Europe's Capital Markets Union and the New Single Market Challenge

This blog post was published today by Bruegel and by the Peterson Institute. 

The European Union has started a conversation on reforming its capital markets which raises difficult questions about market integration in regulated services sectors, of which finance is one. Powerful political constraints, currently centered on (but not limited to) the United Kingdom, prevent the European Union from creating pan-European agencies for regulatory enforcement. But decentralized enforcement in such sectors tends to defeat the aim of cross-border integration. As regulated services are increasingly important in the continent’s economy, Europeans will eventually need to make a choice between building a single market and maintaining sovereignty over regulatory enforcement.

European Commissioner Jonathan Hill announced an action plan on September 30 to transform European Commission President Jean-Claude Juncker's vision of a European “Capital Markets Union” into reality. As Mr Juncker explained it back in July 2014, “[t]o improve the financing of our economy, we should further develop and integrate capital markets. This would cut the cost of raising capital, notably for SMEs, and help reduce our very high dependence on bank funding.” There is much to be commended in the Commission’s new document. It strikes a sound rhetorical balance between the need to develop financial services vital for the European economy and the imperative to ensure proper financial sector regulation. The diagnosis that EU capital markets are underdeveloped, and that less dominance of banks in the system would benefit growth and stability, is important and well-taken. Many of the specific initiatives appear reasonable.

Nevertheless, the incremental nature of the action plan contrasts greatly with the ambitious language of the Capital Markets Union – with its echoes of Banking Union, a separate and genuinely radical policy development. It mostly boils down to pruning existing rules and correcting some of the European Union’s own recent regulatory overreach. This is the normal business of the Commission’s arm that deals with financial regulation, recently renamed from DG MARKT to DG FISMA. But while such fine-tuning work is important, it is not likely to bring much change to the overall structure of Europe’s financial system. Potentially the plan’s most significant initiative is new EU legislation to harmonize insolvency law, to be published by the Commission in late 2016, but this is left undefined and could end up being unimportant. Major obstacles to capital markets integration remain untouched, including divergent accounting enforcement regimes, fragmented market infrastructure, or incompatible frameworks for the taxation of financial investments.

Why this apparent lack of ambition? Special interests that have much to lose from capital markets union may play a part. Some segments of the EU banking industry, and protected financial “national champion” market infrastructure firms in some member states, have made it clear that they do not view the capital markets union as a good idea. But the European Commission has a decent track record on overcoming such resistances. Ideological obstacles, especially in countries where anti-capitalist and anti-market rhetoric has broad public appeal such as France or Italy, may create roadblocks. But this explanation is also insufficient. In fact, the Commission has been appropriately unapologetic about its market-based vision. Its announcements have spurred healthy national debates that may lead to a better understanding of the economic case for capital markets. Even if this happens, however, it won’t be enough to trumpet mission accomplished: ultimately, the European Commission’s mission is about public policymaking, not just public advocacy.

A more convincing explanation for the plan’s underwhelming content is the Commission’s self-imposed restraint on any change in the institutional architecture. Commissioner Hill and DG FISMA officials insist that any discussion of institutional reform would be an unwelcome and ultimately pointless distraction from the policy substance at stake. On this, Commissioner Hill's view diverges from Commission President Juncker's, as expressed in the so-called Five Presidents’ Report last June, which argued that the capital markets union “should lead ultimately to a single European capital markets supervisor.” More importantly, the refusal to consider institution reform is highly debatable on grounds of substance. As practitioners know, having to deal with different regulators in different countries creates duplication, inconsistencies, and ultimately barriers to seamlessly integrated cross-border business.

The Commission may be wary about disputing the turf of Europe’s myriad national financial authorities. (There are no fewer than 51 of them, only looking at membership of the three European Supervisory Authorities and not including non-EU participating members of the European Economic Area.) But the European Union has been able in the recent past to create central agencies with bite when needed: for example, the Banking Union’s supervisory arm hosted by the European Central Bank, known as the Single Supervisory Mechanism (SSM), and the Single Resolution Board (SRB), a new agency in Brussels; or Frontex, the Warsaw-based agency that coordinates border guards for countries including all those in Europe’s Schengen area for the free movement of individuals. These examples, however, also illustrate the limits of European institution-building. The SSM was created under extreme duress, when it was (aptly) seen as the only way to prevent a breakup of the euro area in mid-2012. The SRB and Frontex coexist awkwardly with national agencies that retain much autonomy.

Last but not least, these cases hint at the specific position of the United Kingdom, which is a participant in neither the Banking Union nor Schengen. Commissioner Hill insists that its capital markets union should include the United Kingdom, and he is correct on this: London is the undisputable hub of Europe’s capital markets. An integration project excluding Britain would entail the much more serious risk of creating a harmful fault line inside the European Union than is the case with banking. But British sensitivity about any executive centralization, currently exacerbated by the upcoming UK referendum on EU membership in 2016 or 2017, results in a refusal to consider any joint enforcement or supervision, even in ostensibly nonpolitical areas such as accounting enforcement or audit oversight.

In the short term, there is a solid case for the European Commission not to go against this effective UK veto over any meaningful change in European financial regulatory institutions. The referendum creates the risk that the United Kingdom might leave the European Union, which could be severely detrimental for both. Any initiative that may fan the flames of anti-EU passion across the Channel must be toned down or outright shelved. But therein also lies a great irony. While all member states would gain from a genuine capital markets union, Britain would gain disproportionately. In most other member states, nonfinancial enterprises would unambiguously benefit through better access to finance, but the impact on the domestic financial sector could be neutral or even negative given the additional competitive pressure. By contrast, the City of London and other parts of the UK financial services industry are almost sure to gain from more development and integration of Europe’s capital markets, given their entrenched comparative advantage in financial intermediation—assuming that the United Kingdom remains in the European Union.

This observation can be extended beyond the debate about capital markets and financial services regulation. The traditional view of Europe’s single market project was all about harmonizing product standards, a view that is perhaps best embodied in the Single European Act of February 1986. In markets for goods and unregulated services, harmonization is sufficient to eliminate cross-border barriers, because enforcing standards is sufficiently straightforward to be left to a decentralized network of public authorities and courts. However, in regulated service sectors such as finance, enforcement functions (which include licensing, authorizations, and supervision) involve considerable judgment and discretion. In such sectors, leaving these functions exclusively or mainly to the national level results in cross-border fragmentation, while pooling them at the European level is a necessary (though not always sufficient) condition for cross-border integration. National authorities typically don’t trust each other, defend their territorial prerogatives, and are often motivated to defend or promote their respective national champions. For that reason, “passporting” or mutual-recognition frameworks are often not complied with, as authorities find ways to add national requirements or oversight to participants that have been authorized in third countries. In short, for such sectors, a single market worthy of its name will remain elusive as long as regulatory enforcement remains primarily at the national level.

As it happens, regulated services are also increasingly important for Europe’s growth and its economic and social resilience. Witness Juncker’s flagship structural reform projects—including an “Energy Union” and a “Digital Single Market” along with the capital markets union—that are also focused on regulated services sectors and raise similar trade-offs about European versus national administrative authority. While the “old” single market in goods and unregulated services was satisfactorily addressed through standards harmonization, the new single market challenge is all about regulatory enforcement institutions. Denial of this stark reality is widespread in Europe, not least in the United Kingdom itself. Such denial may be politically expedient but is analytically unhelpful, and stands ultimately at odds with the proclaimed commitment to a European single market. A clear-sighted public debate about this challenge may be delayed until after the UK referendum, but not indefinitely.