised banks early on, which contributed to a quicker end to the crisis. However, governments should not automatically recapitalise banks during a crisis, for this could increase the risk of moral hazard, encouraging bank executives to take excessive risks. 

If policymakers currently lack willpower, and if the government should not automatically bail out troubled banks, what should we do with ailing financial institutions?

One component of the banking union is the single resolution mechanism (SRM), which includes the single resolution fund (SRF). The SRM provides for the orderly restructuring or liquidation of troubled banks. However, in contrast to the general recapitalisation that took place in the US, the SRM is not an instrument to generally recapitalise weak banks that are burdened with non-performing loans. The credibility of these newly created institutions has already suffered, as Italy recently took advantage of an exceptional rule in order to wind down two regional banks using state aid, without bailing in creditors (and savers) as provided for by the SRM rules.

Can the capital markets union guarantee secure asset classes?

The capital markets union could provide a strong boost to European securitisation markets, easing the ability of banks to package and trade debt tranches with varying degrees of risk. This would have numerous benefits. Bank assets would obtain a market price, thus making bank balance sheets more transparent. At the same time, banks could increase the diversification of their assets, and it would become easier to unwind insolvent institutions. While a legal framework now exists to revitalise Europe’s securitisation market, the trading of asset-backed securities remains anaemic. In a planned project at ZEW, we aim to investigate the incentives that should be implemented to promote more vital securitisation markets. In the process, the risk of securitisation can’t be ignored, for unregulated, intransparent securitisation practices were one trigger of the financial crisis.