Capitalising on Brexit? Charting the next phase of European Capital Markets Union

Although the UK embraced Capital Markets Union (CMU) in its early stages, it also strongly resisted attempts to enhance EU-level supervisory powers. Brexit could now see the CMU agenda develop further – but not in the way the UK had initially anticipated

Scott LaverySince its launch in 2014, Capital Markets Union (CMU) has become a flagship initiative of the European Union. CMU embodies Brussel’s latest attempt to construct a ‘single market’ in capital. It follows from numerous previous initiatives which sought to integrate and deepen the flow of capital within and between European member states. At its core, the programme attempts to boost lending through moving European economies away from ‘bank-based’ forms of credit provision and towards ‘market-based’ forms of credit.

The central premise of CMU is that investment and growth in Europe are currently undermined by a number of supply-side issues. First, CMU advocates claim that the EU suffers from a lack of financial diversity. For example, bank loans account for 79 per cent of EU corporate debt whilst in the US the figure is 26 per cent. Since the Eurozone crisis, banks have become more risk averse and face new capital adequacy requirements. According to CMU advocates, this acts as drag on investment and economic growth.

A second impediment is the slow pace of European financial integration. Differing insolvency rules, supervisory practices and tax regimes between member states ensure that European capital markets remain fragmented. Furthermore, this fragmentation has increased in the wake of the Eurozone crisis. For example, in 2008 euro area institutional investors held 27 per cent of their assets in other euro-area states but by 2014 this figure had fallen to 21 per cent. As the European Central Bank (ECB) remarked in 2012, the eurozone crisis “led to a marked deterioration in European financial integration”, particularly in bond markets.

CMU attempts to circumvent these barriers by both deepening and integrating European capital markets. These include activities such as private equity, corporate bonds, securitisation, hedge funds and venture capital.

As the host of Europe’s pre-eminent hub of global finance, the UK was set to be one of the main beneficiaries of CMU. 85 per cent of the EU’s hedge funds and 42 per cent of its private equity are concentrated within the City of London. As Lucia Quaglia has argued, UK policymakers and financial interests therefore became ‘pace setters’ on CMU, enthusiastically engaging with and shaping the agenda in its early stages. A 2015 House of Lords consultation counselled that  CMU represented a ‘’fillip to the UK economy and the City of London in particular…[and as such] the UK must ensure that it is at the forefront of the debate as the CMU agenda takes shape in the coming months’. In this spirit, powerful voices from within the City, the Bank and the Treasury enthusiastically embraced the CMU agenda. As Quaglia points out, 25 per cent of submissions to the Commission’s consultation on CMU were from City-based firms whilst the EU Commissioner for CMU – a position held by the UK’s Jonathan Hill – held numerous meetings with interest groups from the UK’s financial sector.

Brexit therefore has potentially far-reaching implications for the CMU project. The UK’s exit ensures that new barriers will emerge between the EU and its largest capital market. Furthermore, CMU’s staunchest advocate has been marginalised as a result.

Two possible ‘futures’ for CMU after Brexit can accordingly be identified.

The first is the prospect of derailment. Assuming the UK leaves the Single Market and sacrifices its ‘passporting rights’, this will reduce the size of EU capital markets by 25 per cent overnight. In addition, the UK’s exit could precipitate a further fragmentation in capital markets. This is because Brexit creates an incentive for ‘regulatory arbitrage’ as competing European financial centres seek to capture vulnerable sub-sectors from the City through loosely applying EU rules. This issue provoked a recent exchange of fire between Dublin and Luxembourg in relation to the latter’s attempts to lure the insurer AIG to relocate from London.  The loss of the political energy and regulatory expertise of the UK authorities could also slow down the CMU agenda. Simultaneously, Brexit empowers member states – in particular Germany – that have been far more reticent on CMU and its potential impact on their domestic banking systems.

A second possible future for the CMU is its reconfiguration after Brexit. The Commission and financial lobby groups have pointed out that the loss of the City will cause a large liquidity shock to European capital markets. They insist, however, that this adds a new urgency to deepening capital markets inside the EU27. Crucially, they also note that Brexit creates new opportunities for institutional reform and supervisory convergence inside the EU.

These opportunities arise from the fact that whilst the UK enthusiastically embraced the CMU initiative, it also acted – in a classic example of British statecraft in relation to the EU – as a political opponent of supervisory centralisation at the EU level. This opposition shaped the approach which the Commission adopted in relation to CMU in its early stages. The European institutions consciously ‘framed’ the programme as a ‘Single Market’ project for both euro and non-euro states, in large part to appease the UK’s reluctance to cede regulatory sovereignty. At the same time, however, European institutions tacitly acknowledged that CMU’s direction of travel was towards more centralised European supervision. For example, both the important Five Presidents report and European Central Bank documents stated that ‘ultimately’ CMU should lead to the creation of a ‘single European capital markets supervisor’.

British state managers were highly sensitive to this threat during the first phase of CMU. Charles Roxburgh, director-general of the Treasury, stated in 2015 that attempts to create a single European capital markets supervisor were neither ‘necessary [n]or desirable’ and would prove to be a ‘huge distraction’. The Bank of England opposed the prospect on financial stability grounds. Powerful financial lobby groups – such as the CityUK and the City of London Corporation – consistently stated their preference for ‘non-legislative and market-based solutions’ as opposed to supervisory centralisation.

The UK’s exit therefore removes one of the principal impediments to further capital markets supervisory convergence in the EU. UK policymakers consistently resisted the further empowerment of the European Supervisory and Markets Authority (ESMA), the agency charged with ensuring that member states adequately apply capital market legislation. ESMA’s lack of supervisory ‘muscle’ has been frequently cited as a barrier to a fully-functioning CMU. Brexit therefore creates an opportunity for those forces who would like to empower ESMA in order to drive through capital market integration.

For example, John Berrigan, Deputy Director General of the CMU portfolio, recently stated that, ‘Brexit makes regulatory and supervisory convergence more important to avoid fragmentation and to promote more efficient capital markets. This will accelerate market integration by avoiding regulatory arbitrage and a race to the bottom’.

Proceedings from the EuroFi 2016 conference – a high level forum of financial institutions and European regulators – echoed this sentiment. Their report states that ‘the idea of a CMU with 40 national supervisors will not work. ESMA needs to be strengthened. In such a context…CMU must be more ambitious in response to Brexit’.

European institutions’ tacit commitment to creating a ‘single European capital markets supervisor’ has therefore become increasingly explicit since Britain voted to leave the EU in June 2016.

There is a deep irony at work here. The loss of the UK – the ‘pace setter’ on CMU – could form the crucial precondition for the institutional reforms necessary to drive through deeper capital market development in Europe.

With Brexit, the EU loses its staunchest advocate of liberalisation and capital market integration. But it also loses one of the principal political barriers to supervisory convergence. Political economy scholars have often pointed to the distinctiveness of the UK as a powerful advocate of liberalisation within Europe. The paradox of Brexit is that as Europe’s ‘Anglo-liberal’ heartland disentangles itself from the EU’s institutional structures, this could bolster those forces which seek to pivot move Europe towards an ‘Anglo-Saxon’ model of market-based finance.