# EUR-Lex - 52015SC0013 - EN

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# 52015SC0013

**COMMISSION STAFF WORKING DOCUMENT Initial reflections on the obstacles to the development of deep and integrated EU capital markets Accompanying the document Green Paper Building a Capital Markets Union /* SWD/2015/0013 final */**

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Table of content

1..... Introduction.. 4

2..... Overview
of capital markets and their main functions. 4

2.1.     Market-based (direct) vs.
bank-based (indirect) financing. 5

2.2.     Private vs. public markets. 6

2.3.     Primary vs. secondary
markets. 6

2.4.     Main functions of capital
markets. 7

2.5.     Investor groups. 7

2.6.     Important market attributes. 8

2.7.     Economic benefits of capital
markets. 9

2.8.     Obstacles to efficient
capital markets. 10

3..... Underdevelopment
and fragmentation.. 10

3.1.     Regulatory and institutional
reasons. 11

3.2.     Size vs. composition. 12

3.3.     Fragmented market structure. 12

3.4.     Specific impediments to
capital markets. 13

3.4.1.       Endogenous constraints in
reaching critical size. 14

3.4.2.       Impaired market data availability. 14

3.4.3.       Differences in regulation
and supervisory enforcement 15

3.4.4.       Diverse and fragmented
legal frameworks for specific financial instruments  15

3.4.5.       Insufficiently harmonised
or inadequate company law and corporate governance rules  17

3.4.6.       Non-harmonised
conflict-of-law rules in the area of company law.. 19

3.4.7.       Insolvency laws and
enforcement of contracts. 19

3.4.8.       Tax barriers. 20

4..... Barriers
to demand and access to capital markets financing   22

4.1.     Overdependence on bank
finance. 24

4.2.     Lack of (credit) information
for potential investors. 25

4.3.     Underdeveloped market for
risk capital 26

4.4.     Regulatory and other
barriers to SME listing. 28

5..... Barriers
to household investment in capital markets. 28

5.1.     Lack of trust in financial
markets and intermediaries. 29

5.2.     Lack of adequate financial
expertise. 30

5.3.     Household preference for
investment in real estate. 30

5.4.     Language and other technical
barriers resulting in strong home bias. 31

6..... Barriers
to institutional investment. 31

6.1.     Constrained scale of
occupational and personal pension funds. 32

6.2.     Short-termism and regulatory
features drive inefficient asset allocation. 33

6.3.     Challenges associated with
long-term and large-scale infrastructure investments. 34

APPENDIX.. 36

1. 
Introduction

This Commission Staff Working Document
accompanies the Green Paper on Capital Markets Union. It presents initial
reflections and analysis of the range of factors impeding the development of
integrated and well-functioning capital markets in the EU.

EU capital markets have been radically
transformed in the last decades due to, inter alia, financial innovation,
technological development, the introduction of the euro, the growth of
derivative instruments, globalisation, and the regulatory and market response
to the financial and economic crisis. As in the case of financial institutions,
some capital markets have proved resilient to the crisis. Others have proven to
be inherently fragile or, in the absence of adequate safeguards, have
transmitted shocks and contributed to the build-up of systemic risk.

Understanding whether and to what extent EU
capital markets are working well is challenging. This document is a first step
in identifying the relevant issues. Further economic analysis will be
undertaken to inform policy-making in developing an action plan on Capital
Markets Union.

2. 
Overview of capital markets and their main
functions

Figure 1 below attempts to capture the main
thrust of the flow of funds in an economy. Whilst capital markets are
predominantly concerned with direct financing, they are also closely
interlinked with financial intermediaries who are themselves active on capital
markets.

Figure 1:
Stylised view of capital markets in the broader financial system

The term "financial markets" is
often used to refer to all sorts of markets in the financial sector, including
ones that are not directly concerned with raising finance, such as commodity
and foreign exchange markets. In the narrow sense, financial markets are formed
by money markets and capital markets. The money markets are used for raising
short-term finance (sometimes for loans that are expected to be paid back as
early as overnight), whereas the capital markets are used for raising
longer-term finance, such as the purchase of shares, or for loans that are not
expected to be fully paid back for at least a year.[1]

Funds borrowed from the money markets are
typically used for general operating expenses to cover brief periods of
illiquidity or short-term financing needs. For example, a company may have
incoming payments from customers that have not yet cleared, but may wish to
immediately pay out cash for its payroll. When a company borrows from the primary
capital markets, the purpose is often to invest in additional physical capital
goods, which will be used to help increase its future income. It can take many
months or years before the investment generates sufficient return to pay back
its cost.

In this narrow sense, modern capital
markets consist of:

i. 
Debt and equity markets that intermediate funds
between savers and those that need capital;

ii. 
Derivatives markets that facilitate risk
management, consisting of contracts such as futures, options, interest rate and
foreign exchange swaps, typically associated with underlying debt and equity
instruments; and

iii. 
Securitisation and structured finance markets[2] that improve funding
access further by broadening the potential investor base.

The basic functioning and the main benefits
of capital markets are explained in more detail in the subsection sections
below.

2.1. 
Market-based (direct) vs. bank-based (indirect)
financing

Capital markets financing is often labelled
"direct", because it occurs through direct exchange of securities
between investors and borrowers.[3]
This differs from "indirect" financing via financial intermediaries,
notably banks, which collect deposits from savers and lend funds to borrowers.
The latter is also referred to as the "bank-based model", as opposed
to the "market-based model" in the case of direct financing. But this
traditional distinction is less valid now as banks have become increasingly
active in capital market intermediation.[4]
Every economy has a mixture of both rather than being a pure model of one or
the other. The two types of intermediation should rather be treated as
complementary to one another and interlinked. For example, with securitisation,
banks certify borrowers’ credit quality and the capital market finances the
borrowers, thereby lowering financing frictions. In turn, capital market
development lowers the cost of bank equity capital, and thus enables banks to
raise the capital needed to take on riskier loans that they would otherwise
reject.

The relative advantages of bank or
market-based finance depend on the underlying economic structures. The shift
towards more market-based elements of the financial system can be expected to
bring advantages for the EU economy by diversifying the funding sources
available to the economy[5].

Although banks through their traditional
role in relationship banking are instrumental in overcoming problems of
asymmetric information, in market-based financial systems, other intermediaries
can play a role in information provision about potential borrowers and
investment projects. For example, they include credit rating agencies and
financial analysts and advisors that help the ultimate savers to evaluate and
select investment projects. The ultimate savers may also put their wealth into
non-bank intermediaries that evaluate and select investments for them. Credit
insurance may also be an effective mechanism to delegate monitoring activities
to specialised intermediaries. Credit insurers would also have an incentive to
work out distressed assets when it comes to the ultimate borrowers' failure.
The existence of a market for distressed assets allows risk-taking financial
intermediaries such as private equity or hedge funds to step in. The emergence
of these intermediaries is likely to be endogenous to the development of a
market-based financial system – i.e. they would develop as markets develop.

2.2. 
Private vs. public markets

Capital markets can be subdivided into
private and public markets. The private equity market, for example, is an
important source of funds for start-ups, middle-market (so-called midcap)
companies, firms in financial distress and public firms seeking buyout
financing. Other typical examples include public equity and bond markets and
the market for private placement debt, as depicted in Table 1 below:

Table 1: Typology of capital markets

|| Public markets || Private markets

Debt markets || Bond markets || Private placement

Equity markets || Stock markets || Private equity

The main difference lies in the greater
regulatory and disclosure requirements associated with public markets (in terms
of covenants, pricing, etc.), while private markets are subject to much less
onerous disclosure obligations. Public markets are also typically characterised
by a multitude of investors in each transaction, and hence deeper liquidity,
while private debt placements or private equity deals often involve just a
single or a small group of investors (with covenants and pricing tailor-made to
suit their requirements) and rarely trade in secondary markets. Thus, companies
that finance themselves in the public markets face much closer scrutiny. While
regulation and disclosure requirements are meant to guarantee a higher level of
investor safety, it can sometimes act as a deterrent and keep companies in the
private domain.

2.3. 
Primary vs. secondary markets

Another key division within capital markets
is between primary and secondary markets. In primary markets, new stock or bond
issues are sold to investors, often via a mechanism known as underwriting
(typically performed by investment banks). The main entities seeking to raise
funds on the primary capital markets are governments (which may be municipal,
local or national) and companies. Governments tend to issue only bonds, whereas
companies can issue either equity or bonds.

In the secondary markets, existing
securities are sold and bought among investors or traders, usually on an
exchange or over-the-counter (OTC). Transactions on the secondary market do not
directly help raise finance, but they make it easier for companies and governments
to raise finance on the primary market, as investors know they are likely to be
able to swiftly cash out (exit) their investments if the need arises. The
availability of a liquid secondary market for securities also sets incentives
to monitor investment projects as new information about debtors' fortunes opens
profit opportunities from selling or buying securities.[6] All in all, a liquid
and transparent primary market for raising capital is predicated upon a
secondary market with the same qualities.

2.4. 
Main functions of capital markets

Capital markets serve the following main
functions:

– 
 Capital raising and investing: the
primary debt and equity markets provide an alternative way (to banks) to
allocate capital within an economy. For example, they allow corporates to raise
the funds required to expand their business and help governments fund their
budgets or refinance existing debt. Capital markets also allow households to
smooth their consumption over time and to perform intergenerational resource
transfers. For investors, capital markets provide an opportunity to earn a
return on funds that are not needed immediately and to accumulate assets that
will provide an income in future.

– 
Risk management and diversification: the derivatives market helps investors and borrowers to manage
(hedge) the risks inherent in their portfolios and asset/liability exposures.
Risks can be tranched, packaged and traded in financial markets.

– 
Price discovery and asset valuation: secondary markets facilitate the trading and pricing of financial
instruments and their risks.

2.5. 
Investor groups

There are different types of investor, with
different preferences for risk and return and the types of investment/assets
preferred. Some financial market products are deliberately designed to offer
only capital gains and no yield, or vice versa, to satisfy these preferences.
Investors can be broadly divided into two categories:

Households
  (retail investors) own a small proportion of financial assets. Individual
  investing has become increasingly popular and most households in wealthier
  countries own some financial assets, often in the form of retirement
  savings[7].
  Nonetheless, the great majority of individual investment in financial
  assets is controlled by a comparatively small number of wealthy households.
 Institutional investors[8] are responsible for most of the trading in financial markets.
  Asset managers play a very important role in capital raising and investing
  by accumulating significant amounts of resources and investing them in the
  real economy. The size and composition of institutional investors varies
  greatly from country to country and their investment practices vary
  accordingly[9].
2.6. 
Important market attributes

For capital markets to function efficiently
and competitively, they need to attract capital and the critical mass of
investor base. The following important (interlinked) attributes matter in
achieving this:

Liquidity,
  i.e. the ease with which trading can be conducted (or the cost of
  converting assets into full liquid assets). In an illiquid market an
  investor may have difficulty to find a counterparty ready to make the
  desired trade, and the difference, or “spread”, between the price at which
  a security can be bought (bid) and the price, for which it can be sold
  (offer), may be high. Trading is easier and bid-offer spreads are narrower
  in more liquid markets. 
 Transparency, i.e. the availability of prompt and complete information
  about trades, prices and past market behaviour. The knowledge about the
  performance of a company, issuing stocks or the likelihood of a debt
  security issuer repaying the money as promised are also elements of market
  transparency. Generally, the less transparent the market the lower the
  level of trading or at least the higher the level of risk assumed because
  of the lack of information.
 Integrity and accountability, for example when it comes to ensuring that trades are
  completed according to the terms agreed and preventing insider trading and
  other forms market abuse.
 Adequate legal procedures to settle disputes and enforce contracts.
 Suitable investor protection and
  regulation: trading will be deterred if
  investors lack confidence in the available information about the
  securities they may wish to trade, the procedures for trading, the ability
  of trading partners and intermediaries to meet their commitments, and the
  treatment they will receive as owners of a security or commodity once a
  trade has been completed.
 Low transaction costs: many financial-market transactions are not tied to a specific
  geographic location, and the participants will strive to complete them in
  places where trading costs, regulatory costs and taxes are reasonable.
 Adequate infrastructures and
  digitalisation: modern capital markets depend
  on adequate market infrastructures for trading, clearing and settlement of
  transactions and information provision. Capital markets are almost
  invariably hosted on computer-based electronic trading systems. Although
  most can be accessed only by entities within the financial sector or the
  treasury departments of governments and corporations, some can be accessed
  directly by the public. One of the recent developments is the rise of the
  Fintech sector, which can be defined as a breed of new companies that
  combine traditional financial services with the use of new digital
  technologies. Fintech is facilitating access to finance especially for
  those firms not able to obtain capital via banks or (traditional) capital
  markets. A good example is crowdfunding where non-traditional investors
  get access to investment opportunities for the first time and where
  start-ups and SMEs can obtain funding for their investments and operations
  through the internet[10]. 
2.7. 
Economic benefits of capital markets

The development of capital markets
generates numerous economic benefits:

– 
First, capital markets provide financing for the
economy, in addition to bank financing, and enlarge the investor base. They
encourage a broader ownership of productive assets by small savers to enable
them benefit from growth and wealth distribution. Better developed capital
markets may also offer better credit terms and conditions for some borrowers,
potentially making capital more mobile and cheaper. This can be particularly
relevant in times of financial turmoil, allowing companies to arbitrage between
the various potential sources of financing. Overdependence on bank lending
makes the economy more vulnerable when bank lending tightens, as happened in
the recent crisis. Diversification of funding sources implies less
reliance on bank lending and therefore makes the financial system more flexible
in crisis situations. Next to systemic benefits, diversification benefits also
apply from the perspective of investors who benefit from an increased set of
investment opportunities in deeper and more liquid capital markets.

– 
Second, capital markets improve the
allocation of capital. Because the prices of corporate debt and equity
respond immediately to shifts in demand and supply, changes in the outlook for
a company are quickly embodied in current asset prices. The signal created by
such a price change encourages or discourages further capital inflows. The
ability of companies in their early stages of development to raise funds in the
capital markets is also beneficial because it allows them to grow very quickly,
which speeds the dissemination of new technologies throughout the economy.
Furthermore, by raising the returns available from pursuing new ideas,
technologies, or ways of doing business, the capital markets facilitate
entrepreneurial and other risk-taking activities.

– 
Third, well-functioning capital markets have the
potential to distribute risk more efficiently. Part of the efficient
allocation of capital is the transfer of risk to those best able to bear it —
either because they are less risk averse or because the new risk is
uncorrelated or even negatively correlated with other risks in a portfolio.
This ability to transfer risk facilitates greater risk-taking, but this
increased risk-taking does not destabilise the economy. Capital markets can act
as shock-absorbers when an economy hits difficulties. Whilst losses are
incurred throughout the financial system, certain investors may be better
placed to absorb losses than banks. The shock absorbing capacity of
capital markets is particularly high when funding is provided in the form of
equity.

In addition, whereas banking intermediation
is primarily debt-based, capital market financing comprises equity funding.
More equity funding allows more investment without increasing the indebtedness
of the economy.

According
to the economic literature, there does not seem to be a uniformly positive
effect on economic growth at all levels of financial intermediation. A number
of studies identify thresholds beyond which additional financial expansion no
longer yields positive changes in growth.[11]
In particular, empirical evidence shows that banking sector expansion exerts a
positive influence on economic growth especially at earlier economic
development stages. This may be linked to the fact that banks provide different
services to the economy than those provided by capital markets: banks have a
comparative advantage in financing standardised, shorter-term, lower-risk and
well-collateralised transactions. However, as the economy develops, its
relative sensitivity to capital markets increases.

Recent
empirical evidence shows that capital market size is positively correlated with
economic development: the positive impact of stock and bond markets on economic
development is related to their superior capacity to reallocate capital
cost-efficiently across industries and to finance investments by acquiring
capital from many sources, including asset managers (i.e. pension funds, mutual
funds, hedge funds, private equity funds etc.).[12]

2.8. 
Obstacles to efficient capital markets

Obstacles to the adequate functioning of
capital markets fall under the following categories:

i. 
Underdeveloped or fragmented markets, due to regulatory and legal barriers, institutional shortcomings
and other reasons;

ii. 
Barriers on the demand side of the market in terms of access to finance, in particular as
regards SMEs;

iii. 
Constraints on the supply (i.e. investor) side of the market that limit the flow of
savings into capital market instruments;

Market distortions or regulatory
  failures that limit or impede direct
  financing of investments with a long-term horizon.

Modern capital markets are closely
interconnected. It is thus no surprise that the four categories of problems
identified share many underlying causes. However, for ease of exposition each
of these set of problems is addressed separately.

3. 
Underdevelopment and fragmentation

Capital market activity has increased
significantly in the EU over the last two decades. Between 1992 and 2013, the
total EU stock market capitalisation has progressed from €1.3 trillion (21.7%
of GDP) to €8.4 trillion (64.5% of GDP) , whilst the total value of outstanding
debt securities has grown from €4.7 trillion (74.4% of GDP) to €22.3 trillion
(171.3% of GDP). Nonetheless, a number of EU capital markets remain underdeveloped,
at least in comparison to the US markets.

Chart 1: Size of the banking sector and capital markets in EU and other jurisdictions (% of GDP) ||

|| Europe has traditionally relied more on bank finance, with total bank sector assets far exceeding those of the US (see Chart 1). Although a number of technical reasons can explain some of the observed differences, (e.g. differences in the mortgage market and accounting practices), a corollary of this overreliance on bank finance is that certain capital markets are relatively less developed. Simple cross-country comparisons need to be interpreted with care, but differences in capital market development between Europe and the US are nonetheless telling.

Source: IMF ||

While Europe's economy is slightly larger
than the US economy, [13]
in the US, markets for:

– public equity are almost double in size (138% of GDP vs. 64.5% in
EU),[14]
and so are private equity markets

– private placement are up to three times bigger ($50 billion vs. €15
billion in EU)[15]

– corporate (non-financial) debt securities are three times as large
(40.7% of GDP vs. 12.9% in EU)[16]

– corporate high-yield securities (in terms of issuance volumes) are
more than 2.5 times as high (€187 billion vs. €68 billion in EU).[17]

However, there is wide variation in capital
market development across EU Member States. For example, domestic stock market
capitalisation exceeded 121% of GDP in the UK, compared to less than 10% in
Latvia, Cyprus and Lithuania[18].
Moreover, while the post-crisis downscaling of gross
capital flows affected all regions, the EU (and the euro area, in particular)
has undergone the most sizeable decline in the magnitude of gross capital
inflows and outflows as a percentage of GDP. All components of gross capital
inflows (portfolio investment, foreign direct investment, and bank
intermediated claims) were lower in 2013 than in 2007[19].

3.1. 
Regulatory and institutional reasons

Capital market development in the US was in
part spurred by the development of a private pension system. The growth of
large corporate pension plans created a large group of institutional investors
who had strong incentives to operate directly in the capital markets in order
to increase the returns on their plans’ assets.

Chart 2: Total assets of pension  funds and insurance companies (in % of GDP)

Source: ECMI

US private pension funds hold more than
double the assets of EU pension funds, eclipsing even the EU insurance industry
which also provides pension products (see Chart 2). There is however
considerable variation across EU Member States, with some (e.g. the UK and the
Netherlands) having highly developed private pension markets. Taken together,
the EU insurance and pension fund industries manage assets worth over 80% of EU
GDP.

3.2. 
Size vs. composition

Notwithstanding the benefits associated
with well-developed and functioning capital markets, size alone is not
necessarily the only important factor – composition matters too. Larger capital
markets do not necessarily deliver positive effects for the real economy - nor
does size guarantee market liquidity when it is most crucial, that is, in times
of stress.

Chart 3: EU debt securities outstanding by issuer (in % of GDP)

Source: ECMI

Chart 3 shows that corporates account only
for some 7.5% of the total EU debt securities outstanding, whilst governments
account for some 42.5% and financial firms account for almost 50%.

In fact, the growth in debt capital markets
over the last two decades is largely driven by financial entities, essentially,
selling and trading debt with each other. Indeed, bonds issued by financial
firms are bought by other financial firms. Not all of this intra-financial
trading may contribute to improved financial services to end-users but instead
may simply reflect a lengthened intermediation chain and greater
interconnectedness, thereby enhancing contagion and systemic risk. Similarly,
only a fraction of the large volume of total derivatives transactions involves
non-financial firms as counterparties.

3.3. 
Fragmented market structure

Despite the considerable progress achieved
with integration so far, EU capital markets still too often tend to be
fragmented along national lines. This fragmentation hinders the development of
deep and liquid markets, impeding the flow of finance within the EU and with
the rest of the world. Even the best designed national markets in the EU could
lack critical size, leading to a smaller investor base and fewer financial
instruments to choose from. This lack of market size and depth inhibits
investors' interest in acquiring financial assets and the realisation of scale
advantages. For example, venture capital investment can be profitable only by
diversifying across many investments, such that one successful firm in the
portfolio more than compensates for the losses of many others. Diversification,
which benefits from pooling uncorrelated risks, is generally not possible in
small national markets, where market players face similar (and hence correlated)
conditions and risks. It follows that measures to deepen EU capital markets
need to go hand in hand with measures to promote further market integration,
giving investors the ability to invest their funds across the EU and enabling
companies to access funds irrespective of their location.

Financial markets in the EU had become more
integrated pre-crisis in terms of cross-border holdings of financial
instruments. As the crisis revealed, however, this integration was driven by
debt-based wholesale banking flows (e.g. cross-border (inter-)bank lending),
which are pro-cyclical, typically prone to sudden reversals and vulnerable to
liquidity and confidence shocks. More integrated equity markets, instead, may
have allowed market participants to better absorb shocks. At this time,
however, equity markets in the EU remain characterised by a marked home bias,
limiting the extent to which potential losses (and hence risk) can be shared
across borders.[20]
Similarly, cross-border holdings of corporate debt remain low.

Although significant progress has been made
in dismantling barriers to post-trading, the European financial market
infrastructure for post-trade services is still characterised by fragmentation
and by large values of bilateral over-the-counter (OTC) transactions.
Post-trade services refer to the activities after a trade has been concluded,
which are clearing and settlement. If the trade has been executed on a stock
exchange, it is typically cleared by a central counterparty (CCP). Thus, market
participants can effectively carry out a cross-border transaction only if they
have access to the same trading platform and the same CCP. Furthermore, when
buyers and sellers settle their obligations following a trade that has been
cleared, assets (cash or securities) are exchanged. Securities are settled in
central securities depositories (CSDs), whilst cash settlement takes place in
central bank accounts for CSDs (except for the international CSDs (ICSDs) where
it is done in the books of the ICSD itself).

As another example,[21] almost every European
country has one (or several) CSD(s), generally serving their local market. This
is in contrast with the US, where securities markets are underpinned by only
two CSDs. In addition, market practices often differ across European countries.
As European securities are not held in any one CSD, but in a range of CSDs in
different countries, investors may need to rely on additional intermediaries to
access European markets. Since it is often neither practical nor possible to open
accounts in each European CSD, investors will go through ICSDs, global
custodians or local custodians that have the necessary expertise about local
market practices. These additional intermediaries can make the instruction
chain longer and thus increase operational risks and costs. Moreover, they
often preclude shareholders from directly exercising their voting rights.

The EU has taken important steps to ensure
that financial market infrastructures (such as CCPs and CSDs) are robust by
imposing additional regulatory requirements in the CSD Regulation and European
Markets Infrastructure Regulation (EMIR), as well as expects the fragmentation
problem to be tackled by means of the CSD Regulation and the Target2Securities
project run by the Eurosystem.

3.4. 
Specific impediments to capital markets

The main impediments to the development and
adequate integration of capital include the following.

3.4.1. 
Endogenous constraints in reaching critical size

Capital markets cannot function effectively
or efficiently if there is a small investor base and a limited flow of savings
to capital markets. Conversely, fund raisers (representing demand) and
investors (representing supply) will not be drawn to capital markets that lack
depth and remain fragmented.

The EU has almost four times as many
exchange-traded funds (ETFs) as the US (see Chart 4) and more listed companies
(see Chart 5) despite the fact that EU market capitalisation is only half of
that in the US. The high number of asset managers could make it difficult for
them to achieve a minimum critical size and to realise economies of scale. In
the EU asset management industry, the top 5 players have only 17% of the
overall assets under management, which helps competition but can also indicate
a fragmented market.

Chart 4: Number of listed exchange-traded funds (ETFs) || Chart 5: Total number of listed companies ||

|| ||

Source: ECMI || Source: ECMI ||

3.4.2. 
Impaired market data availability

Another important problem that could be
holding back further development and indeed the integration of European capital
markets is data availability. The production and consumption of market data is
part of a larger value chain that includes the trading of financial
instruments. Financial markets need reliable and relatively high frequency data
to be efficient and liquid. Where there are no data, there are no markets.
Market data provision services in Europe are fragmented, reinforcing the home
bias in those markets that exist.

Technological advances in the IT sector
have enabled easy processing of vast data volumes. Nevertheless, these data
have to be gathered and systematised first to enable this process. Moreover,
even where data may be available across EU member states, it may not correspond
to the same standards and definitions, making aggregation challenging. In
addition, there is evidence that market data services can cost up to 7 times
more in the EU than in the US.[22]
Seven years after the EU opened up European stock exchanges to competition it
is still not possible to get a full picture of price information across the EU
market despite repeated industry efforts to consolidate the data stream from
Europe’s markets into a ‘consolidated tape’. One obstacle to progress has been
standards, since each European exchange produces data in its own way and
merging them has proved difficult.

The industry has been given two years to
come up with a solution. Otherwise, under the revised Markets in Financial
Instruments Directive (MiFIDII), the regulator can appoint a consolidated tape
provider.

3.4.3. 
Differences in regulation and supervisory
enforcement

Significant progress has been made in
strengthening the regulation and supervision of capital markets across the EU.
Developing a single rulebook and the increasing adoption of directly applicable
EU Regulations in recent years has been an important element in the creation of
a more harmonised framework for capital markets. However, the success of the
reforms still depends on the detailed implementation and enforcement of the
rules.

Although regulatory frameworks have largely
been harmonised, we still lack convergence in the application of these
frameworks. Also, national measures in areas which are not harmonised at EU
level may create barriers to capital movement which prevents EU financial
reform from realising its full potential. Such barriers may take the form of
divergent/additional requirements imposed by host authorities on financial
market operators using their passport. For instance, supervisory fees or other
additional requirements imposed by host authorities on European funds may
discourage these funds from operating beyond their home Member State.

The reform programme is not yet complete.
For example, while the regulatory framework that applies to the infrastructures
that support trading and post-trading in financial markets is now more
harmonised, no common frameworks exist for their recovery and resolution. This
is of particular concern for central counterparties that carry systemic risk
and presents barriers to market integration if these infrastructures are
"cross-border in life, but national in death". Work on resolution for
non-banks is under preparation.

While there has been considerable progress
in harmonising rules needed for the transparency and integrity of securities
markets, legislation relating to investors' rights in securities is not yet
harmonised. Different Member States define securities in different ways. Some
stakeholders argue that this hampers the integration of EU capital markets
because investors in one Member State cannot correctly assess the investment
risk in another Member State.

Discussions on a 'pan-European securities
law' date back more than a decade. This is a politically sensitive and complex
subject as it touches on property, contract, corporate and insolvency law, as
well as the laws on holding of securities and conflict-of-laws. Furthermore, it
is argued that the launch of Target2Securities (T2S) initiative in mid-2015
will remove the legal and operational risks associated with the transfer and
holding of securities across jurisdictions, reduce costs and significantly
increase cross-border investment.

3.4.4. 
Diverse and fragmented legal frameworks for
specific financial instruments

The legal framework for certain financial
instruments remains fragmented across the EU and in some cases absent. In
particular, there is limited standardisation, for example, as regards
information requirements and investor protection.

Some markets may not be able to start
without a common set of market rules, transparency on product features and
consistent supervision and enforcement. For example, it is widely believed that
the market for securitised financial instruments has been subdued by the crisis
experience to a suboptimal size. In 2014 (2013), securitisation issuance in
Europe amounted to some €216 billion (€180 billion), of which more than half
was retained rather than placed, compared to €594 billion in 2007.[23] A
certain degree of standardisation as well as transparency and simplicity may
allow for the development of a deep secondary market, striking the right
balance between the benefits and the risks of securitisation. Work has already
started to ensure a comprehensive and consistent approach for highly
transparent, simple and sound quality securitisation (i.e. Solvency II and
Liquidity Coverage Ratio delegated acts). These initiatives on securitisation
represent a good starting point, but are considered insufficient. A large
amount of stakeholders including central banks, regulators, national authorities
and private sector representatives have expressed the need to bring forward a
more comprehensive approach to (re)launch these markets. For investors, this
needs to increase safety, legal certainty and comparability across
securitisation instruments.

Similar reasoning could also apply to
covered bonds, which have become an increasingly important funding instrument
for European credit institutions.[24]
Although covered bond markets have remained relatively resilient in recent
years, the crisis revealed fragmentation in European secondary markets, as
pricing of covered bonds varied significantly depending on the Member State of
issuance. Access to new issuance became difficult in particular for smaller
issuers. In the EU, 26 Member States have passed covered bond legislation, but
harmonisation has been limited to the prudential aspects of these instruments.
The presence of well-developed national frameworks did not stop European
markets from fragmenting along jurisdictional lines during the crisis. A lack of
clarity for investors over the legal requirements in different Member States or
actual differences between national covered bond regimes may have actually
contributed to this trend.

Similarly, as regards markets for private
placements, many European companies currently tap the US markets because of an
insufficient European investor base.
While the current regulatory framework allows private placements and some
Member States have already developed these markets, an
EU framework for private placement does not exist to date[25]. The
Commission has commenced a mapping exercise of national private placement
regimes and notes that barriers to the development on a pan-European basis
include lack of standardised processes and documentation, lack of information
on the credit worthiness of issuers[26]
and lack of liquidity in the secondary market.[27]
To attempt to overcome the problem of lack of standardisation of documents and
processes, the Pan-European Private Placement Working Group coordinated by the
International Capital Markets Association (ICMA)  has published a guide to best
practice to facilitate the emergence of common market practices, principles and
standardised documentation. The constituents of this group have also recently
launched template documents for use in European private placement transactions.

Another problem area that deserves further
analysis is that of financial collateral, which is a vital part of the
financial system as it provides a safety net in certain transactions in case of
unexpected problems. Since the financial crisis, the demand for collateral has
increased, driven by market demand for more secured funding as well as new
regulatory requirements. The flow of collateral throughout the EU is
restricted, preventing markets from operating efficiently. While the Financial
Collateral Directive created a harmonised regime for the taking and enforcing
of financial collateral and also introduces important protection of close-out
netting in collateral arrangements, it has been argued that - due to the narrow
scope as well as divergent implementations in the Member States - significant
disparities remain, leading to legal uncertainty (e.g. as regards close-out
netting rules and the reporting of collateral under different legislations).

At the basis of many financial operations
such as securitisation, financial collateral arrangements or factoring lies a
basic legal operation: assignment - essentially a transfer of claim between two
parties. However, differences between the national conflict-of-law rules in
respect of the third party effects of assignment and the order of priority
between an assignment over the rights of other persons, as well as between
certain substantive rules such as the conditions for the effectiveness of an
assignment hamper the development of cross-border financing instruments. These
differences have been estimated to create additional legal costs of between
£350,000 and £1 million per transaction. Furthermore, 47% of stakeholders
encounter problems in securing the effectiveness of an assignment against third
parties.[28]

A final example is the market for
crowdfunding, where some Member States have already introduced ad-hoc
legislation but where one is far from a common market where investors can fund
projects across borders and entrepreneurs can tap capital across borders. At
the same time, standardisation or a common regulatory response may interfere
with the natural development of a nascent market and the discovery of best
business models, given the idiosyncratic and diverse circumstances of potential
users at both sides of the platform.

3.4.5. 
Insufficiently harmonised or inadequate company
law and corporate governance rules

Company
law and corporate governance is mainly regulated at national level, and EU
legislation focuses on harmonising certain key requirements to ensure a level
playing field for the protection of shareholders and creditors of European
companies[29].
National traditions in the area of company law and models of corporate
governance vary greatly between Member States. While this diversity of
approaches allows to best respond to the specific needs of different national
markets, it can also make cross-border operations of companies and cross-border
investment more difficult and more costly.

From
the perspective of the founders of companies, differences in company law rules
make it more difficult to establish companies in many Member States. Once
established, companies still often face barriers to their mobility from one
Member State to another or to cross-border restructurings[30]. As a consequence, the
SME participation in the Internal Market is low. For instance, only around 2%
of SMEs establish companies abroad (in the form of a subsidiary, branch or
joint-venture)[31].
Similarly, companies seem to establish a limited number of branches in another
EU country[32].
Further harmonisation might therefore be useful as regards rules on
cross-border establishment and operation of companies as well as rules on
cross-border company mobility, including transfer of seat[33].

From
the perspective of cross-border and foreign investors, two sets of rules are
particularly relevant. Efficient minority protection improves corporate
governance and the attractiveness of companies for foreign investors, as these
are typically minority investors. There are only limited rules at EU level on
minority shareholder protection. The ongoing revision of the Shareholder Rights
Directive aims at introducing more safeguards for the interests of minority
shareholders in the context of transactions with related parties. Other ways of
protecting minority rights may also have merits. For example, previous
consultations have shown support for a right of minority shareholders to
appoint or nominate certain company directors. Furthermore, the efficiency of
company boards in controlling company managers is subject to debate, especially
since the financial crisis. Criticism points in particular to inactivity and
insufficient expertise of certain board, and also to lack of real independence
of mind. As they protect the interests of the investors, efficient and well-
functioning company boards are also key to attract investment.

In
general, European and national company law and corporate governance rules do
not sufficiently integrate the benefits of modern technologies. Exchanges of
information between companies, shareholders and public authorities are to a
large extent paper-based. For example, in many companies shareholders still
cannot vote electronically and, especially in case of cross-border voting, are
faced with complex rules and lengthy procedures for the establishment of voting
entitlements, resulting in substantial costs. Similarly, on-line registration
of companies is not yet available in all Member States, only handwritten
signatures are accepted by the registers, and often paper versions of documents
still must be stored by companies. While the new regulation on electronic
identification[34]
should now make it easier to overcome technical barriers, company law
provisions may need revisiting in order to better align to the opportunities
offered by the use of e-identification[35].
Concerning cross-border access to company data, several steps have been taken
already, such as the requirement to provide access at EU level to information
on limited liability companies (Business Registers Interconnection System
(BRIS) project) or to information on issuers on regulated markets (revised
Transparency Directive). However, the scope of these initiatives remains
limited, as BRIS will cover only approximately 45% of legal entities in the
Member States[36].

Use
of modern technologies in the area of company law and corporate governance
could help reduce costs and burden, but also ensure more efficient
communication, in particular in a cross-border context.[37]

3.4.6. 
Non-harmonised conflict-of-law rules in the area
of company law

At present,
conflict-of-law rules in the area of company law are regulated by Member States
and the content of these rules differs substantially. In particular, the
connecting factor determining the applicable law varies significantly among
Member States. Some Member States follow the real seat theory, i.e. the law
governing a company is determined by the place where the central administration
of that company is located. Other Member States follow the incorporation
theory, i.e. the law governing a company is determined by the place of its
incorporation (where the registered office is located).

The divergence
of national private international law regarding companies causes legal
uncertainty for economic actors operating within the internal market. Today,
nearly half of companies in the EU, in particular SMEs, regularly use the
internal market freedoms. Legal certainty as to which is the law governing
their operations is of the essence for them. The divergence of conflict rules
leads to a situation where a company may be subject to the laws of various
Member States at the same time. This means that on important matters regarding
the internal functioning of the company, such as its incorporation,
shareholding, management, diverging or even conflicting laws may be applicable.

A harmonisation
of conflict rules would ensure that companies operating in the internal market
and beyond know which legal regime is applicable to their creation,
functioning, and dissolution, avoiding that conflicting regimes apply to them
when they operate abroad.

3.4.7. 
Insolvency laws and enforcement of contracts

As can be seen in Charts 6 and 7 below,
insolvency frameworks and the effectiveness and enforcement of contract law
continue to differ significantly across EU Member States, despite ongoing
efforts to improve the efficiency of European insolvency and restructuring
procedures.

Chart 6: The number of years required to enforce a contract or resolve an insolvency || Chart 7: The recovery rate in enforcing a contract  or resolving an insolvency

Source: World Bank Doing Business 2014 || Source: World Bank Doing Business 2014

The considerable
differences in the insolvency laws of Member States create additional costs for
foreign investors to assess the risk properly and thus hamper the emergence of
pan-European credit markets. In particular, the lack or inadequacy of rules
enabling early debt restructuring in many Member States, the absence of
provisions to give a second chance for entrepreneurs and the length and costs
of formal insolvency proceedings in many Member States lead to low recovery
rates for creditors and discourage investors who either hold back from
investing or do so only at a higher premium.[38]

The Commission Recommendation of 12 March
2014 on a new approach to business failure and insolvency[39] set out certain
minimum standards with the aim of modernising the insolvency laws. The
Recommendation requests Member States put in place debt restructuring
proceedings which would enable viable debtors in financial difficulty to
restructure and thus prevent their insolvency. If correctly implemented, these
measures would ensure that every Member State has in place reasonably fast,
cost-effective and transparent debt restructuring procedures which yield higher
returns to creditors than liquidation procedures.

The Recommendation also requests Member
States to ensure that honest bankrupt entrepreneurs can have a second start
after a maximum of three years from a first failure. This will ensure that
young entrepreneurs are not discouraged from innovating by the risk of failure,
and that they can return to the productive economy with the experience they
have gained from a first failure. Evidence shows that second starters are 40%
more successful than first starters.[40]

The implementation of the Commission
Recommendation is only a first step. While the Recommendation addressed the two
ends of the insolvency cycle in an attempt to change the culture of stigma
associated with failure in many Member States, it does not touch upon the main
bulk of the insolvency law, namely formal insolvency proceedings which end in
the liquidation of the debtor and the distribution of the proceeds to
creditors. Yet for most debtors formal insolvency proceedings are the only and
best solution, and investors need to have confidence that, in the event of an
insolvency, they will recover their claims or at least a high percentage of
those claims. However, the differences between the Member States' laws and practices
in the field of insolvency – which have developed so far outside any Union
involvement - are significant. Minimum standards in this area would ensure that
investors have greater clarity and predictability when it comes to the
substantive insolvency rules affecting their claims. As a measure of the
effectiveness of insolvency laws, proceedings should also be relatively short
(e.g. maximum 2 years), cost-effective and transparent, and thereby capable of
yielding higher returns to creditors.

As long as insolvency law remains national
in character, it will be difficult for investors to assess the risks they
assume when investing in securities issued in other jurisdictions. This is
harmful as regards cross-border investments in secured securities, but also detrimental
when it comes to unsecured debt (e.g. high yield bonds), which carries as a
result a much higher risk in case of default. A more
harmonised and efficient insolvency law would increase the recovery rates for
creditors (bad debt loss in the EU was estimated at €350 billion in 2013) and
thus encourage investment.[41]

An evaluation of the implementation by the
Member States of the Commission Recommendation of 2014 on a new approach to
business failure and insolvency is planned for 2015.

3.4.8. 
Tax barriers

The
power to raise taxes and set rates lies predominantly with national
governments. However, differences in tax regimes across Member States can have
a significant impact on capital market activity and the location of market
participants. These differences in taxation can lead to location decisions
biased by tax considerations instead of economic ones, leading to
misallocations of capital. Given the free mobility of capital within the EU,
taxes can be effective instruments in promoting deeper and more liquid capital
markets, leading to positive spillovers and related economic benefits.
Conversely, taxes can be used to discourage excess risk taking, unproductive
capital market activity, or market distorting conduct.

A prominent example is the tax bias in favour
of debt in corporate taxation, due to the deductibility of interest payments on
debt without a similar treatment for equity-financing.[42] Similarly,
the deductibility of mortgage interest payments coupled with a relatively light
recurrent taxation of housing creates a bias against equity and an
overinvestment in real estate, as opposed to channelling funds into potentially
more productive investments. This systematic tax bias in favour of debt
discourages the development of loss and shock-absorbing equity markets across
the EU.

Tax systems can enhance access to finance
and be designed in such a way as to better support productive investment
benefitting the real economy. Another area where tax incentives matter and
diverge across the EU is the national tax reliefs granted to specific
investments such as research and development (R&D). It is important to
ensure that R&D tax incentives are regularly evaluated and that young
innovative companies are able to benefit from them.[43]

One practical difficulty in investing
across borders within the EU is that of obtaining refunds of high source
country withholding taxes, even where this tax relief is due under double
taxation treaties. A Commission Recommendation of 2009[44] outlined how EU Member States could make it easier for investors
resident in one Member State to claim entitlements to relief from withholding
tax on securities income (mainly dividends and interest) received from another
Member State. The Recommendation also suggested measures to enable financial
institutions to make the claim for withholding tax relief on behalf of
investors. In 2009, the costs related to the reclaim procedures were estimated
to be approximately €1 billion annually, while the amount of foregone tax
relief is estimated at approximately €5.50 billion annually.

Following the Recommendation[45]
a Commission expert group (the Tax Barriers Business Advisory Group) presented
its report entitled “Workable solutions for efficient and simplified fiscal
compliance procedures related to post-trading” in 2013. One problem identified
was the lack of standardised documentation. More than 56 different paper
documents can be necessary today to claim tax relief in the EU. This results in
complicated, costly and time consuming procedures not just for investors and
intermediaries but also for tax authorities. The Group proposed the
standardisation of the present documentation into one single electronic
document and comprehensive solutions based on a system of relief at source
(i.e. at the time of payment of the securities income) and the use of Taxpayer
Identification Numbers (TINs).

4. 
Barriers to demand and access to capital markets
financing

Access to finance is a
crucial pre-requisite for economic growth. Funding
choices of the non-financial corporations (NFCs) have an impact on the
variation of financial instruments available in an economy, since the corporate
sector is the only one that combines a persistent net-debtor position with room
to choose among different financial liabilities, i.e. funding via debt or
equity in public or private financial instruments from other institutional
sectors.[46]

To
put things into perspective, it is useful to have a brief look at the way
European NFCs raise financing. Chart 8 below shows that equity financing
accounts for roughly 55% of the total, of which 1/3 (i.e. 18% of the total) is
in public equity.

Chart 8: Sources of financing for NFCs,
EU28, financial liabilities (2013, Q4)

€ billion || Percentage of total liabilities || Percentage of GDP

Note: Loans include bank
loans and other loans, the latter being mainly intercompany loans. Other
financing mainly includes trade credit and advances.

Source: ECB, Eurostat and own calculations

Loans
represent some 29% percent of the total NFC financing, about half of which is
actually intercompany loans and similar. In other words, bank loans represent
roughly 15% of the total financing. Bonds account for over 4% of total
liabilities, whilst the remaining 12% are represented by other financing
(consisting mainly of trade credit and advances).

Compared
to the US corporates, EU companies rely much more on intercompany loans than US
companies (15% vs. 2%, respectively). The EU companies’ share of bank loan and
bond financing differs from that in the US by roughly 5 percentage points (15%
vs. 10% for bank loans and 4% vs. 9% for bonds, respectively)

Industry structure may provide some
explanation to the observed differences between the EU and the US: e.g. there
is a higher share of large firms in the US, which tend to rely on public
markets more than smaller companies. Such structural differences deserve
further analysis as they may explain some of the differences between EU and US
NFC financing structures.

Chart 9: Use of marketable financial instruments by NFCs in the EU (in % of total liabilities, 2012)

Source: Eurostat

The cross-country variation in the use of
market instruments among EU Member States also points to structural
determinants. Member States in which NFCs rely more strongly on quoted shares
than on other forms of equity tend to be the same in which NFCs use fewer bank
loans and more debt securities (see Chart 9). The UK, in particular, stands out
in its use of marketable instruments (bonds and quoted shares), consistent with
its larger capital markets. More generally, market instruments tend to be used
more intensively in larger countries or where per capita GDP is higher.

Over the last years, NFCs financial flows
have shifted on the debt side towards market instruments and on the equity side
towards non-market instruments. With bank loans declining since the onset of
the crisis, there has been a notable increase in the issuance of corporate
bonds by NFCs, in particular in the high-yield segment. In fact, on aggregate,
this increase in net issuance has been sufficient to offset the decline in the
net flow of bank loans at aggregate level (see Chart 10).

However, this development masks significant
differences across countries. Focusing on the euro area, the positive net
issuance of corporate bonds is concentrated in the non-distressed countries,
where there has been no decrease in the net flow of bank loans. In contrast,
there has been a strong decrease in the net flow of bank loans in distressed
countries, where the net issuance of corporate bonds is only moderately
positive. Put differently, capital market access differs across the EU, also
reflecting market fragmentation.

Chart 10: Non-financial corporates issuance of debt securities, bank
loans and quoted shares in the euro area

Source: ECB

Access to capital markets also differs
across firms. Capital markets work best for large firms, which have sufficient
size to warrant the fixed costs of using capital market instruments (e.g.
commissioning an external rating, disclosing information required by investors
and regulators) and which are big enough so that each individual issuance is
sufficiently large to attract the attention of underwriters, investors and
analysts.

While there is no conclusive evidence of a
general funding gap in the EU economy (also because of currently low levels of
demand), there are important frictions in the flow of finance, in particular to
SMEs[47]
and in distressed countries.[48]
These problems have increased significantly since the crisis, given the high
dependence on bank finance and banks' pressures to deleverage. Where such
financing constraints apply, this can impede productive investment from being
undertaken, with consequences for growth and jobs.

Focusing on SME financing, there are a
number of underlying problems that limit their access to finance in general and
to capital market finance in particular:

4.1. 
Overdependence on bank finance

SMEs' balance sheets and performance are
typically more opaque from an investor's perspective, also as a result of less
informative financial statements.[49]
This in turn translates into greater informational asymmetries and higher
transaction costs for potential investors. These disadvantages can be partly
overcome within longer bank lending relationships, where banks accumulate a
rich history of information on their borrower that allows them to more
efficiently assess their creditworthiness. Among other factors, this explains
the dependence of SMEs on bank financing.

In the crisis, bank lending decisions
inevitably became more selective, on the grounds of both banks' own balance
sheet constraints and the rising default probabilities of their borrowers. As
SMEs are typically perceived to have a higher probability of default than
larger firms and are more opaque, they are more likely than larger firms to be
penalised by tightening credit standards [50]
in times of heightened bank risk aversion. As shown in Chart 11, European banks
have increasingly differentiated the lending rates between small and large
loans, in particular in the distressed countries of the euro area.

Chart 11: Spreads between bank lending
rates on small and large loans

Source: ECB

Larger companies can tap capital markets
and issue debt to substitute for the decline in bank loans. Indeed, as shown in
Chart 10 above, debt security issuance by EU corporates increased during the
crisis, partly also reflecting a market environment that has been favourable
for bond issuers (i.e. low interest rates). However, debt issuance is not an
option for most SMEs. For SMEs, trade credit, leasing and factoring are closer
substitutes for bank loans. As these latter alternative financing sources are,
however, closely related to SMEs' business activity, the potential for
substitution is constrained if there is a decline in turnover levels, as was
the case specifically for SMEs located in distressed countries.

4.2. 
Lack of (credit) information for potential
investors

Credit information is essential to access
finance. But the information on SMEs is usually held by banks, so the SMEs
struggle to disseminate credit information to non-bank investors. As noted
above, this structural hurdle is one reason why SMEs are so dependent on bank
financing. The analysis conducted to date suggests that the information problem
is severe. Around 25% of all companies and around 75% of owner-managed
companies do not have a credit score.[51]
There are differences in national laws that hinder the collection of
information. Moreover, there is a lack of positive data sharing (e.g. on
payment records) in many Member States.

More generally, there is inadequate
business information on SMEs that have a listing or seek a listing. One of the
reasons is that equity research analysts and business information providers are
far less likely to cover SMEs with their research than large enterprises. The
lack of investment research and analysis on SMEs partly explains the limited
interest of investors. It is expensive to provide good quality independent
research, which is necessary to provide added value over the provision of raw
data.

As regards SME credit information, a
mapping of the actual landscape of data used for the credit assessment of SMEs
in each Member State is ongoing. A survey of EU Member States recently
identified the following general principles for future policy in this area: (i)
to make use of current initiatives taking place EU-wide, such as the Business
Registers Interconnection System; (ii) to identify the minimum set of variables
needed to assess creditworthiness of SMEs; (iii) to encourage Member States to
facilitate access to data via the reciprocity model which is already business
practice in some countries; (iv) to facilitate access to positive and negative
information; and (v) to address potentially complex data protection issues. The
mapping exercise also examines, which underlying data about SMEs is needed for
developing credit scores.

As regards the provision of financial
information to investors more generally, the financial statements prepared by
companies vary greatly from one Member State to another, except for listed
companies on regulated markets in which case consolidated financial statements
are prepared under International Financial Reporting Standards (IFRS). There
may also be variations within a Member State, depending on the company type,
situation or size. This fragmentation is de facto imported on
Multilateral Trading Facilities (MTFs). In order to avoid this, some MTFs
require companies to prepare their financial statements in accordance with
IFRS. However, IFRS are widely seen as a source of significant additional cost
for some issuers, in particular smaller companies, and thus preparation of IFRS
accounts could present a significant hurdle for SMEs seeking capital.

Furthermore, while issuers of financial
instruments are required to disclose information to investors at the moment of
issuance in the prospectus, there is no such obligation in force[52] for disclosing information
on a permanent basis. Consequently, investors lack the data to monitor their
investments in financial instruments over time, limiting investor appetite in
particular when investing in a cross-border context.

ESMA recommends that an SME growth market,
as provided for under MiFID, should not be required to have rules prescribing
the use of IFRS. However, no alternative standard is available yet, except for
national standards derived from the Accounting Directive. The International
Accounting Standards Board (IASB) has developed a set of simplified standards,
the so-called IFRS for SMEs, but the IASB has made the availability of this
standard subject to the condition that it is not used by listed companies
(either on a Regulated Market or an MTF) or financial institutions. There is
therefore the question of whether there is a need to develop a common, high
quality and simplified accounting standard for smaller companies, tailored in
particular to the needs of companies listed on MTFs. Such a standard could
deliver greater transparency and comparability for investors, while at the same
time minimising unnecessary administrative burdens for issuers.

4.3. 
Underdeveloped market for risk capital

While capital markets can complement the
role of bank lending for SMEs, their diversity and scant credit information as
well as the fixed-cost nature of sourcing and monitoring rather small and
mostly local firms imply an important role for banks. Thus,
relationship-lending through banks will continue to be important in SME
financing, and for many SMEs that are comfortable in their local niche, however
small, it would be neither feasible nor necessary to tap capital markets.

However, capital market funding sources
have an important role, in particular for smaller but rapidly growing firms.
These firms typically display low levels of cash flows and are dependent on
external finance to grow their business. Bank finance as well as other
financing tools, such as leasing and factoring, are often inaccessible or
insufficient for companies with significant intangible assets that can less
easily be used as collateral to obtain bank loans.

The economic literature identifies the
so-called ‘financial growth circle’ that most companies go through. At the
beginning of an entrepreneurial activity, when the product or service
distinguishing the company is still in a development phase, insider investments
are the most common source of finance. In this phase, information asymmetries
towards external investors are particularly acute and create important
obstacles to attract outside finance. Business angels typically play a role in
a more advanced phase of the development of a firm based on formal business
plans, which are not available at the earliest stages. After the necessary
resources for structured product development have been gathered in this way,
venture capital funds are likely to step in, targeting successfully
test-marketed businesses.

Markets for such risk capital remain
relatively underdeveloped in most EU Member States. As noted above, many
national markets lack scale, and the current fragmentation holds back the
development of sufficiently large pools of potential risk capital.

Focusing on venture capital as an example,
the financing role of venture capital for SMEs is still very small in most EU
Member States. The lack of an equity investment culture, informational problems
and high costs are among the main reasons. Market fragmentation along national
lines seriously limits the overall supply of this financing for SMEs, as venture
capital funds in some Member States face problems reaching the critical mass
they need to spread their portfolio risk.

In 2013, the Regulations on European
Venture Capital (EuVECA) and European, Social Entrepreneur funds (EuSEF) were
adopted with the view to bring together investors and SMEs and other mid-range,
small or 'start-up' companies. The Regulations create a capital raising
passport, along with the EuVECA and EuSEF labels for the relevant funds. The
passport and the right to market funds under these labels currently apply to
smaller fund operators - defined as those managing a portfolio of assets
inferior to €500 million. The Regulations were limited to smaller operators
because this group do not usually have access to the fund raising passport provided
for in the Alternative Investment Fund Managers Directive (AIFMD). Since entry
into force of the EuVECA Regulation, national authorities have registered 17
EuVECA funds that aim to raise approximately €1.3 billion in capital. There are
two EuSEFs with a target size of €6 million[53].

The Commission's Impact Assessment
estimates that, over time, roughly €4 billion in additional venture capital
funding could result from EuVECA. One of many other reasons preventing wider
take-up of both EuVECA and EuSEF is that managers whose portfolio (at the
moment they wish to set up a EuVECA or EuSEF fund) exceeds €500 million cannot
apply to set up and operate a fund using the EuVECA or EuSEF labels, nor can
they use the EuVECA/EuSEF designations to market these funds in the Union.
Widening the range of market participants could significantly increase the
number of EuVECA and EuSEF funds available.

With the development of new technologies,
crowdfunding (including crowdlending and equity crowdfunding)[54] is becoming another
source of risk capital for smaller companies and projects, as already noted
above. The online nature of crowdfunding would suggest a good cross-border
potential for this industry. The crowdfunding market has been growing
substantially over the last few years, from an annual growth of 64% in 2011 to
81% in 2012 globally. In 2013 some 600 crowd funding platforms are forecasted
to raise € 3.8 billion in total globally, a projection in growth of 88%. Only
for the European market, €735 million was available representing a growth of
65%.[55]

However, the development of the markets has
been quite different across the EU. Some Member States have taken legislative
measures to enhance the potential of crowdfunding while protecting investors.[56] These national
approaches might encourage crowdfunding activity locally, but may not be
necessarily compatible with each other in a cross-border context. As a result
of the legal landscape, cultural and linguistic differences, and also some
local bias, there is very little cross-border or pan-European activity in
investment-based crowdfunding, including peer-to-peer lending.

4.4. 
Regulatory and other barriers to SME listing

Access to public capital markets is costly.
Initial public offerings (IPOs) and debt underwriting are characterised by
substantial fixed costs generated by due diligence and regulatory requirements,
which may present a disproportionate burden for smaller firms. This includes
the costs of disclosing information required by investors or regulators and
meeting other corporate governance requirements. In the case of debt
underwriting, there are the costs of commissioning an external rating. In
addition, companies may be at an early stage of development and may have a
commercial interest in not disclosing detailed information about their business
plan. They may be reluctant to give up control or face greater external
scrutiny. These features often preclude SMEs from obtaining access to more
standardised public equity and debt markets and gives access mainly to private
debt and equity markets that are generally less standardised, more complex, and
often more selective and expensive.

The prospectus is usually the gateway to
capital markets for entities wishing to offer transferable securities to the
public or to have them admitted to trading on a regulated market. Through the
single passport mechanism, it facilitates the widest possible access to
investment capital on an EU-wide basis. In practice, the process of drawing up
a prospectus and getting it approved by the national competent authority can be
expensive, complex and time-consuming, especially for smaller companies.
Proportionate disclosure regimes were introduced following the last revision of
the Prospectus Directive for companies with lower market capitalisation and SMEs,
but they have not delivered their intended effect and are not used in practice
by issuers in most Member States. Besides, over time, prospectuses have become
long documents (sometimes in excess of 1000 pages). A review clause in
Directive 2010/73/EU amending the Prospectus Directive requests the Commission
to report by 1 January 2016 on the application and the effects of the
Prospectus Directive, as subsequently amended.

5. 
Barriers to household investment in capital
markets

The size of capital markets depends on the
volume of funds being channelled. Ultimately, this depends on the willingness
of ultimate savers to turn to other forms of financial asset holdings than bank
liabilities. Households are the principal net savers in
the economy, whilst both the public sector and non-financial corporations
(NFCs) are the ultimate debtors.

Most
households either deposit their savings at a bank or invest them in real
estate, or they may save via a pension or insurance contract. As a result,
there is limited direct household investment in capital market instruments.
Taking euro area as an example, 96% of households have deposits with a bank,
but only 5% have direct investments in bonds and 10% in shares.[57] Mutual fund ownership
applies to 11% of households, whilst 33% are invested in a pension plan or life
insurance. The data shows that participation in capital market instruments
increases with net wealth and education levels.

Looking at asset allocation, the largest
share of EU households’ financial assets (35% in 2012) is invested through
insurance and pension funds. Currency and deposits with banks represent the
second biggest allocation item (33%), whilst direct holdings of bonds and
quoted shares make up for a much lower share (slightly under 10%). Financial assets
invested in mutual funds account for yet a smaller share (7%). Holdings of
quoted shares by households reached their peak in 2000 in a number of
countries, but then fell when the dotcom bubble burst.[58] See Appendix for more
details on asset allocation by households in various countries.

While the price mechanism and the principle
of maximisation suggest that households are price sensitive, social norms and
convictions seem to have also a strong impact on actual savings behaviour. One
could expect that receding low deposit rates, risk aversion, rising prices
(e.g. in equity markets) and rebounding growth would create incentives for
households to shift part of their financial wealth from banks into market
securities. However, evidence suggests that households are fairly reluctant to
redirect financial assets from banks to market instruments, especially in the
short term. The sizeable part of their financial wealth stored in insurance
firms and pension funds may therefore be a more promising venue to stimulate
market financing if these intermediaries had advantages from reducing the share
of the portfolio they administer that is invested in banks (via deposits, bank
debt securities or bank shares)[59]
to financial instruments issued by the non-bank sector. This will, inter alia,
depend on the non-financial sector's interest in redirecting liabilities from
bank loans to other financial instruments such as debt securities and shares.

A number of different reasons explain the
investment patterns of EU households:

5.1. 
Lack of trust in financial markets and
intermediaries

The
limited investment in capital market instruments may reflect the lack of trust
of retail investors in financial markets and intermediaries. The lack of an
"equity culture" and risk aversion on the part of households mean
that these traditions are slow to change, and have been further entrenched by
the crisis experience. More than 60% of EU citizens surveyed in 2013 stated
that they had lost confidence in the financial sector as a result of the
financial crisis. Recent scandals of non-competitive and abusive market
practices further contributed to this. In 2013, only 35% of retail investors
trusted investment services providers to respect consumer protection rules. The
low levels of confidence hinder the flow of savings into capital market
instruments.

One
could be tempted to conclude that households prefer bank deposits to capital
market investment because deposits are insured up to €100,000. Although this
could be relevant to some extent, it is important to note that deposits are
also insured in the US (and to a higher level), yet US households allocate a
much lower proportion of assets to bank deposits, preferring quoted shares
instead.

Another
reason could be that EU capital markets are far less integrated when it comes
to investor protection rules (see section 3 above). Better investor protection
promotes the development of capital markets, ultimately improving resource allocation
and so increasing economic growth. At a more micro level, public intervention
in financial markets to protect investors is justified by a number of factors:

i. 
Information asymmetries between originators,
distributors and investors reduce the competitive functioning of the market and
shift the relative market power to financial intermediaries. There are
conflicts of interest, and investors are exposed to a range of risks, e.g.
fraud and other misuses of funds.

ii. 
Behavioural biases present among investors
affect their ability to process information provided by the more informed party
(e.g. distributors).

iii. 
Investors’ financial capability, and the advice
they might receive, shape key investment decisions for the financial security
of investors.

There may also be a problem of investor
choice and the visibility of available products. For example, the EU now has a
vibrant cross-border market in Undertakings for Collective Investments in
Transferable Securities (UCITS). These are standardised mutual fund products that
can reach investors across the EU. UCITS funds started to appear in the
market in 1988 and by 1992 had accumulated around €800 million in assets under
management. By 2013, UCITS had grown to more than €6.86 trillion of funds under
management.[60]
By 2012, cross-border sales within the internal market accounted for 45% of
European assets under management, compared to only 21% at the end of 2001.[61]
The rate of retail participation in UCITS remains relatively low. Private
households account for about 26% of investment fund ownership in the euro area
in 2013[62].

5.2. 
Lack of adequate financial expertise

Investment
in capital markets requires specialist knowledge that most households do not
possess, which is why many retail investors prefer to invest indirectly via pooled
vehicles (investment funds, pension funds, life insurance contracts) that are
managed by institutional investors. The preference of retail investors to
invest indirectly could also be facilitated by the fact that the Key
Information Document is consumer friendly, which is not the case for
information on direct investment in shares or bonds. This preference could be
further reinforced by the Packaged Retail and Insurance-Based Investment
Products (PRIIPs) Regulation, which requires that all packaged retail
investment products provide a Key Information Document. Another explanation of
this preference by retail investors could be the fact that financial advisers
are no longer marketing direct investment products (e.g. company shares and
bonds) to retail investors.

A
number of factors make it difficult for investors to understand the full set of
risks involved in investment products, including the nature of the investment
process. According to surveys, some 40% of individuals in Europe actually do
not understand that their capital is at risk when investing. Poor numerical
skills also reduce the ability of investors to understand even simple pricing
and payoff structures. Moreover, clients do not frequently purchase financial
services, and it is precisely the rarity of such purchases that impedes the
build-up of useful experience.

Due
to their superior information, originators (i.e. manufacturers or issuers of
financial instruments and products) and distributors may have an incentive to
exploit any existing asymmetries of information. For example, intermediaries
may ‘churn’ clients’ accounts with transactions that are not necessarily in
their best interest.

5.3. 
Household preference for investment in real
estate

Real
assets constitute 85% of the gross total assets of households in the euro area,
the majority of which is represented by the value of the households' main
residence. Only 15% of total assets are represented by financial assets, split
between bank deposits and capital market instruments as described above. There
is however significant variation across the EU as home ownership levels differ
markedly between Member States.

Chart 12: EU household saving behaviour (four quarter moving average, in % of gross disposable income)

Source: Eurostat

As can be seen from Chart 12 on the left,
EU households have been dedicating more than 9% of their gross disposable
income to real estate investment (i.e. the gross investment rate) throughout
most of the 2000s, which has diminished to slightly below 8% in light of the
crisis. At the same time, their savings rate declined from 12% to 10.5% in
mid-2008, equalising with the investment rate. This means that in mid-2008,
households dedicated as much funds to real estate investment as to all the
financial assets combined, including bank deposits. Although the savings rate
jumped when the crisis hit, it is now back to its 2008 levels.

The
preference for real estate can be explained by a number of different factors
and varies across countries. Tax incentives (deductibility of interest
payments, coupled with low recurrent taxation of housing) may have a key role
to play in many countries. General lack of financial education and expertise
could also serve as an explanation, because understanding real estate
transactions may appear relatively easier, also because real estate investment
is tangible. The lack of suitable retail financial investment products may have
been another factor. As a specific example, UCITS funds can be marketed
cross-border to retail investors but these funds are not adequate to longer
-term investment given their liquidity constraints. In this context, the
European long-term investment funds (ELTIF) Regulation is expected to fill the
gap in the offer of long-term products as a good alternative or complementary
solution for EU citizens.

5.4. 
Language and other technical barriers resulting
in strong home bias

Household
financial investment is characterised by home bias. The linguistic barriers are
self-explanatory. Cross-border investment also suffers from fragmented legal
frameworks in many areas, as laid out in Section 3.4.4. This includes the
insolvency rules, judicial systems, corporate governance and takeover codes,
consumer and investor protection and employment rules. Every national financial
system is unique, and the 28 EU Member States all have their own peculiarities.
How people save, how they fund their investments, which institutions they trust
and which markets are most liquid are shaped by past experience and current
incentives.

Competition
in the execution-only brokerage market in many countries is rather limited,
with the access to non-domestic securities being often more difficult and
expensive. Direct market access in Europe still needs to improve further.
Standardisation of products may also play an important role in retail investor
access. At the same time, efforts to increase greater direct retail
participation have to be balanced against the need of investor protection.
There needs to be caution against exposing retail investors to risks which they
are not well-placed to assess.

6. 
Barriers to institutional investment

Most
EU citizens are eligible for public pay-as-you-go (PAYG) pensions and other
social safety nets. Thus, their social security contributions go directly to
the state budget. This results in a smaller savings pool at EU level that is
devoted to capital market investment.

European
households are direct owners or indirect beneficiaries of 60% of financial
assets. Amidst growing longevity and fiscal pressures at individual country
level, they face a need to save efficiently for their retirement and other
future consumption needs, implying long-term investment horizons. The EU single
market holds the potential to maximise scale economies while increasing the level
of competition in the marketplace, delivering high-quality and low-cost savings
solutions to beneficiaries. In addition, from a long-term investing
perspective, high scale is needed to access less-liquid asset classes. Scale
eases access to less-liquid asset classes, by spreading related costs among a
larger number of participants and facilitating diversification within a larger
pool of managed assets. Less-liquid assets have longer-term life-cycles and
offer higher potential returns. Yet, direct investments in these are unlikely
to lead to net positive returns, unless undertaken by schemes with sufficient
scale.

The growth in institutional investment,
including growing private pension provision in Europe, would generally increase
investment flows into capital market instruments and facilitate a move towards
market-based financing. At the same time, as noted above, there are particular
challenges for SMEs to tap capital markets directly (though they can benefit
from them indirectly via bank-intermediated products such as securitisation),
mainly relating to informational problems on the part of potential investors
and costs. There are also specific impediments to the financing of long-term
projects, including infrastructure investment.

6.1. 
Constrained scale of occupational and personal
pension funds

Public
and private pension schemes exist alongside one another in the EU. As mentioned
above, public pension plans are typically set up as PAYG schemes, meaning that
current employees pay for the pensions distributed to current pensioners. Thus,
there is no capital stock that guarantees the funding of the future pension
claims of current contributors. Depending on the size of the pension payments
covered by PAYG schemes, a given fraction of national savings bypass the
capital market, which might negatively impact its size. Pension fund assets in
the EU make up only about 40% of those in the US[63].

Further
development of funded pensions, either in occupational or personal plans, would
have a positive impact on the size of EU capital markets. Empirical evidence
shows that there is a significant positive relationship between the size of
such pension funds and capital market depth (as measured by the ratio of the
market capitalisation of outstanding domestic stocks and bonds to GDP)[64]. Private pension plans
are administered by private institutions. In almost all cases these are funded 
pension  plans,  which  means  that  dedicated  assets  cover  the  plan’s 
liabilities, albeit the extent of this also depends on the underlying
assumptions (e.g. the discount rate applied to liabilities). To the extent that
these liabilities are covered by dedicated and legally separated assets, the
underlying savings are allocated via the capital market. This, in turn, tends
to support the diversity of participants in capital markets, particularly given
the propensity of pension funds to allocate capital to a range of investment
strategies.

On occupational pensions, the
Commission's Institutions for Occupational Retirement Provisions (IORP) 2 proposal
of March 2014 supports the development of occupational retirement provision
across the EU, with a view to unlocking efficiency gains in this market through
scale economies, greater risk diversification and innovation. The proposal also
aims at strengthening the governance of IORPs and disclose information more
effectively to scheme members. A safer and more efficient IORP market will
encourage take-up of occupational pensions, particularly in Member States where
they are currently underdeveloped. IORPs could hereby better fulfil their
natural role as major institutional investors in European capital markets.

On personal
pensions, the array of providers (banks, insurers, asset managers) is
subject to a number of different pieces of EU legislation or to no particular
EU legislation at all. The question therefore arises whether the patchwork of
prudential regulation and consumer protection rules constitutes an obstacle to
the full development of a large and competitive market for personal pensions.
Another problem is to incentivise personal pension providers to offer products
across borders and thus offer consumers the benefits of more competition and
more choice. The introduction of a standardised product or removing the
existing obstacles to cross-border access would strengthen the single market in
pension provision and lead to efficiency gains stemming from standardisation
across geographic regions. To address these issues, the Commission mandated the
European Insurance and Occupational Pensions Authority (EIOPA) to work on a
Call for Advice on personal pensions in July 2014, which is expected in
February 2016. Based on this input, the Commission expressed its intention to
consider how best to promote the development of personal pension products across
the EU, thereby mobilising untapped resources and strengthening the
institutional investor base in a capital market union.

6.2. 
Short-termism and regulatory features drive
inefficient asset allocation

An apparent problem in the EU is that
institutional investors, such as pension funds, which have long-term
liabilities and have the capacity to be "patient" investors, often do
not allocate sufficient amount of funds to long-term investment. This can
predominantly be explained by their short-term investment horizon, and
sometimes also by flaws in the regulatory framework[65]. For example, the
short-term outlook for financial reporting may focus investors’ minds
disproportionally on short-term investment performance. Incentive schemes and
compensation structures for asset managers may tend to exacerbate this
short-termism (for an extended analysis see, for example, the Kay report on
equity markets, published end 2012). In addition, cross and self-referential
performance measures result in market instability and severe distortions.

One example, certainly not the only one, is
that private EU pension schemes lack a clear retirement objective (e.g. in
terms of replacement rates) and bear too much resemblance to other
(shorter-term) investment solutions readily available on the market. Notably,
the use of long-term investment targets to benchmark performance is rare. The
use of relative benchmarks is commonplace, even though absolute return
objectives are more in line with retirement savings. The reform of governance
appears more difficult for small providers, given a relative lack of skills and
resources.

Pension schemes also tend to emphasise
relatively high liquidity for investors, regarding the frequency and length of
redemption windows and the immediacy of execution of redemption orders. High
liquidity in this sense is, however, incoherent with long-term investment for
retirement. It does  not  allow  long-term  assets  to  be  held  to 
maturity,  to  build  and maintain strategic equity stakes or investment in
less-liquid asset classes. Pension solutions need to be fairly illiquid until
retirement to maximise the potential risk- adjusted return over the long term.[66] Moreover, taxation may
deter redemptions before retirement anyway, making the actual liquidity profile
of pension solutions in some markets far less liquid than advertised.

As a result of the above, funds tend to
hold a disproportionate amount of liquid assets, including cash. Similarly,
investment practices are conditioned by the pursuit of short-term relative performance
rather than long-term absolute return objectives. The available evidence
indicates that most defined-contribution pension plans do not consider asset
liability management (ALM) practices. They do not distinguish between
return-seeking and liability-hedging portfolios either. Pension funds often buy
a significant amount of sovereign debt, which may crowd out investment in
public equity and public corporate debt. Also, some Member States have rules
which de facto limit pension funds from investing in infrastructure[67].

In addition to the negative impact on the
availability of long-term financing, the focus on short-term relative
performance benchmarks incentivises investors and asset managers to evaluate
companies' performance on a short-term horizon. A myopic focus of investors
results in a reduced interest in the long-term prospects of investee companies.
It often also results in short-term pressure on corporations and management,
which can create a barrier to productive investments, future competitiveness
and growth[68].

The ongoing revision of the Shareholder
rights Directive aims at incentivising a better alignment of the long-term
interests of institutional investors, their asset managers and companies though
transparency and public accountability.

6.3. 
Challenges associated with long-term and
large-scale infrastructure investments

The 2014 Commission Communication on
long-term finance in Europe already discussed the challenges and possible
policy options for incentivising long-term savings to flow into long-term
projects via capital markets. For example, the European Long-Term Investment
Funds (ELTIFs) are aimed at investment fund managers that want to offer
long-term investment opportunities to institutional and private investors
across Europe. ELTIFs are expected to have particular appeal to investors such
as insurance companies and pension funds which need stable, steady income
streams or long term capital growth.

The EU requires a significant amount of new
infrastructure investment to maintain its competitiveness (and diffusion of
technology and ideas). In some areas such as energy provision and the digital
economy there may be cross border benefits. However, some market participants,
notably banks, argue that there is a lack of appropriate financing vehicles as
high fees and extensive leverage mean only the largest investors can
participate. Also, the lack of objective high quality data and agreed
benchmarks implies it is difficult to assess risk and understand correlations
with other assets.

A stable framework with legal certainty and
common rules would help to ensure projects are possible and commercially
viable. For example, schemes like the Europe 2020 Project Bond Initiative,
credit guarantees and syndicated project finance loans can promote funding at
different stages of infrastructure projects.

Where adequate sources of private funding
are not available, the joint initiative by the European Commission and the
European Investment Bank to attract additional long term financing for large
scale infrastructure projects can help stimulate markets. Credit quality is
increased via the provision of a subordinated tranche of debt to a level where
institutional investors are comfortable investing long term. The project is in
pilot phase pending a final decision in 2015.

Some stakeholders have also called for a
tailored treatment of infrastructure investments in the context of prudential
regulation, in particular the calibration of capital requirements of banks and
insurers. However, the diversity in infrastructure investment makes it
difficult to come to a definition and a corresponding history of appropriate
data that would allow calibration for prudential regulatory purposes.[69]
Moreover, infrastructure investment is prone to specific risks that indeed
merit particular attention from the prudential point of view.

The latest technical advice requested by
the Commission on this matter is a report by EIOPA about the calibration of the
Solvency II regime for insurers.[70]
EIOPA highlighted promising findings that could support the creation of a
tailored, more favourable treatment for certain infrastructure niches. For
example, unlisted infrastructure funds have little correlation listed equities.
EIOPA also pointed to decreasing default risk over time and higher recovery
rates in certain types of project loans which appear more creditworthy than
investment-grade corporate debt. However, EIOPA stopped short of recommending a
tailored calibration for the relevant infrastructure sub-classes, because of
data-related factors.[71]

In its 2014 Communication, the Commission
already announced that it would evaluate the feasibility of collecting and,
where possible, making available comprehensive and standardised credit
statistics on infrastructure. There may also be a case for taking a fresh look
at other asset subclasses, such as unlisted infrastructure equity, using the
accumulated data and experience with those funds.

APPENDIX

Financial asset allocation by households
in OECD countries (in % of total financial assets)

Source: OECD
Factbook 2014

[1] Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles
in action. Upper Saddle River, Pearson Prentice Hall. p. 283. ISBN
0-13-063085-3.

[2] Among other things, these markets include financial instruments
such as asset-backed securities (ABS), mortgage-backed securities (MBS),
collateralised debt obligations (CDOs), collateralised loan obligations (CLOs),
collateralised mortgage obligations (CMOs) and whole business securitisation
(WBS). Bank lending, if not securitised, is typically not classified as capital
market transactions.

[3]       The saver invests the proceeds in a financial market
instrument issued by the entity (e.g. a corporate or government) that wishes to
obtain funds. In the case of common equity, the transfer results in an
ownership stake. In the case of debt, typically there is a contractual
obligation to pay interest on the debt and ultimately to repay the debt on a
well-defined schedule.

[4]       Banks hold significant amounts of bonds and shares issued by
EU residents and are themselves significant issuers in the market. Banks play a
role in supporting IPOs and other placements of securities through underwriting
and book-building and make markets in these instruments. Depending on the
country, most small investors that buy financial instruments do so through
their retail banks.

[5] See for example Langfield, S., and Pagano, M., ”Bank bias in
Europe: Effects on systemic risk and growth”, December 2014.

[6] Secondary capital market transactions can also have a negative
effect on primary borrowers. For example, if many investors try to sell their
bonds simultaneously, this can push up the yields for future issues from the
same entity.

[7] Most such holdings, however, are quite small, and their composition
varies greatly from one country to another. In 2010, equities accounted for 9%
of households’ financial assets in Germany, but 34% in Finland. Although the
2008–09 stock market crash caused households to reduce their equities’ holding,
the extremely low yields on bond investments and bank deposits drove individual
investors back towards equities in 2013.

[8] Institutional investors include banks, insurance companies, pension
funds, collective investment vehicles including mutual funds, exchange-traded
funds (ETFs), private equity funds and hedge funds, high-frequency traders
(HFTs), among others.

[9] At the end of 2011, for example, US institutional investors kept
roughly identical proportions of their assets in the form of shares and in
bonds. Until recently, British institutional investors tended to hold a greater
proportion of assets in shares, whereas institutional investors in Japan have
tended to favour bonds and loans over shares.

[10] Global investments in FinTech have increased from $930 million in
2008 to nearly $3 billion in 2013. In the UK and Ireland alone, FinTech
companies received over $700 million from investors between 2008 and 2013. See
”The Boom in Global Fintech Investment. A new growth opportunity for London” by
Accenture.

[11] For example, see OECD (2014), BIS (2014), Cecchetti et al (2012)
and Arcand et al (2012). BIS (2014) identify a threshold of 95% for the
turnover ratio, expressed as the value of total shares traded to average market
capitalisation.

[12]     See for example Kaserer, C. and Rapp, M.S., Capital Markets and
Economic Growth – Long-Term Trends and Policy Challenge, Research Report, March
2014.

[13] In 2013, the EU GDP was around €13.03 trillion and that of the
United States €12.65 trillion, although on a per capita base, the EU reached
only two thirds of the US level.

[14] ECMI statistical package 2014.

[15] However, mid-sized European companies have also been accessing the
US private placement market, e.g. raising $15.3 billion in 2013. See ICMA
Quarterly Report No.3 2014.

[16] ECMI statistical package 2014.

[17] AFME (2013), "Unlocking funding for European investment and
growth".

[18] ECMI statistical package 2014.

[19] According to IMF data, the total stock of cross-border portfolio
investments globally stood at €25 trillion at the end of 2013. The total stock
of cross-border portfolio investments between EU Member States was €9.6
trillion, whereas portfolio investments coming from outside the EU amounted to
€5 trillion. At the same time, according to UNCTAD World Investment Report
2014, total inflows of foreign direct investment (FDI) into the EU amounted to
$246 billion, constituting 17% of the world total in 2013, which is 30% less
than the pre-crisis peak in 2007.

[20] For example, intra-euro area cross-border equity holdings (i.e.
equity issued in the euro area and held by residents of other euro area
countries) amount to just over 40% of total holdings (source: ECB), which has
steadily increased over the last decades but is still less than would be
expected in fully integrated markets.

[21] The discussion here only touches on CSDs and CCPs, although there
is a wider set of relevant market infrastructures and issues to consider.

[22] Pricing of market data services. An economic analysis, Oxera,
February 2014.

[23] SIFMA/AFME Structured Finance Data Tables, Fourth
Quarter 2014

[24] Total outstanding covered bonds amounted to €2.8 trillion in 2012
globally, of which more than 80% is accounted for by six EU Member States
(Germany, Spain, Denmark, France, Sweden and the UK).

[25] The largest and longest established of
these is the German "Schuldschein" market, whereas the "Euro
PP" market in France and the UK market are described as successful
emerging markets for these instruments, although from a low base.

[26] In the US, insurance State-level regulators have organised a
centralised risk-scoring body for privately placed (unrated) loans. The credit
rating designations are assigned to privately placed bonds by the Securities
Valuation Office (SVO) of the National Association of Insurance Commissioners
(NAIC) or are self-assigned by the insurance company if the bond is publicly
rated by an approved credit rating provider. The US NAIC reviews the papers
after closing of an issue and issues a stamp on the transaction grading it on a
scale of 1 to 6.

[27] Since information on recovery is particularly important for
investors in these products, the differences in European insolvency laws have
also been cited as barriers to the development of a wider cross-border private
placement market and explain at least partly the lack of standardisation.

[28] http://ec.europa.eu/justice/civil/files/report_assignment_en.pdf

[29] Several company law directives provide for harmonisation on matters
such as disclosures, formation and maintenance of capital, disclosure for
branches, takeover bids, mergers and divisions or shareholders' rights.

[30] For example, due to a lack of relevant rules at EU level,
companies wishing to undertake a cross-border division currently have to
perform several operations, such as a national division and a cross-border
merger or the creation of a subsidiary and a subsequent transfer of assets,
which could lead to more burdens on companies in terms of costs and time.

[31] Final Report on the Opportunities for the Internationalisation of
European SMEs (2011), p. 21, available at:
http://ec.europa.eu/enterprise/policies/sme/marketaccess/files/web_internationalisation_opportunities_for_smes_final_report_aug_2011_en.pdf

[32] According to a
survey conducted by the Commission with the EU business registers, less than 1%
of limited liability companies in the Member States represent branches of
companies registered in another EU country

[33] See recent public consultation on cross-border mergers and divisions.

[34] Regulation (EU) No 910/2014 of the European Parliament and of the
Council of 23 July 2014 on electronic identification and trust
services for electronic transactions in the internal market and repealing
Directive 1999/93/EC (eIDAS Rregulation)

[35] In this context, the proposal for Directive on Single-Member
limited liability companies  has a potential of pioneering the cross-border
registrations and identifications.

[36] In addition, there is a lack of information on relationships
between companies (branches, subsidiaries), information which would be
extremely valuable to investors.

[37] This could take different forms, such as:
i) the submission of statutory information and other
documents required from companies in a standardised electronic format, on-line
registration and storage of documents, improved information on group structure
and relationships between legal entities in general;
ii) electronic secured circulation of documents
between authorities, to avoid many filings (one stop shop/ once only reporting
principle); or iii) electronic
voting systems, electronic platforms for voting, exchange of information
between companies and shareholders, but also between different shareholders, in
standardised electronic format

[38] Commission Staff
Working Document "Impact Assessment accompanying
the Commission Recommendation on a new approach to business failure and insolvency", SWD (2014)
61 final.

[39] C(2014) 1500 final.

[40]
http://ec.europa.eu/enterprise/policies/sme/business-environment/files/second_chance_final_report_en.pdf

[41] Intrum Justitia (2014), "European
Payment Index 2013".

[42]  This problem is particularly acute for the financial sector. It
also goes in the opposite direction than the regulatory efforts to make
financial institutions hold more capital. Recent studies have found that
eliminating this bias would result in substantial reductions in systemic risks
and costs of financial crises. See for example De Mooij , Keen and Orihara
(2014), "Taxation, Bank Leverage, and Financial Crises", in De Mooij
and Nicodeme eds., Taxation and Regulation of the Financial Sector, MIT Press
and Similarly, Langedijk, Nicodeme, Pagano and Rossi (2014), "Debt Bias in
Corporate Taxation and the Costs of Banking Crises in the EU", Taxation
papers, N.50, DG TAXUD.

[43] CPB (2014) 'Study on R&D tax incentives'. Commissioned by the
European Commission. Taxation papers No 52.

[44] Recommendation on Withholding Tax Relief Procedures, COM (2009) 7924 final.

[45] The OECD Committee on Fiscal Affairs successfully approved the
Treaty Relief and Compliance Enhancement (TRACE) implementation package 2013.
This package is to some extent in line with the principles of the EC
Recommendation. With the OECD approval, the work on this dossier has now, not
only successfully resulted in a European, but also a global, impact.

[46] While the public sector is also a sector with a continuous deficit
position, its funding is dominated by the issuance of debt securities. Only a
small part is funded via loans, while equity issuance is not feasible.

[47]     To be defined broadly to capture also small / mid-cap companies
that do not meet the current SME definition.

[48]     There is also a lack of finance for long-term projects,
including infrastructure investments. Short-termism, regulatory barriers and
other factors restrict the flow of long-term (institutional) investment to
long-term projects (see section 6 below). Many infrastructure projects display
characteristics of public goods, implying that private financing alone may not
deliver the optimal level of investment.

[49] An additional factor explaining the overdependence of companies on
bank finance is the corporate debt bias mentioned above, as the deductibility
of interest paid on debt makes it a more interesting financing tool than the
remuneration of own equity for which there is no tax deductibility.

[50] Lack of demand for finance stems from generally weak economic
conditions and growth expectations following the crisis as well as already high
levels of indebtedness of many firms in Europe.

[51] In some Member States, individual entrepreneurs remain very long
with a negative score once they enter bankruptcy. The entrepreneur does not
have a second chance.

[52] As of the 1st of January 2017, article 8b of Regulation 1060/2009
will require issuers of structured finance instruments to disclose information
on the performance of the underlying pool of assets.

[53]Figures from ESMA, the European Securities and markets Authority at:
http://www.esma.europa.eu/page/Venture-Capital-and-Social-Entrepreneurship-Funds.

[54] In crowd-lending the public lends money to companies through a
platform in return for a higher interest they would obtain if a bank was in
between. Equity crowdfunding is the other form of crowd funding where an
investment company takes equity in a start-up or  SME and sells this equity in
small coupures to the public.

[55] Within crowd funding, the lending model takes the better part of
the annual growth with an increase of 111% globally in 2013. The equity model
is more modest with an annual global growth of 30% in 2012.

[56] For example, Italy, the UK and France have introduced specific regulations, and
other Member States (Spain, Germany, Austria, the Netherlands and Finland) are
envisaging legislative changes in the near future. Belgium and Austria amended
their prospectus rules to better fit this business model.

[57] Based on the Eurosystem household wealth and consumption survey
(results of the first wave)

[58] As a comparison, the US households hold a much smaller share of
financial assets in bank deposits (13%) to the benefit of much higher shares of
corporate equity (31%), investment funds (11%) and bonds (9%).

[59] The financial accounts data reveals that insurance and pension
funds hold around 8% of their assets in deposits. EIOPA data gives a share of
around 5% for insurance firms and indicates that around 18% are held in bonds
issued by financial institutions.

[60] Non-UCITS funds accounted for an additional €2.9 trillion under
management. Total assets under management of the European asset management
industry (including funds and discretionary mandates) amount to some €17
trillion. Source: European Fund and Asset Management Industry, Key Facts and
Figures 2003-2013.

[61] Lipper 2013
European Fund Market Review

[62] Fact Book 2014, European Fund and Asset
Management Association.

[63] In 2012, EU occupational and personal pension funds had €3.6
trillion (28% of GDP) in assets under management, compared to €8.8 trillion
(70% of GDP) in the US.

[64]     The same research shows that increasing the size of pension
funds by 10 percentage points of GDP would lead to an increase in stock market
size of 7 percentage points of GDP. See Kaserer, C. and Rapp, M.S., Capital
Markets and Economic Growth – Long-Term Trends and Policy Challenge, Research
Report, March 2014.

[65] E.g. constraints in the investment mandates of pension funds in
some member states, requiring that over 50% of assets under management is
invested in sovereign bonds.

[66]     Regulation and supervision can also have a significant impact
on capital markets, generally by promoting or discouraging, sometimes
unintentionally, the market activity of affected financial institutions. For
instance insurance companies have long-term liabilities. Hence they are
particularly well suited to make long-term investments and satisfy long-term
financing needs, even in the absence of liquid secondary markets. It has been
argued that strengthening capital requirements as part of Solvency II to
capture all quantifiable risks and the introduction of market-consistent
valuation may distort insurers' investment behaviour and long-term asset
allocation decisions. However, this concern may be misplaced in light of recent
implementing rules of Solvency II.

[67]     In early 2014, the Commission proposed a directive which, among
other things, would stop member states banning occupational pension funds from
investing in assets with a long-term profile such as infrastructure, unless the
restrictions are justified on prudential grounds.

[68] A more long-term investment horizon is seen
as a key enabler of responsible shareholder engagement
Responsible shareholder engagement implies monitoring of companies on matters
such as strategy, performance, risk, corporate governance, environmental and
social performance, etc. and having a dialogue with companies on these matters
with a view to improve the long-term efficiency, performance, competitiveness
and sustainability of the company.

[69] From the investors' perspective, risk is not only driven by the
nature of the project in which they invest. It is also driven by the types of
financial instruments used for such investment, which are extremely diverse,
ranging from equity investment (listed or private, held directly or using
funds) to debt (listed or unlisted bonds, and loans, directly or using funds).
Even within the two classes of equity and debt investment, separating out
infrastructure and other investments is not straightforward.

[70] Technical report on standard formula design and calibration for
certain long-term investments, EIOPA (2013)

[71] For example, methodological inconsistencies and doubts over
market-consistency in the various sources of performance measurements, data
sets spanning too short a period, difficult access to banks' or rating
agencies' proprietary data sets, etc.