EUROPEAN COMMISSION Brussels, 30.9.2015 SWD(2015) 183 final COMMISSION STAFF WORKING DOCUMENT Economic Analysis Accompanying the document Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions Action Plan on Building a Capital Markets Union {COM(2015) 468 final}

{SWD(2015) 184 final}







Contents EXECUTIVE SUMMMARY Chapter 1 THE IMPORTANCE OF THE CAPITAL MARKETS UNION 1.1 Overreliance on banking as an impediment for growth 1.2 The growth weakness became entrenched through the fragmentation of the EU financial sector 1.3 Objectives of the CMU Chapter 2 TAKING STOCK OF EU CAPITAL MARKETS 2.1 Bank-based versus market-based financial systems Optimal financial structure is dependent on the stage of development of the economy Relative advantages of bank-based and market-based funding systems Competition or complementary? 2.2. Historical, legal and economic structures as barriers for capital markets development 2.3 Financial stability and macro-prudential policy oversight for a stronger CMU Chapter 3 FINANCING NEEDS BY THE EUROPEAN CORPORATE SECTOR AND INFRASTRUCTURE 3.1 Theory on businesses' access to funding 3.2 Do European SMEs lack funding? 3.4 Do European companies face barriers to going public? 3.5 Debt versus equity financing and the tax-induced debt bias 3.6 Barriers to access infrastructure finance

Chapter 4 THE PROVISION OF FUNDING THROUGH CAPITAL MARKET INSTRUMENTS 4.1 Identifying and understanding the investor base 4.2 Promoting saving and investment by households through capital markets 4.3 Promoting capital market investments by institutional investors Chapter 5 REAPING OPPORTUNITIES TO PROMOTE CROSS-BORDER MARKET FUNDING 5.1 Benefits and determinants of cross-border investments 5.2 Insolvency rules and procedures and company law 5.3 Withholding tax and other tax barriers to cross-border investments 5.4 Financial market infrastructures 5.5 Supervisory and regulatory convergence Chapter 6 A COUNTRY PERSPECTIVE ON THE CMU 6.1 Financing needs 6.2 Financing sources 6.3 Intermediation: linking financing sources with financing needs 6.4 How can the CMU benefit EU Member States with different levels of capital market development? REFERENCES



List of Abbreviations CCP Central Clearing Counterparty CSD Central Securities Depository CMU Capital Markets Union EBRD European Bank for Reconstruction and Development ECB European Central Bank EFSI European Fund for Strategic Investments EIB European Investment Bank EIOPA European Insurance and Occupational Pensions Authority ELTIF European Long Term Investment Fund ESG Environmental, Social and Governance ESMA European Securities and Markets Authority EU European Union EUR Euro FDI Foerign Direct Investment FSAP Financial Services Action Plan GDP Gross Domestic Product IFC International Finance Corporation IMF International Monetary Fund IPO Initial Public Offering MiFID Markets in Financial Instruments Directive MiFIR Markets in Financial Instruments Regulation MTF Multilateral Trading Facility NFC Non-Financial Corporation OECD Organisation for Economic Co-operation and Development OJ Official Journal of the European Union PP Private Placement PPP Public Private Partnership PRIPs Packaged Retail Investment Products (Directive) R&D Research and Development SME Small and Medium Enterprise SWD Staff Working Document TFEU Treaty on the Functioning of the European Union UCITS Undertakings for the Collective Investment in Transferable Securities USD Dollar of the United States of America

EXECUTIVE SUMMMARY This Commission Staff Working Document (SWD) accompanies the Action Plan on the Capital Markets Union (CMU). By providing an economic analysis of the functioning of financial markets in Europe, it substantiates the rationale for the objectives of the CMU and provides the context for the Action Plan. In particular, the SWD analyses the evolution and the current state of financial markets in the EU, the financing needs of the economy, the role of investors and how the two meet, and the obstacles to cross border investments in Europe. The SWD provides a general context for identifying weaknesses and market failures in the functioning of European capital markets, some of which may be suitable candidates for action for the CMU Action Plan. However, some structural problems or market failures cannot be addressed effectively by policy action at EU level or our understanding of the nature of the market failure does not yet allow us to frame corrective policy action. Other problems may be better addressed through intervention at Member States' level or in other ways. It is nevertheless important to analyse these issues in the SWD to understand the context in which EU level initiatives can be usefully deployed through the CMU. This SWD builds on the SWD that accompanied the Green Paper on the Capital Markets Union , which provided initial reflections on the obstacles to the development of deep and integrated EU capital markets, and the 2015 European Financial Stability and Integration Review (EFSIR) that provides an extensive statistical overview of the EU financial system, including capital markets. Chapter one explains how reducing the reliance on the banking sector and strengthening the integration of EU financial markets can support growth in Europe, and introduces the concept and objectives of the CMU in this context. Chapter two describes how the banking sector and capital markets have been developing in the EU and explores their respective roles and relative advantages in different stages of development of an economy. It demonstrates that banks and capital markets are two vital components of the financial system, not competing but complementing each other and co-evolving. It also explains why banks have a dominant role in the European financial structure and what complementing this structure with more market-based funding means for financial stability. Chapter three analyses how enterprises, and in particular SMEs, could benefit from a larger share of financing made available through capital markets. It describes the various funding sources of European non-financial corporations and explores their comparative advantages. After analysing how the financing needs of a company evolve over its life cycle, it explains why specific capital markets instruments that would be most appropriate to support the development of a firm remain under-developed in Europe. For non-financial corporations to have access to more market funding, as argued in chapter three, investors' savings through market instruments have to increase. This is what chapter four analyses. It first describes the EU investor base, distinguishing between retail investors, non-financial corporations and institutional investors. While households and non-financial corporations are the largest ultimate suppliers of funds, the intermediation role of institutional investors is crucial. The chapter then discusses how correcting information asymmetries, tackling barriers to cross-border investment by European funds and exploring the development of personal pension funds could promote households' investments in capital markets. It then analyses various obstacles to more investment by institutional investors in capital markets instruments. Chapter five provides a thorough insight into the barriers and obstacles to cross-border capital market transactions. After describing the economic benefits stemming from cross-border capital flows, it provides more detail on those aspects of capital markets' organisation that appear the most relevant in a cross-border context, in particular insolvency procedures, tax barriers, financial market infrastructures, as well as supervisory and regulatory practices at Member State level. Chapter six documents similarities and differences between Member States as regards their financing needs, their funding sources, and the structure and level of development of their financial markets. This diversity means that, while all Member States will benefit from the CMU, gains will materialise in various forms, depending on the specificity of each Member State. Chapter 1THE IMPORTANCE OF THE CAPITAL MARKETS UNION Through the CMU, the European Commission strives to increase the benefits that capital markets and non-bank financial intermediaries can provide to the economy. Building a CMU is a key initiative in the work programme of the European Commission. It is also one of the elements for completing the Economic and Monetary Union, as set out in the recently published Five Presidents' Report. It would ensure a greater diversification in the funding of the economy and reduce the cost of raising capital, particularly for SMEs. The motivation for the CMU also stems from the shortcomings of the European Union (EU) financial system revealed by the financial crisis that are impeding economic growth and are holding back recovery. While there are a variety of funding sources available to finance the EU economy, it seems to overly rely on financing intermediated through banks. At the same time, market-based financial instruments could be more extensively used, at least in some countries. This document makes the case that if the EU financial system was more diversified and had a larger share of funding channelled through capital markets, this should ultimately lead to a wider choice of financial instruments for the benefit of both enterprises and investors and a lower cost of raising capital, notably for SMEs, and increase the attractiveness of Europe as a place to invest. The EU economy could move towards a higher growth path and be more resilient to economic shocks. 1.1 Overreliance on banking as an impediment for growth The financial and sovereign debt crisis has taken a heavy toll on EU growth performance. Significant GDP loss occurred in many developed countries and became permanent. Support programmes for banks entailed non-recovered fiscal costs of about 5% of GDP or more in Belgium, Greece, Ireland, Luxembourg, the Netherlands, Austria and the UK. The unemployment rate increased from a pre-crisis low of 7.5% in 2007 to 11.6% in 2014 in the euro area, and from 7.2% to 10.2% in the EU. Compared with 2007, 6.5 million more people are now unemployed in the EU. In addition, European economies are not only suffering from permanent and significant losses of GDP, but in addition a reduced potential real GDP growth rate (see Charts 1 and 2). An investment gap opened in the EU and poses risks to achieving competitiveness and sustainable growth. The level of investment (gross fixed capital formation) in the EU has dropped by about 10% (EUR 300 billion in 2010 prices) since its peak in 2007 as a consequence of the economic and financial crisis. Capital inflows from abroad into the EU have also come down considerably, suggesting that weaker growth prospects have made the EU a less attractive place for financial investment. This investment gap poses a threat to reaching the targets set by the Europe 2020 Strategy and needs to be closed to achieve the overarching European policy goals of smart, inclusive and sustainable growth. The European Commission's new Investment Plan, including the European Fund for Strategic Investments (EFSI), was adopted to unlock investment to fill the gap. The Regulation setting up the EFSI explicitly requires that EU projects are consistent with EU policy priorities, such as the 2030 climate and energy package to achieve a low carbon economy. The EU's international investment policy is focused on providing EU investors and investments with market access and with legal certainty and a stable, predictable, fair and properly regulated environment in which to conduct their business. The relatively large reliance on banks weighs on growth and recovery. In the run-up to the financial crisis, banks' balance sheets and off-balance sheet exposure grew fast, and credit provided in the form of bank loans outpaced GDP growth. The financial crisis imposed significant restructuring and deleveraging needs on the sector. Subsequently, the EU banking sector has become considerably less supportive to economic activity than in past upturns. Factors causing this include the following: (i) pre-crisis bank lending contributed to the accumulation of debt among private households and firms, part of which became unsustainable with the economic downturn; (ii) economic recessions tend to be more severe when accompanied by financial crises and especially banking crises; and (iii) EU banks reduced their coss-border activities (fragmentation). Banks' asset quality eroded amid weakening economic activity, particularly in EU Member States heavily exposed to stress on sovereign bond markets. As a result, the share of non-performing loans on banks' balance sheets increased. This has been identified as a crucial factor that has held back credit provision to the economy. High bank dependency means that enterprises, and particularly SMEs, have difficulties accessing alternative funding sources when they cannot get credit from banks. For many companies, particularly in vulnerable Member States, access to finance has become markedly more difficult with the financial crisis. Difficulty in accessing finance is one of the obstacles that prevent SMEs from launching new products, broadening their activities and markets, strengthening their infrastructure and taking on more employees. This situation is equally true for well-established SMEs and those innovating ones that are small and rapidly expanding. Financing conditions remain tight in countries whose economies have been hit most severely by the crisis and especially for start-ups, SMEs and/or innovative companies. From a systemic point of view, higher dependence on bank lending makes the economy more vulnerable when bank lending tightens, as happened in the recent crisis. In times of economic downturns coinciding with financial crises, capital markets have the ability to act as more effective shock-absorbers (see Section 2.1). The shock-absorbing capacity of capital markets is particularly high when borrowers can switch between funding sources and when funding is provided in the form of equity. Thus, diversification of funding sources and a higher share of equity funding make the financial system more stable. The diversification benefits apply equally to investors, who enjoy an increased set of investment opportunities in deeper and more liquid capital markets. 1.2 The growth weakness became entrenched through the fragmentation of the EU financial sector The combination of the global financial crisis and euro-area sovereign debt crisis has halted the process of integration in EU banking and triggered a process of financial fragmentation. By 2007, European banks were significantly more internationalised than banks in the USA, Japan or China. This resulted primarily from their cross-border expansion within Europe. However, the crisis revealed that financial integration in the EU was hitherto shaped by cross-border inter-bank flows, which fuelled local credit bubbles and emerged as pro-cyclical and prone to sudden reversal. From 2008, cross-border lending in the euro area and the EU declined in absolute and relative terms. At the same time, banking activities, assets and risks migrated increasingly back to home jurisdictions. In parallel, banks invested increasingly in domestic sovereign bonds, thereby exhibiting home bias in most Member States. In Member States that experienced acute sovereign funding stress, banks' access to cross-border funding became particularly difficult and bank funding costs widened in both absolute and relative terms. Shortfalls in private funding in these banks have been partially compensated by higher borrowing from the Eurosystem. Financial fragmentation has a significant effect on the possibility to share economic risks across borders. Economic literature identified capital markets and bank credit markets as having a potentially important role in cushioning the impact of economic shocks. By giving access to foreign assets, the capital markets channel provides stable revenues to investors when domestic income sources decay. The bank credit market channel assumes that banks provide stable funding to the economy even when the economic activity weakens and credit risks increase. The literature on risk sharing in the euro area found that it is underdeveloped and that it was not effective during the financial crisis. Indeed, the credit market played a small role because the severity and persistence of the economic downturn weakened the banking system, and because the fragmentation it entailed annihilated the cushioning effect of diversification. The reasons for the capital market channel to have had a limited cushioning effect during the crisis were seen in the limited size of capital markets in the EU. Economic theory has long conjectured a link between financial integration, risk sharing and higher economic growth through a "risk-amelioration" channel. The macroeconomic consequences of a limited risk sharing became evident with the weak bank lending in vulnerable Member States that resulted from the crisis. An important element of cross-border risk-sharing was unavailable when needed most, leaving corporates in vulnerable Member States reliant on domestic banks that encountered funding problems either because they had to repair balance sheets themselves or were exposed to a weak sovereign. In other Member States, weak domestic demand for credit coupled with the unwinding of interbank lending resulted in excess liquidity in the banking system. Since SMEs are particularly dependent on funding from domestic banks, the fragmentation of banking markets aggravated financial constraints in the SME sector. EU cross-border banks did not compensate for the decline in credit supply by domestic banks. Difficulties to tap foreign sources were also observed for other funding instruments. Cross-border corporate bond holdings declined substantially during the financial crisis. The home bias in equity fell during the financial crisis, but remains significant, with 64% of EU equity holdings and 61% of euro area equity holdings being of domestic origin. 1. 2.

1.3 Objectives of the CMU The CMU complements the regulatory financial reforms of recent years and the Banking Union. The aim of the financial reform agenda has been to strengthen regulation and supervision of the financial sector after the financial crisis, in order to restore and safeguard financial stability. The Banking Union, partly in response to the sovereign debt crisis, addresses supervision and resolution of banks, thereby targeting the nexus between banks and the sovereign risks in participating countries. With the overarching objective of maximising the benefits of capital markets and non-bank financial institutions for the real economy, the CMU provides additional value to those reforms. The CMU has three main objectives: a.The CMU will broaden the sources of financing in Europe towards non-bank financing by giving a stronger role to capital markets. It will offer to borrowers and investors a broader set of financial instruments to meet their respective needs. b.The CMU will help deepen the single market for financial services. Capital markets will benefit from the size effects of the single market and become deeper, more liquid and more competitive, for the benefit of both borrowers and investors. c.The CMU will help promote growth and financial stability. By facilitating companies' access to finance, in particular SMEs, the CMU will support growth and jobs' creation. At the same time, by promoting more diversified funding channels to the economy, it will help address possible risks stemming from the over-reliance on bank lending and intermediation in the financial system. By diversifying the risks, it will make the whole system more stable and help financial intermediaries granting more funding to the economy. Capital markets enlarge the set of potential financing instruments and are complementary to bank financing. Non-bank financing does not merely substitute for investment that was previously funded by banks, but it enables additional investment that banks would not be ready to fund. As further detailed in Section 2.1, market financing is usually regarded to being better at dealing with uncertain environments and therefore better suited to fund riskier investment projects (with a higher required rate of return). The creation of the CMU not only complements banking activity, but also boosts it as banks provide important services to participants in many capital market segments and receive from it considerable revenues, notably in the form of fees. Besides, by providing a larger pool of financial assets which could be potentialy included in open market operations conducted by central banks, deeper capital markets could also strenghten the transmission of monetary policy impulses. Deep, liquid and efficient capital markets bring advantages to borrowers and investors. They have three main advantages for companies seeking finance: (i) improve their access to funds; (ii) reduce their capital costs by creating competition among investors; and (iii) reduce the risk of disruption in financing by diversifying their funding sources (see Chapter 3). On the investors' side, by increasing the investment opportunities, efficient capital markets offer investors a broader set of financial products to (i) meet their investment objectives, (ii) diversify and manage their risks, and (iii) optimise their risk-return profile, while respecting their investment constraints – whether in terms of risk, duration, or other assets' characteristics (see Chapter 4). Overall, capital markets (especially equity markets) facilitate entrepreneurial and other risk-taking activities, which have a positive effect on economic growth. Large and well-integrated capital markets can contribute to jobs and growth through a number of channels. They can contribute to allocative efficiency by opening up investment and diversification opportunities for investors across Europe, improving access to risk capital for borrowers, and allowing greater competition (unleashing corresponding benefits such as productivity gains, lower costs, greater choice, financial innovation, etc.). Unobstructed capital flows within the single market should allow financial resources to reach the most profitable investments. Portfolio diversification possibilities should also be enhanced because the larger financial markets are and the better integrated across borders, the more opportunities they allow to share risks among actors and economies. Cross-border integration increases the size of the relevant market, which allows for scale effects originating from lower costs to run market infrastructures, better capitalisation on search costs (see Section 5.1), and higher market liquidity. The CMU goes beyond previous initiatives to foster the single market for financial services. The CMU shares some economic objectives with the Financial Services Action Plan (FSAP), which led to the adoption of 42 regulatory measures, including 24 legislative measures, between 1999 and 2004. The FSAP also aimed at reducing obstacles to cross-border financial investment, thereby increasing efficiency gains through higher competition and realisation of scale effects and allowing a better diversification of risks on integrated financial markets. The CMU continues to build on this, focusing on the obstacles to cross-border investment, strengthening the contribution of capital markets to the EU financial system and funding households and companies. At the same time, the role of stronger supervisory convergence and enhanced financial stability feature more prominently than in the FSAP. Notes: The height of each box is proportional to the actual size of the sector. Assets and liabilities of the real economy and RoW include funds channelled both through intermediation and direct financing. Source: ECB, Eurostat and own calculations.

Chapter 2TAKING STOCK OF EU CAPITAL MARKETS Non-bank finance is small in the EU, though the situation differs from one Member State to another… The size of capital markets is conventionally measured by the ratio of outstanding financial assets relative to economic activity. International Monetary Fund (IMF) standard indicators of capital market size reveal that the EU has a particularly large capital market when financial assets held by banks are included. Should these assets be excluded and the size of capital markets be measured as the volume of outstanding bonds and shares, financial markets in the USA and Japan would be considerably larger. By the same token, several EU Member States (LU, IE, NL and DK) have relatively larger capital markets than the USA, suggesting that conditions in the EU can be supportive to the development of large capital markets. … and enterprises make little use of market financing sources. A large share of bank loans on the funding side of European enterprises witnesses the important role banks play. Bank loans respectively represent 14% and 3% of the total liabilities of European and US companies, respectively. Conversely, corporate bonds are more used as a source of funding by US companies, representing 11% of their total liabilities, to compare with 4 % in EU firms. As a result, corporate bonds amount to a third of bank credit in the EU whereas they are a more important funding tool than bank loans for US corporates. The dominance of market over non-market funding sources in the US is also evident when equity is looked at. While the share of equity on firms' balance sheets is broadly comparable in the US and the EU, slightly more than half of this equity is in the form of listed shares in the US, to compare with about one third in the EU. If not listed, shares are more difficult to trade and therefore less liquid, which entails a higher illiquidity premium that investors require as compensation for their longer-term engagement. Stock market capitalisation is markedly larger in the USA than in all EU Member States except Luxembourg and the UK. More detailed comparisons suggest that access to financial instruments that enterprises may want to use in special situations is easier in the USA. Examples would be when they are young and small and cannot provide collateral, when their investments are particularly risky or large compared to firm size, when their corporate or financing structure needs to be restructured etc. In such situations, these companies may want to tap non-standard markets such as high-yield bonds, leveraged loans, securitisation, or private equity markets, which are underdeveloped in many EU Member States. Source: Eurostat. Source: OECD. This chapter discusses three caveats often mentioned with respect to the development of capital markets in the EU. First, the advantages of a more market-based financial system would need to be balanced against the advantages that bank financing provides (Section 2.1). Second, the development of a stronger capital market would be a break with historical, legal and economic structures that led to a mainly bank-based system (Section 2.2). Third, the benefits and risks of a stronger capital market for financial stability (Section 2.3). 2.1 Bank-based versus market-based financial systems Optimal financial structure is dependent on the stage of development of the economy Available research fails to provide a general rule determining which financial structures are optimal with respect to their contribution to economic growth. As regards the causality between long-term growth performance and the size or structure of the financial system, the ultimate jury is still out. However, empirical studies suggest that very high credit relative to GDP may lower economic growth. A similar threshold has not been identified for market financing, especially equity financing (see Table 1). Some research even suggests that larger stock markets could be particularly supportive to economic growth. Depending on criteria and circumstances, studies highlight advantages of both bank-based and market-based financial systems. Analogously to firm-level choices where the optimal financial structure depends on the firm's characteristics, the optimal financial structure for a country depends on country-specific factors (see Chapter 6). In addition, studies show that economies at different stages of economic development require different mixtures of financial services to operate effectively. For example, as economies develop, the marginal gain in economic activity associated with an increase in bank intermediation becomes smaller, while the marginal impact associated with a further development of capital markets increases. When it comes to moderating business cycle fluctuations, the influence of bank lending and capital markets differs considerably. In downturns that are not accompanied by financial tensions, healthy banks are the key element to help cushion shocks. But when recessions coincide with financial crises, bank-oriented economies tend to suffer more than market-oriented ones. Some studies show that market-based economies recover faster than bank-based economies even after controlling for the origin of the recession, the policy response, and the degree of economic flexibility. Accordingly, heavy leaning towards banks constraints the pace of economic rebound, making a diversified system indispensable to cushion economic shocks. The optimal financial structure shifts towards capital markets along with higher levels of economic development. Banks are particularly well-placed to serve economies at an early stage of development because foreign bank entry allows for a swift growth of the banking system, hence providing a broader access to financing. They also have an uncontested role in certain market segments, for example to provide funding to firms that are too small to tap market sources. Capital markets take longer to develop because they require extensive technical and legal infrastructures (e.g. clearing, settlement, information provision). Services provided by financial markets become comparatively more important for high-income countries because, when economic and institutional systems mature, demand for a broader set of risk management and capital-raising tools increases beyond what banks can typically supply. Table 1: Selected empirical estimates of the impact of financial development on economic growth Study Method and data Findings King and Levine (1993a, 1993b) Economic growth rates are related to measures of lagged financial development in 80 countries. Indicators of economic performance are positively associated with the size of the financial sector at the beginning of the sample period. Rousseau and Wachtel (2011) Cross sectional and panel data on financial and macroeconomic indicators for 84 countries over the period 1960-2004. Positive correlation of financial size with economic growth disappears when concentrating on the period since 1990. In order to have positive effects on growth, financial deepening needs to be accompanied by appropriate financial sector policies. Pagano and Pica (2012) Growth regressions by Rajan-Zingales (1998) are re-estimated using UNIDO data for annual value added for 28 industries and 63 countries from 1970 to 2003. Financial development increases employment, labour productivity and wages. The impact is stronger at low levels of financial development. Beyond a certain point, financial development does not contribute significantly to real economic activity. Arcand, Berkes and Panizza (2012) Analysis according to the set-up described in Beck and Levine (2004). Data covers the period 1960-2010 The relationship between credit to the private sector and growth is concave and non-monotone. Finance starts having a negative effect on growth when credit to the private sector reaches 100% of GDP. Cecchetti and Kharroubi (2012) Panel regressions on a sample of 50 advanced and emerging countries over the period 1980–2009. The level of financial development is good only up to a point, after which it becomes a drag on growth. For private credit extended by banks, the turning point is closer to 90% of GDP, lower than for market-based credit. Demirgüç-Kunt and Levine (2011) Quantile regressions are used to assess the sensitivity of economic activity to both bank and securities market development. Data on 72 countries, over the period 1980-2008. The sensitivity of economic development to changes in bank development decreases with economic development. The sensitivity of economic development to changes in securities market increases as countries grow. The demand for the services provided by securities markets increases relative to the demand for services provided by banks as economies develop. Langfield and Pagano (2015) Panel regressions with fixed effects and year dummies. Dataset contains 748 observations for 45 countries between 1988 and 2011. Bank bias is negatively correlated with GDP growth, such that an increase in the size of the banking sector relative to stock and bond market capitalization is associated with lower GDP growth. Cournède and Denk (2015) Growth regressions on data for OECD and G20 countries between 1961 and 2011. The composition of finance matters for growth. Credit expansion to the private sector slows growth in most OECD countries, but greater stock market capitalisation exhibits a highly significant link with stronger GDP growth. Box 1: CMU, transaction costs and the theory of the firm A number of theoretical approaches discussed the role of banks versus markets in the intermediation of savings to investments. The debate roots in a wider theory about the role of firms and markets in economics with the key initial contribution by Coase (1937). He recognised that the use of markets is not costless and in some cases transaction costs are lower if exchange is organised within firms. These transaction costs include search and information costs, bargaining and decision costs, and monitoring and enforcement costs. New institutional economics, for example Williamson (1985) used the concept of transaction costs to explain the existence of institutions. Transaction costs are particularly important for credit contracts beause the lender needs to be sure that the borrower pays back, but the former has an information disadvantage with respect to the choices the borrower may take, opening scope for moral hazard of the latter. Banks can ease the impact of information asymmetries and thus help reduce transaction costs in financial exchanges. For example, Leland and Pyle (1977) formally show that a bank can communicate information to investors about potential borrowers at a lower cost than individual borrowers. In their model, intermediaries can solve moral hazard problems by monitoring the actions of firms. Diamond (1984) shows that the costs of monitoring and enforcing debt contracts issued directly to investors is the reason why raising funds through an intermediary, acting as a delegated monitor, can be superior. Overall, the theory postulates that financial intermediaries play an important role in reducing information and transaction costs arising from information asymmetries, even if their existence does not replicate the credit market outcomes that would occur under a full information environment. A further optimisation of information structures and determinants of information costs and other transaction costs will further help overcome credit frictions. Relative advantages of bank-based and market-based funding systems

Those arguing for the superiority of bank-based financial systems emphasise the advantages of banks in information gathering and relationship formation, as well as in financing standardized, lower-risk and well-collateralised projects. Given the economies of scale and scope in information gathering and processing, banks are in a better position than capital markets to address the inherent agency problems between debtors and creditors. A large literature has been devoted to understanding the special role played by banks in acquiring information about borrowers and in mitigating asymmetric information problems. The long-term relationship with a bank allows a firm to develop a reputation for good creditworthiness and ultimately to access finance at a lower cost (the "certification effect"). Even if other agents (such as credit rating agencies) may assume a similar function, it is argued that banks have an advantage in this regard due to the special knowledge they acquire from performing complementary functions on a large scale (e.g. account keeping of borrowers, provision of payment instruments). Market-based systems are more transparent as they reveal information publicly, thereby reducing incentives for investors to seek and acquire information. As a result, information asymmetries related to the debtor-creditor relationship are more accentuated in market-based than in bank-based structures. Proponents of market-based systems point to the strength of capital markets in providing services to finance novel, longer-duration and high-risk projects. It is also often pointed out that non-bank finance is generally more flexible than bank finance (e.g. as regards repayment schedules or providing finance based on expected future earnings). Therefore, by not merely substituting for investment that was previously funded by banks, but enabling additional investment that banks would not be ready to fund, capital markets enlarge the potential investor base. This is possible because capital markets treat risk differently from banks. While banks do not only intermediate between depositors and borrowers but also typically take up themselves a major part of the risk, capital markets bring investors and those in need of funding directly together, transferring a higher share of the risk to investors. Dividing investment opportunities into numerous small-denomination securities allows capital markets to create a diverse menu of investment options at higher or lower risk, short-term or long-term, and allocate those according to investor type. Consequently, even risky projects get matched with appropriate investor types and so find the needed funding. The described process facilitates direct financial interactions between households, corporations, banks and governments, thereby filling in gaps where banks are constrained to lend. Banks and capital markets have a differential impact on incentive formation through various channels. First, as they are decentralised and more diversified by nature, market-based systems are considered less susceptible to the development of monopoly and oligopoly powers. In such a scenario of collusion between a bank and firm managers against other creditors, high-collateral and low-productivity projects may be fostered, crowding out productive resources from the economy. In such a situation, the development of capital markets could provide additional disciplining forces to credit decisions and thereby increase the efficiency of asset allocation. Second, economic theory postulates that well-functioning capital markets can act as a disciplining device on managers and thereby enhance corporate governance. In banking, corporate governance is complicated by the existence of deposit guarantee schemes, lender of last resort facilities, and potential state implicit subsidies. The introduction of the Bank Recovery and Resolution Directive and the Banking Union package should reduce perceived implicit and explicit public guarantees for banks. Studies examining the role of market takeovers as corporate control devices also conclude in favour of market-based financial systems. The threat of an acquisition, which is easier to realise with well-developed stock markets, helps align managerial incentives with those of the owners. Competition or complementary? The conventional “bank versus market” dichotomy suggests that the two components are in clear competition. If true, the development of the two would be a zero-sum game and each segment would develop at the expense of the other. But more recent studies propose an integrated theoretical framework, where banks and capital markets not only compete for servicing a limited pool of investment projects, but also co-evolve. Complementarities between banks and capital markets are becoming more and more apparent, broadening the set of financing sources the ultimate borrower can choose from. Bank and market funding offer different mechanisms to overcome information problems such as adverse selection and moral hazard. The banks' capacity to select and monitor credit risk can also be separated from the provision of funding. Such complementarities are easy to notice in scenarios where a firm is contemplating either bonds issuance or bank credit. No matter which financial instrument is chosen, both banking and non-banking financial institutions may get directly or indirectly involved in the transaction, i.e. banks manage the issuance of bonds on behalf of the firm, or if they provide funding in form of a loan resell it on the market as part of a securitised product. Box 2: Information frictions and incentives for long-term investments In microeconomic analysis, financial issues are predominantly driven by information frictions, such as asymmetric information (see also Box 4) between creditor and debtor before agreeing on a contract or incentives to exploit leeway left open in the contractual terms to their advantage later on (moral hazard). Banks and markets offer means to deal with different information frictions. Markets help to deal with diverse opinions. They imply interaction among many actors, who may have very different views, and the price can be seen as a mechanism to aggregate diverse information. The interaction also allows suppliers of exotic goods to find buyers. The economic function of competition on capital markets among buyers and sellers is hence not limited to the discovery of market clearing prices for financial assets, but also to detect innovative firms and products. Conversely, involvement of banks has advantages over market funding in the unearthing of information if the evaluation of the credit risk is complex and requires the creditor to build up special expertise. Moreover, getting financial support from a bank often means building a long-term customer relationship, which can be useful in case of information frictions and when one needs to monitor and control the borrower. While financial support from a bank to a debtor may facilitate the establishment of a long-term financing relationship, market financing must not necessarily be more short-term. A number of institutional investors, such as insurance companies and pension funds, have long-term liabilities and should therefore be natural long-term investors. The Kay Review (2012) demonstrated that short-termism is an issue in the asset management industry. Behind this are governance and information problems that are more related to how capital markets are organised in practice than with the principle of market transactions. The relationship between ultimate savers and institutional investors is subject to principle-agent problems that can give rise to a myopic behaviour of the latter. For example, if the ultimate holders of investments use short-term performance indicators to monitor asset managers or formulate short-term targets in investment mandates, then asset managers have an incentive to favor short-term profits over long-term profitability. This effect will be augmented if part of the managers' remuneration depends on short-term performance indicators. The Kay Review recommended discouraging the use of measures and models that rely on short-term volatility of returns and deviations from indexes when deciding on the remuneration of asset managers. A better alignment of long-term interests between institutional investors and asset managers would contribute to a longer-term focus in investment strategies, notably taking into consideration risks and opportunities associated with challenges related to the environment, climate change and the energy sector. It could also lead to more investment into equity, as "perpetual" equity is considered to better support the financing of long-term investment. Myopic investment horizons may also be the result of information limitations. While there is a wealth of data available to support investment decisions, its translation into relevant information is often not straightforward. Using price signals or other investors' decisions as proxies for own information gathering efforts bears the risk of herd behaviour and procyclicality on capital markets. The Kay Review recommended that the regulatory framework enables "companies, savers and intermediaries to adopt investment approaches which achieve long-term returns by supporting and challenging corporate decisions in pursuit of long-term value." Long-term investment is subject to long-term risks, for example climate change could significanty erode the value of some financial assets. Therefore, decision-making would also benefit from the disclosure and reporting of environmental and climate, social and governance (ESG) risk exposures. Integration of ESG issues in investment strategies, besides supporting climate friendly and sustainable investment opportunities, can contribute to investors' protection against long-term risks, in line with asset managers' fiduciary duties. There are many areas where markets and banks offer complementary information and funding services, among them: (i) issuance of bonds, where banks provide a number of advisory and administrative services for the issuer; (ii) securitisation, where banks focus on credit analysis and markets focus on financing; and (iii) bank capital, where capital markets reduce the financing friction by lowering banks’ cost of equity, and enable banks to raise additional equity to expand their lending scope. At the same time, banks' expansion and improvement in credit analysis tend to boost investors' confidence, encourage investor participation in capital markets and spur capital markets evolution. Both the banking and capital markets' channels lead to feedback loops where each of the two components of the financial system benefits from the development of the other. The shift of banks from their traditional relationship-oriented business model towards a more transaction-oriented business model over the last decades underscores the strong links between banks and capital markets. Until 1980, banking was predominantly based on long-term relationships with bank customers: loans were granted to households and firms for a long term and were kept on the balance sheet for their entire duration. The interests of the bank and the customer were thus clearly aligned as bank performance was closely related to the performance of its customers. The return on equity in this period was relatively modest but stable and balance sheets grew moderately with respect to the growth of the economy. As of 1980, however, and even more so as of 2000 in the run-up to the crisis, transaction-oriented banking became prominent, putting a larger focus on the short term. Banks' balance sheets expanded rapidly following innovations such as securitisation and returns on equity increased, leading to a lengthening of the intermediation chain (in which banks start to play different and increasingly important roles). In conclusion, the recent economic theory emphasises the desirability of well-developed capital markets but pays less attention to the respective importance of capital market and bank funding. The distinction between bank-based and market-based financial systems seems to be fading while greater emphasis is put on their complementarity. Quite simply, it turns out that banks and capital markets are two vital components of the financial system, not competing but complementing each other and co-evolving. 2.2. Historical, legal and economic structures as barriers for capital markets development Financial structures do not evolve independently from historical, legal and economic structures. This section investigates factors that seem to have led to a bank-dominated financial system in the EU. The comparison with the more market-based system in the US suggests that some of these factors are exogenous at first sight: different historical starting conditions, as well as differences in legal system and type of pension systems, for instance. In the EU, they shape firms' preferences for bank loans as they are more used to relationship based services as to transaction based services. And they give reason to households' incentive to save in bank deposits, which are considered safe as protected by public guarantees, most apparent in deposit guarantee schemes. While these factors limit the scope for the EU financial structure to converge to the US financial structure, they must not mean that the contribution of capital markets to economic activity has no potential to develop, especially when legal determinants are made more supportive to market funding. In the end, legal, economic and financial structures are mutually dependent on each other. Differences in legal systems have been an important factor in the development of financial systems. Using various indicators of legal differences across countries, studies found that legal origin (US-English common law, French-Latin civil law, German, Scandinavian) and especially variables that cover investor protection are having a significant influence on the size and structure of financial systems. Capital markets are more developed in countries with a common law tradition and/or where rules that protect borrowers from expropriation by creditors and controlling owners and enforcement of legal rules are stronger. The World Bank's Doing Business Report provides indicators of business regulations in 189 economies including almost all EU Member States. The report shows that the scoring of Member States is very different. National performances widely differ in terms of business information disclosure, conflicts of interests, corporate transparency, minority investor protection, tax rates, recovery rates, contract enforcement costs, strength of insolvency frameworks, length of resolving insolvency, etc. Interestingly, some new Member States with still small capital markets are well placed with respect to some of the legal determinants that are favourable to capital market developments: Bulgaria, Cyprus and Slovenia are in the global top 20 with respect to the World Bank's protecting minority investors index, as are Lithuania and Latvia with respect to the enforcing contracts index. Over time, internationalisation of financial markets and convergence of legal rules that govern financial activity at an international and EU levels should lead differences in national financial systems to dissipate. Source: World Bank.

Starting conditions have shaped differences in financial structures and may explain why capital markets took different sizes. Economic research on the role of historical factors in explaining economic institutions stipulates that starting conditions can be essential and may determine the path of economic development over long time. Since institutions change slowly, there is scope for inertia, i.e. economic structures reflect historical conditions, but may no longer be ideal with a view to current ones. A number of observations are consistent with the hypothesis that structural differences in the EU and the US financial system could be caused by different starting positions: prior to industrialisation, merchant banks had an important role in financing cross-border trade in Europe and were established financial institutions. Since the late 18th century, savings banks have popularised bank accounts as means for ordinary household to store financial wealth. The significant role of banks may have reduced the need and interest to develop capital markets in many European countries. In the US, banks came into existence only at the end of the 18th century. The need to attract foreign investors to fund high US public debt in the early 19th century seems to have fostered the development of securities markets in the US early on. Historical disasters deepened differences in financial developments in the 20th century. While starting conditions for the development of the financial structures have been different in Europe and the US, there were also a number of events in the 20th century that are often quoted to explain why capital markets are more developed in the US. Thriving economic growth fuelled demand for market funding from the late 19th century in the US, and the Great Depression led the country to initiate a package of financial reforms that seemed to have discouraged banking activity, possibly to the advantage of capital markets. For example, the Glass-Steagall Act separated investment and commercial banking in 1931. The Bank Holding Company Act of 1956 impeded inter-state banking. Meanwhile, in Europe, the accumulation of financial capital was interrupted by World War I and hyperinflation in some countries. Private financial wealth evaporated in many European countries and substantially reduced the stock of capital available to be allocated on capital markets. After World War II, many European countries rebuilt their pension system by establishing a pay-as-you-go system, whereas pension funds became an important provider of funds on the US capital market. This led to significant differences in the amount of savings made available for investment in financial securities. Still nowadays, countries with an important pension funds sector tend to have larger capital markets. Several major policy initiatives have paved the way to greater financial integration in the EU. The Treaty of Rome enshrined the freedom of movement of capital and freedom of cross-border services in 1957. However, decisive steps towards the integration of EU financial markets were taken only by the mid-1980s with the adoption of a White Paper on the completion of the internal market. The launch of the euro and the Financial Services Action Plan were major milestones in this integration process in 1999. They aimed at tackling obstacles to integration stemming from currency and regulatory segmentation. Following the EMU and the FSAP, conditions were in place for a greater consolidation and internationalisation of the EU banking sector. Mergers and acquisitions activity intensified, first among domestic institutions and then across borders. Western European banks notably acquired market share in most of the Central and Eastern European Member States. As a result of their expansion within Europe, European banks were, by 2007, significantly more internationalised than US, Japanese or Chinese banks. Meanwhile, capital market infrastructures remained geographically more fragmented. They provide the technical habitat for trading, clearing and settlement operations (see Section 5.4). Transparency, liquidity, price formation, information disclosure and data collection capabilities crucially depend on the existing market infrastructures. In the EU, different trading systems and platforms without interconnections have formed an obstacle to more efficient price formation mechanisms and to the availability of standardised data, notably in debt markets. The economic effect of global financial integration materialised across EU Member States in different forms. Most visible has been the rise of financial centres in some, mainly larger Member States with more developed capital markets. Member States with a less developed financial system had large scope to catch up, but this materialised less in the form of strong growth of the country's financial industry. Instead, companies benefitted from remote access to capital markets in other Member States, for example through corporates issuing stocks on foreign stock exchanges. Convergence of framework conditions also allowed foreign investors to access smaller capital markets, for example foreign venture capital funds to invest in small firms in small Member States with less developed domestic capital markets. However, this effect has been of lesser importance for reasons set out at different places in this document. In conclusion, underdeveloped capital markets may have been the cause of reigning legal structures and historical development, and also reflect institutional inertia. Since banks were dominant providers of finance, the need to develop legal conditions supportive to capital markets as a complement was less pressing. Hence, strengthening the rights of investors or minority shareholders was a lower priority because capital market instruments were underused. There is likely a self-reinforcing process between economic and financial structures: industries that are better served by bank funding, such as established firms with capital-intensive production and collateral tend to flourish more in bank-dominated financial systems, which results in a bias in industrial structures towards bank-dependent firms and more demand for bank services than for market funding. 2.3 Financial stability and macro-prudential policy oversight for a stronger CMU Financial stability is a pre-requisite for delivering sustainable growth and jobs in the EU. Episodes of financial instability have historically been associated with considerable economic costs, and the global financial crisis revealed that a stable financial system is necessary for delivering sustainable growth. To this end, the EU's legal and institutional framework of financial regulation has been extensively recalibrated in recent years so as to ensure that the financial system is more resilient to shocks. Important financial reforms introduced enhanced prudential regulation of capital and liquidity requirements for banks, reflecting the need for stronger oversight of deposit-taking institutions and systemic banks. The CMU should help to enhance financial stability in the EU by promoting more diversified funding channels to the wider economy. In doing so, it will help address possible future risks stemming from a strong reliance on bank lending and intermediation in the financial system. Given the central role of banks in the financial system including for market-based finance – as originators of risk, facilitators/intermediaries, as well as investors – the already undertaken financial reforms will have important positive effects for financial stability under the CMU. Additional macro-financial stabilising effects are expected to materialise as a consequence of the availability of broader sources of funding for productive investment in the EU, helping to avoid constraints to the supply of credit to the economy similar to those that emerged during the crisis amid strong bank deleveraging pressures. This highlights the complementarity of direct and indirect credit intermediation under the CMU, with positive effects stemming from the availability of more diversified sources of debt and equity finance for borrowers in the EU, greater risk-sharing and a more sustainable and smoother credit supply through the cycle. At the same time, it is important to ensure that the further development of capital markets does not allow other systemic vulnerabilities to accumulate unchecked. While the banking business is, due to maturity transformation and its role in the money creation process and in the payment system, subject to potential systemic risks, non-bank financial institutions can also be vulnerable to runs, which may lead to considerable financial losses for their shareholders, debtors or other counterparts. A more market-based financial system, involving increased direct investor exposures to risk, could be more vulnerable to episodes of volatility. In the event of a sudden re-pricing of risk, contagion can propagate across markets and financial institutions through balance sheet and collateral channels. A higher exposure of financial market participants to volatility in market prices, for example, can feed into higher risk premia and thus lead to increases in the cost of capital for companies and financial losses for households. Thus, financial instability can adversely affect economic activity even when it does not result in systemic shocks. Two sources of potential systemic vulnerability can be identified in a more market-based financial system: possibly greater interconnectedness and growing intermediation by entities outside the regulatory perimeter. First, while well-functioning markets support risk-sharing in the economy, the price discovery process also entails externalities for other holders of the same type of asset. Greater interconnectedness can lead to higher asset price correlations, which can reduce portfolio diversification benefits for investors. These effects can create a vicious cycle in times of broad-based sell-offs in markets with potential systemic implications. A second potential source of vulnerability is that activities gradually shift from more closely supervised and/or strongly regulated areas to less supervised and regulated ones. This could be conducive to a situation in which the ultimate risk-takers are taking more risks than they can eventually bear. Against this background, concerns have been voiced that the CMU project might lead to a further risk transfer from the more heavily regulated banking sector to less regulated areas, commonly referred to by the terms 'shadow banking', and more recently, market-based finance. The European Commission approach to market-based finance is to deliver transparent and resilient market-based financing while tackling major financial risks. The financial reforms already put in place, such as the introduction of an EU regulatory framework for alternative investment funds, including hedge funds and private equity in the Alternative Investment Fund Managers Directive, are important in this respect. Furthermore, and in line with the FSB's 2013 recommendation to address the risks inherent to securities lending and repurchase agreements, the recently agreed Securities Financing Transactions regulation will ensure that the necessary information on these transactions is reported to trade repositories and investors in collective investment undertakings. The development of the CMU should be accompanied by appropriate oversight for the financial system as a whole. In recent years substantial efforts have been undertaken at European and global levels to define, monitor and regulate market-based finance activities and the entities engaged in them. As the CMU takes shape, analysis will be undertaken to determine the continued appropriateness of measures and instruments available to address possible macro-prudential risks stemming from more market-based finance. In that regard, work is already ongoing internally in the European Commission and within the European Systemic Risk Board to assess issues concerning market liquidity and interconnectedness within the financial system, and certain intermediation activities undertaken by non-banks. Given the strong inter-linkages within financial markets and across sectors, micro-prudential supervision seems not sufficient. The main objective of the essential complementary macro-prudential oversight is to identify potential weaknesses in the structure and/or the cyclical dynamic of the system, and address them through well-targeted instruments and policy actions where necessary and justified. In addition to strong micro- and macro-prudential supervision and oversight, a well-functioning CMU requires appropriate consumer and investor protection rules. A more market-based financial system relies on greater participation by both institutional and retail investors and necessitates that the ultimate risk-bearers are well equipped to independently evaluate and price risk. While this is equally relevant for individual and institutional investors, retail investors face particular difficulties in assessing risks and making informed investment decisions, given the associated cost in assessing some partly opaque and complex financial products. An important cause behind this are information asymmetries in favour of originators and distributors, rendering the full utility or return from these products difficult for consumers to ascertain until their final maturity (so-called 'credence goods'). Thus, appropriate investor protection is needed for enhancing and sustaining consumer and investor confidence. The European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) have already been given increased powers on investor protection through MiFID II, PRIIPS, the Short selling Regulation and other legislative acts. Chapter 3FINANCING NEEDS BY THE EUROPEAN CORPORATE SECTOR AND INFRASTRUCTURE This chapter analyses the financing needs of European firms and infrastructures. Section 3.1 describes ways in which these needs can be filled and lists the company's characteristics that determine its access to funding. Section 3.2 focuses on the particularities of SMEs, which are important for the European economy but face considerable funding restrictions. Section 3.3 explains the consequences stemming from the lack of verifiable information about SMEs and from the limited financial knowledge by SMEs. Barriers preventing companies from going public, such as high costs and insufficient investment research coverage, are discussed in Section 3.4. Private placements are shown as a useful supplement and gateway towards public corporate bond issuance. Section 3.5 analyses various corporate liability structures and explains risks stemming from excessive company indebtedness. The specificity of infrastructure investment and related funding problems are described in Section 3.6. 3.1 Theory on businesses' access to funding In order to develop their business and grow, companies get finance through internal or external funding. The latter term is used to describe funds that firms obtain from outside of the firm, such as debt or equity issues, contrary to internal financing which consists mainly of initial own resources and profits retained by the firm for investment. The pioneering work by Modigliani and Miller (1958) suggests that the capital structure of a company has no impact on its value when markets are perfect and frictionless. However, many capital markets are characterised by information asymmetries, and studies show that capital market imperfections make financing decisions relevant. For a given level of risk, external financing is typically more costly than internal financing due to the additional transaction costs and a premium, which compensates outside investors for the lack of knowledge of a company’s true creditworthiness or prospects. In consequence, firms financing decisions are strongly determined by information problems. In corporate finance, the pecking order theory highlights the role of asymmetric information in determining the cost of financing. As depicted in the funding escalator model of corporate finance, a company's financing needs depend on various factors. In particular, variables such as its stage of development, growth objectives, innovativeness, sector of operation, and attitudes towards risk determine its financing needs. In the start-up phase, a company needs money to develop its business idea. Given the typical absence of retained earnings at this stage, the firm primarily sources funding externally, often from friends and family members for small companies. Although retained earnings increase when a company is successful and grows, a firm's external financing stays typically high in the growth stage with the main sources being bank funding, peer-to-business lending and/or private equity (especially in the form of venture capital). Once the firm enters the mature stage, financing structures adjust to the pace of earnings, a firm's growth and the collateral at disposal. At a certain point, the company may decide to go public, offering its stock to the general public on a security exchange as a means of equity financing and/or issuing bonds. Finally, in a declining phase, once new projects become scarce, funding needs become lower. If a firm cannot or does not want to put all retained earnings to profitable productive use, it may decide to buy back its debt or equity. While the exact funding needs differ across a company's lifecycle, external funding features prominently in all stages of a firm's development either for basic maintenance or for investment and growth.

Source: European Commission. Companies face financing constraints. These constraints affect firms' investment decisions and growth prospects, and need to be addressed by appropriate policy action. Among other factors, the weak macroeconomic environment has caused corrections in financial markets and restricted the availability of external funding. The global financial crisis, followed by the euro area sovereign debt crisis, affected European businesses via multiple economic and financial channels and led to a global recession. But the negative effects have been uneven across countries, sectors and companies. Both a company's characteristics and external factors are important determinants of its access to financing. The funding escalator model already highlighted the importance of the company’s stage of development. It is also harder to access finance for firms operating in countries whose regulatory environment is considered risky, burdensome or overly expensive due to extensive bureaucracy. Access to financing is also easier for firms that are able to resort to foreign capital markets, such as firms that are part of a multinational group. More available company data allows the development of better measures for the presence of financing constraints. Empirical evidence suggests that financing constraints are widespread and particularly affect smaller, younger, or single-unit firms. Their business prospects are more difficult to evaluate for investors, they are perceived as riskier because they are less diversified, and they are often not in the possession of collateral. Since the onset of the financial crisis, European companies and in particular SMEs have been facing a more difficult access to funding, reflected by both quantity and price restrictions. Some of the reasons have been cyclical, such as the deep recession, leading to higher credit risk and lower profitability. Other reasons have been firm-specific, such as poor credit standing, insufficient profitability, lack of viable business plans or operating in industries in need of restructuring. At the same time, some supply frictions have also weighed on the amount of financing granted: the financial crisis has aggravated funding conditions because sources of short and long-term financing have been affected by liquidity problems and increased risk aversion in the banking sector. Moreover, rising sovereign risk premia led to higher interest rates on lending to the private sector in crisis-ridden countries. Rising late payments by the public sector to its suppliers have further weighed on the funding situation of SMEs in vulnerable countries. Consequently, SMEs operating in some Member States have become disadvantaged in relation to their peers in the rest of the EU. 3.2 Do European SMEs lack funding? Despite some stabilisation of the SME sector in Europe following the global financial and euro area sovereign debt crises, funding constraints remain a concern. The 2014 survey on the access to finance of enterprises in the euro area (SAFE) shows that small businesses are getting increasingly optimistic about their growth prospects, but it also shows that many profitable and solvent SMEs remain concerned about their access to finance. More than a third of SMEs surveyed did not manage to get the full bank loan financing they applied for, with particular problems reported by micro enterprises. Perceptions also differed across countries. 34% of the SMEs in Greece, 15% in Ireland and 15% in the Netherlands named access to finance as their most important problem, compared with only 7% in Germany and Austria. According to the Organisation for Economic Co-operation and Development (OECD) , many SMEs in Europe could use additional funds productively, but cannot obtain these from the financial system. In a previous edition of the report, the OECD noted that securing suitable financing constitutes a problem especially for innovative SMEs whose technology and business models are not supported by many traditional financial institutions. The results of the European Commission's Innobarometer survey confirm that access to funding is a key obstacle for spurring R&D and the commercialisation of innovative products or services. Market analysis reveals that Europe has a smaller pool of non-bank funding available for investment by SMEs than the US, though the size of both economies is similar. Barriers to funding faced by small and innovative companies have notable economic implications. More than 99% of all European businesses in the non-financial sector are SMEs. Combined, they provide two thirds of private-sector jobs, contribute to more than half of the total value added created by business activity in Europe, and are crucial for income and growth in the EU. At the same time, economic research considers innovation a crucial driver of long-term productivity and economic growth. Countries which are able to generate innovation and to adopt new technologies grow faster. At the current juncture, where many companies need to restructure following the protracted recession, there is a particular need to support innovative, growth-enhancing, while risky, investment. Smaller firms are more constrained in receiving external funding because of their high sensitivity to economic cycles and shocks, which is in turn due to greater sectoral and geographical specialization. This disadvantage is reflected in higher interest rates on small loans when compared to large loans as well as in other forms of credit constraints. A comparison of the average cost of loans in Europe (see chart) shows a significant gap between lending to SMEs and to large firms. In addition, unlike large corporations, small companies have limited access to capital markets and thus remain disproportionally reliant on banks. The smaller a firm, the more restricted the spectrum of potential non-bank funding options (see table). Alternative sources of financing are shown to be accessible only to larger firms, firms having high credit ratings, and firms located in countries with better developed financial markets. Table 2: Use of financing instruments by non-financial corporations (percentage averages out of total sample over 2009-2014) Micro Small Medium Large Retained earnings 24 30 38 46 Grants/subsidised loans 12 16 20 22 Bank overdrafts 38 43 40 42 Bank loans 28 39 43 48 Trade credit 26 30 35 38 Other loans 9 12 19 28 Leasing 19 40 50 56 Debt securities 1 1 1 4 Mezzanine 1 2 4 6 Equity 4 6 8 9 Sources: ECB and European Commission Survey on the access to finance of enterprises. SMEs' dependence on bank lending is often rooted in long-standing client relationship. The comparative advantage of banks in acquiring information, as discussed earlier, is particularly relevant for SME financing. A study conducted in the UK finds that over half of the SMEs seeking finance and eligible for bank funding go to their main bank. More than two-thirds of SMEs approach only one bank and do not shop around for better offers if financing is granted. This is possibly because SMEs, once a workable relationship with a bank has been developed, see little value in devoting too much resources into financial enquiry, an activity that they usually do not consider their core business. Investments in novel, longer-term projects, such as in the area of research and development, carry higher credit risk. Innovative companies often lack collateral that could be used to obtain credit, as investments in research and development typically mostly translate into intangibles assets, which are difficult to value. At the same time, banks need to comply with risk-based capital requirements and thus can allocate only a limited share of credit to riskier projects. As a consequence, some innovative, but risky, investment opportunities may remain unfunded in financial systems relying exclusively on banks. The SME credit gap was estimated at USD 1.5 trillion globally in 2011 – a third of it being in high-income OECD countries.

SME funding can be increased by supplementing banks with non-bank finance providers that have expertise in identifying risky projects. While banks intermediate between depositors and borrowers and at the same time take part of the risk themselves, capital markets directly link savers and investees. The inherent diversity of views and risk preferences present on capital markets makes it possible even for risky projects to get matched with appropriate investors. Hence, the more diverse nature of capital market funding is suitable not only for well-defined and predictable business projects, but also for risky and innovative endeavours. There are various ways in which funding is provided beyond bank lending (see Chart 11). Leasing, factoring and various forms of trade and supply chain finance are capable of easing corporate financial problems, but are usually more expensive than bank loans. Loans by non-banks, including crowdfunding and peer-to-business platforms, are other potential sources of finance but are underdeveloped to date, even if they often carry lower borrowing costs than bank loans. Still another source of alternative finance, particularly suited for fast-growing firms, is private equity. Depending on the size of the investment and the stage of a company's growth, equity can be raised through family and friends, crowdfunding, business angels, venture capital, and, when a company matures, listing on a stock exchange. Note. When outstanding volumes were not available, turnover or cumulative issuance was issued as a proxy. Source: Factors Chain International, EVCA, Leaseurope, Massolution, IKB Deutsche Industriebank, C/M/S Bureau Francis Lefebvre and own calculations. So far, external equity funding for SMEs is rather limited in Europe. Private equity, a key source of funding for companies in a growing phase was significantly hit by the financial crisis, with funds raised dropping from over EUR 100 billion in 2006 to less than EUR 20 billion in 2009 (see Chart 12). Business volumes recovered in recent years, and fundraising by European private equity investors reached EUR 45 billion in 2014. Yet, net funds raised were only EUR 6 billion in 2014. Notes: Data include venture capital. Funds raised: gross increases of liabilities. Investments: use of liquidity to purchase equity. Source: EVCA 2014 European Private Equity Activity. Business angel investment, which refers to private individuals offering financial support and other operational counsel to start-ups, also faced difficulties during the crisis. While banks have been unable or unwilling to provide loans to young and innovative start-ups, angel investors, acting either individually or through groups, syndicates or networks, have also become more risk adverse and have focused on later stage investments. Available figures suggest that the amounts invested by business angels in the EU remain small and highly concentrated. The statistics by the European Trade Association for Business Angels, Seed Funds and Early Stage Market Players (EBAN) show that business angels' outstanding investment in the EU amounted to EUR 5.5 billion in 2013, of which a large part is undertaken in the invisible market. More than half of the annual investment by business angels was estimated to be directed to the UK, Spain or France. Venture capital, which can be a key funding source for growing companies, is usually invested through funds, often provided by institutional investors. With a market volume of EUR 3.6 billion in 2014, venture capital is particularly important for financing innovative companies. It can in particular play a determining role in stimulating entrepreneurship, supporting young companies and replacing or complementing traditional bank finance. Start-up stage investment represents the major part of venture capital activity. Companies active in growing business sectors such as life sciences, communications and electronics attract the majority of the available funds. Academic literature argues that venture capital spurs innovation by relaxing financing constraints that innovative firms face due to asymmetric information and moral hazard problems. Business experience and research confirm that companies backed by venture capital are more likely to create patents, have high productivity and are competitive. The impact of venture capital investment on productivity growth has also been studied and shows that enterprises backed by venture capital are more competitive than others, feature higher individuality of their products and have better technologies. Overall, economic analysis shows that venture capital investment enhances productivity growth. Despite positive effects on economic growth, venture capital constitutes a small part of total SME external financing. For most world economies, venture capital represents a negligible percentage of GDP, i.e. often less than 0.03%. Its presence is greater in Israel and the United States, where the venture capital industry is more mature. It represented in 2012 around 0.4% and 0.17% of GDP respectively. By contrast, venture capital investments expressed as a percentage of GDP did not exceed 0.1%. in any EU country. In 2013, venture capital firms invested only EUR 5 billion in Europe, an amount significantly lower than the EUR 26 billion invested in the US. The financial crisis has severely affected the venture capital industry worldwide. In 2012, the level of venture capital investments was around 60% of 2007 levels in most developed countries. In spite of signs of recovery, total venture capital investments in Europe remain at around half their pre-crisis peak whereas in the US venture investments surpassed their pre-crisis peak in 2013. This means that the recovery in Europe is progressing sluggishly, with venture capital investment growing by only 6% in 2014 compared to 2013. This slow growth dynamics highlights the limited potential for a more radical expansion without policy intervention. Moreover, the number of companies backed by venture capital is similar to the level registered in 2007, indicating that the average size of the investment in individual companies in Europe has lowered over the last years. Currently, approximately 3200 European companies are venture-backed. Other estimates show that the venture capital market is only 12% of what it would be if it were as deep as in the US. If only half of the mentioned gap was closed, an additional EUR 25 billion could be raised every year to finance investment. The main obstacles to the development of venture capital investment are market fragmentation and constraints on the supply side of the market. European venture capital investors have difficulties with reaching critical size and sufficient diversification in their portfolios. Three quarters of venture capital funds were in 2014 smaller than EUR 82 million and only 20% of funds had raised more than EUR 100 million over the last six years. Moreover, the activity is concentrated in a few Member States, such as the UK and France. Larger venture capital funds would be able to realise scale economies, specialize and thus possibly attract additional capital commitments for individual companies. However, the high degree of fragmentation along national lines limits the growth of the market and prevents economies of scale from materializing, which implies relatively high transaction costs. On the supply side of the market, private institutional investors such as pension funds, funds of funds, banks and insurance companies have traditionally been important sources of funds for venture capital investment. However, regulatory or self-imposed constraints on their asset allocation may prevent institutional investors from scaling up their investments in this asset class. The small size and fragmentation of European venture capital funds represent additional barriers to investment by institutional investors. Moreover, since venture capital funds use equity issuance to exit from their investment, the declining liquidity on equity markets is an important deterrent to venture capital investment. National business growth funds and related private- or public-led consortia can help pool funding resources and thus unlock the potential of fast-growing businesses. By pooling funds, large-scale investment projects could more easily be funded. In particular, allocating public financial resources to a pan-European Fund-of-Funds programme could help attract more private capital back to venture capital, particularly from non-EU sources. A Fund of Funds could act as a useful intermediary bridging the gap between large institutional investors and smaller venture capital funds. Thereby, it could provide access to larger pools of international capital and enable more SMEs to be financed and for longer periods of time.

Box 3: Case studies of business growth funds A. France – BPI scheme (public-private co-financing): The French Banque Publique d'Investissement (Bpifrance) was created in 2012 In partnership with banking and finance establishments, Bpifrance funds SMEs along different stages of the funding escalator. It provides cash to cover R&D expenses and equity seed capital to strengthen a company’s financial structure and thus prepare it for initial fundraising. It also provides industrialisation loans to fund downstream expenditure for R&D projects; participatory development contracts to strengthen the equity capital base to implement development projects, innovation loans to finance the launch of innovations; and reindustrialisation assistance to fund investment expenditure. Through innovation development contracts the fund helps to fund non-tangible investment and working capital requirements associated with an innovation. B. Fondo Italiano D'Investimento: The Fondo Italiano d'Investimento SGR manages three closed-end investment funds for qualified investors, for a total amount exceeding EUR 1.5 billion, one active in the private equity sector investing in companies with a turnover ranging from EUR 10 to 250 million and in other funds and investment companies; another active as venture capital fund of funds and another as private debt fund of funds. C. UK - Business Growth Fund (private led): Launched by five major UK banks as a large-scale investment vehicle to invest in SME equity, this fund pools money to make large scale investments in growing companies. Investments between EUR 3 million and EUR 15 million are made in established, profitable companies with a turnover of up to EUR 150 million . Investment is provided as equity capital, alongside loans and trade finance. The Fund focuses on growth capital, not buy-outs, taking stakes of less than 40%. Scale effects drive down portfolio costs, making SME equity investments more attractive. In addition, investment in the fund is treated as a risk-weighted asset (rather than requiring a deduction from capital) and the banks are able to benefit from the capital treatment within CRD IV which covers risk-weighting for Collective Investment Undertakings. In 2013, the fund invested GBP 1.47 billion through a total of 652 deals. D. Danish Growth Fund (public-private co-financing): Re-launched in 2001 as a strategy to develop venture capital markets in Denmark, this government-backed investment fund co-finances high-risk and knowledge-based SMEs. The fund has USD 2 billion capital under management and annually co-finances 500-800 SMEs. It uses both equity and loan instruments to leverage private investors and focuses on profitable growth companies. Facing a lack of sufficiently experienced venture capital management teams, the fund decided to build capacity to invest directly in companies alongside the support of existing venture capital funds. The initiative resulted in dynamic growth of the Danish venture capital market and a significant increase in the Danish venture capital funds' returns. The market has also consolidated, leading to fewer and bigger venture capital funds E. Spain - Fond-ICO Global (public): This public venture capital fund of funds is a financing facility of the state-owned bank Instituto de Crédito Oficial. With a total of USD 1.2 billion of funds available, the fund seeks to promote privately managed venture capital funds. Its action is directed by the following principles: collaboration with private venture capital and private equity investment; forming private-public partnerships without interfering in the market; simplicity (recurrent schemes) and transparency (public tenders). Until end-2014, ICO helped to create 23 new venture capital and private equity funds, committing EUR 631 million. It aims at creating about 40 new venture capital funds mobilising an amount of around EUR 4 billion to be invested in Spain. SMEs can obtain non-bank funding not only via private equity but also through peer-to-peer investment and borrowing. However, despite their rapid expansion, securities-based crowdfunding and peer-to-business lending still represent a small share of SMEs' funding. Today, there are approximately 400 crowdfunding platforms in Europe, and the funds raised through crowdfunding have grown from EUR 487 million in 2012 to EUR 2 957 million in 2014, at an average yearly growth rate of 146%, almost reaching the size of the venture capital market. The number of start-ups and SMEs in Europe financed through crowdfunding has grown from 1084 in 2012 to 5801 in 2014. Greater awareness of securities-based crowdfunding and peer-to-business lending among investors and businesses is expected to result in an accelerated growth of the market. Moreover, more crowdfunding and peer-to-business lending could have a positive signalling effect for SMEs towards other sources of finance. At the same time, perceived uncertainty on the laws applicable to crowdfunding platforms is an obstacle to further development. Due to the lack of a precise definition of crowdfunding and the absence of applicable EU legislation, localised platforms that want to operate cross-border have to comply with several – and often divergent - national rules. Although, at present, the crowdfunding market remains localised, significant potential exists in this area in the future thanks to digitalisation and technological progress. An important fact explaining differences between the UK and the rest of Europe is that investing in early stage companies is incentivised via targeted regulation in the UK. Insufficient clarity about the rights of investors participating in crowdfunding platforms weighs on their popularity. Only some EU countries, e.g. Germany, Spain, France, Italy, Austria and the UK, have introduced specific legislation on crowdfunding, which includes for example: registration of platforms, organisational requirements, capital requirements, professional requirements, liability. In a similar context, Belgium and Austria amended their prospectus rules to better fit the crowdfunding business model while Germany, Austria, Finland are considering legislative changes in the near future. Still, rules on the operation of crowdfunding platforms and related investor protection mechanisms are still absent in many EU countries. The anonymous nature of the peer-to-peer market and the lack of comparable credit information about borrowers seeking funding on the platforms constitute further obstacles. Gathering and processing credit information is a resource-intensive activity that might not be undertaken if the associated costs are too high. Consequently, the potential of crowdfunding that could complement traditional sources of finance and contribute to helping startups move up the "funding escalator" remains underused. The lack of verifiable information about SMEs restricts access not only to crowdfunding but also to other funding sources (see more details in Box 4). Investors and lenders need verifiable information about a company before supporting it financially. Financial statements and a firm's credit history and payment behaviour are essential to assess the repayment capacity of an SME. In addition, companies themselves use credit information services to assess the creditworthiness of clients or suppliers. Those SMEs about which information is missing may be rejected as a potential investment target already during the pre-screening process. Usually the bank that has built up a long-term relationship with an SME and knows well its financial situation, indebtedness and payment behaviour is the best placed to assess its true creditworthiness. But the sharing by banks of data with other market participants (such as business registers, credit bureaus and business information and scoring firms) is limited and varies from one Member State to another. Positive credit data coverage, while important because it provides information about the credit quality and behaviour of borrowers, also differs considerably between Member States. The lack of standardised, verifiable and accessible credit information about SMEs represents a significant barrier for alternative finance providers to invest into European SMEs. Therefore, tackling this shortcoming is a prerequisite to broaden SMEs' possible funding avenues. Information problems prevent the securitisation of SME loans from taking off. The assessment of the creditworthiness of an SME loan is much more difficult than a mortgage loan. The monitoring effort is significant due to the heterogeneity of the businesses and information limitations. This makes the securitisation of SME loans more complex and difficult than the securitisation of a pool of mortgages. As a consequence, addressing information challenges is key to stimulate growth in the SME loans' securitisation market. Box 4: Credit market failure due to asymmetric information When lenders cannot adequately assess the credit quality of borrowers, they typically respond to such information asymmetry by raising interest rates on loans. This behaviour is at the root of the adverse selection problem: higher interest rates drive low-risk borrowers out of the market, while more high-risk borrowers step in. Moreover, borrowers may be incentivised to invest in riskier projects to compensate for the higher interest rates (an instance of moral hazard). In addition, some borrowers may not repay their debts, as in the absence of information about their creditworthiness they could still obtain loans from other lenders (another example of moral hazard). The presence of asymmetric information can ultimately lead to credit restrictions, even in competitive markets, and to dysfunctional or missing markets. Insufficient financial education is another obstacle restricting SMEs' access to external funding. SMEs tend to lack knowledge on alternative sources of finance as well as on which information to submit to potential investors or lenders and how. Another problem is the lack of awareness about credit reports and credit history. Many SMEs are not able to get their own credit history and use it to obtain alternative financing. The lack of transparency on banks’ feedback to SMEs about their creditworthiness makes it even harder for SMEs to build their financial knowledge. Banks' feedback to borrowers varies in quality in Europe and only about half of SMEs find the feedback received by banks useful as regards obtaining future funding. Lack of financial knowledge by SMEs considerably narrows their financing options. According to the SAFE survey, one SME out of three is not confident about talking with banks and only 20% are comfortable in negotiating with equity investors and venture capital firms. The smaller the firm size, the more limited its confidence in its own financial competence. Another report shows that only a quarter of those responsible for making finance decisions in SMEs possess financial qualifications, and for SMEs as a whole only a minority have a financially trained person. Alongside the lack of in-house expertise, SMEs also experience problems with using external advice. Only 9% of SMEs asked for advice when seeking an overdraft and only 16% when seeking a bank loan. The resulting knowledge gap and the lack of a recognised source of business finance advice for SMEs, able to guide them through the complexities of bank and non-bank finance and help them secure access to the most appropriate form of finance, hampers the use of financing options by SMEs. Finally, limited research on SMEs impedes their visibility and further contributes to SME funding shortages. Despite the importance of SMEs for the European economy, little is known in a detailed and systematic manner about these specific companies, their activities and business profiles. For instance, 50% of SMEs listed on Euronext Amsterdam, Brussels, Paris and Lisbon do not benefit from any financial research and 16% are followed by only one analyst while NASDAQ OMX estimated in 2013 that only 10% of listed companies were covered by financial analysis. An empirical study confirms the significant impact of analyst coverage on corporate investment and financing costs. A decrease in analyst coverage increases information asymmetry and thus raises the cost of capital. 3.4 Do European companies face barriers to going public? The larger a firm, the broader the spectrum of available external financing options... Corporate finance theory and business firm evidence suggest that larger firms can more easily meet their funding needs than smaller firms, as mentioned at the beginning of this chapter. In addition to bank loans, larger firms can finance their needs using existing purchase orders or accounts receivable factoring. They can also use their assets to obtain a secured business loan or line of credit. Lastly, they may acquire financing through issuing debt and/or equity. Fixed transaction costs, minimum denominations, lack of business histories, lack of brand and insufficient collateral impede smaller firms from accessing external finance.

… but certain market segments are accessible only to the largest firms. Issuing debt or equity is the start of a new phase for a company. Besides the need to prove to investors that its business has competitive strengths and an acceptable risk profile, a company that goes public has to change in many respects. Among other things, its management and corporate governance structure needs to be adapted, its accounting and reporting systems have to be enhanced, its capacity to communicate information with different stakeholders must be stepped up. For all these reasons, and also because raising capital on equity and debt markets involves high average transaction costs and heavy listing or issuance regulatory requirements, going public remains largely the domain of large firms. In 2015, of the 23 million SMEs in Europe, only 11 370 (less than 0.05%) are admitted to trading on a regulated market or a multilat