By Adam Jacobs (pictured), Director, Head of Markets Regulation, AIMA
The financial crisis of 2008 threw into sharp relief the weaknesses of the banking sector, prompting massive state bail-outs and decisive supervisory action by G20 nations.
But this has left policymakers in the EU with a dilemma. How do they ensure that building a more stable, resilient financial system does not come at the expense of economic growth? New rules have required banks to scale back the amount of money that they lend, which in turn means that European firms – particularly the region’s legion of small- and medium-sized enterprises (SMEs) − are less able to access the capital that they need to be able to invest in and grow their business.
This has led to increasing interest on the part of EU policymakers in the role that market finance − sometimes referred to as part of the ‘shadow banking’ system − could play in terms of filling the lending gap and allowing firms to access the capital that they need for growth.
In its simplest form, market finance is based on a model whereby businesses are able to raise capital from investors by issuing shares and bonds − by accessing capital markets.
Europe is an interesting region to consider, because it is characterized by differences between countries in terms of the balance between market-finance and bank-based lending. We at AIMA, the global hedge fund industry body, were keen to explore these differences, to see whether this could provide broader insights into global financial structure and its future evolution. Specifically, what do differences in the balance between bank lending and capital markets mean for economic growth? Do capital markets offer a source of finance that has positive spill-over effects on the economy?
AIMA asked two leading German academics in this field – Christoph Kaserer, professor of finance, chairman of financial management and capital markets, TUM School of Management, Munich; and Marc Steffen Rapp, professor of finance, Accounting & Finance Group, School of Business and Economics, Philipps-Universität Marburg – to explore these questions. Their work has resulted in the publication of a new study, entitled Capital markets and economic growth − Long-term trends and policy challenges, which was launched in Brussels on 20th March.
The study’s key finding is that the balance between market finance and bank lending does matter and that overreliance on banks comes at a cost in terms of reduced economic growth.
Significantly, the study’s authors have put a figure on the economic impact of “deeper” (larger and more liquid) capital markets. They estimate that growing combined stock and bond markets in Europe by one-third could increase long-term real growth rate in per capita GDP by around 20%, as stock and bond markets improve reallocation of capital across industries.
As we know, hedge funds are important providers of liquidity, risk management and price discovery in capital markets. The study finds that the broader spectrum of asset managers − from passive investors through to dynamic and active investors such as hedge funds − further complements the effectiveness of capital markets, both in terms of enhancing market liquidity and in terms of providing capital for potentially riskier business investments.
Some of the most striking findings relate to the positive impact of stock markets and their participants on economic growth. The authors say that stock markets are useful sources of funding for long-term risky investments. They provide evidence that firms in bank-based economies have less flexibility in their financing decisions and therefore follow a more conservative financing strategy. This might lead to underinvestment in R&D.
Further benefits come from improvements in corporate governance that are driven by stock market participants. In particular, active shareholders such as hedge funds are able to effect positive governance changes in the firms in which they invest, by virtue of their expertise and willingness to engage with a firm’s management.
The study also explores the extent to which economies in the EU that were traditionally regarded as bank-based have embraced capital markets in recent years. It suggests that the old distinctions between the bank-based economic structure of parts of Europe and the more market-based structure of the UK (and US) are rapidly disappearing.
By way of illustration, average stock market capitalization in European economies with bank-based financial systems – historically known to be much lower than in economies with market-based financial systems – was 35% of GDP during the 1990s, but increased to 58% over the period 2000 to 2012. Over the same period, stock market capitalization in market-based European economies only increased from 110 to 117 percent. What this means is that, in relative terms, stock market growth was much more pronounced in bank-based European economies.
Convergence has also been evident at the micro level. Today, European firms tend to rely much more on equity financing than in the 1990s. And differences in capital structures between different European countries have become less pronounced in recent years. Similarly, the level of ownership concentration in listed firms, historically known to be higher in bank-based economies, has become more balanced over time as ownership has become more dispersed in firms located in bank-based economies.
A policy programme to support capital markets
The study goes on to explore how policymakers in the EU could build a policy programme that aims to support the development of capital markets and tap into their underexploited growth potential.
Clearly, capital markets could make an important contribution to the EU growth strategy. Capital markets could be strengthened by improving the quality of minority shareholder protection rights, just as the role of independent institutional investors could be enhanced. The study also notes that retirement savings rules and tax laws could be designed in a way that encourages a larger part of national savings to be invested via capital markets, which would also help funded pension schemes to provide for an ageing population. And, finally, it is worth considering how tax rules could enhance the role played by stock markets.
EU governments would benefit from a well-developed capital markets policy that recognises that a critical feature of a stable financial system is having strong capital markets with a necessary diversity of key participants. In terms of translating this into legislative and regulatory action, we believe that the following concrete steps could be considered:
- Development of a pension fund vehicle that can be marketed across Europe under a harmonised set of rules.
- Reform of European corporate governance requirements with a view to strengthening shareholder protection.
- Development of a harmonized framework for loan origination outside the banking sector.
- Development of a harmonized and strengthened insolvency framework across the EU.
- Review of the existing rules for securitisations to ensure that the market can function effectively.
- Avoid homogenization of financial markets participants which extends regulatory approaches from one sector to sectors with radically different business models.
Ultimately, we believe that a co-ordinated and ambitious policy programme along these lines could help to provide additional sources of financing for the real economy, while making for a stronger financial sector.