COMMISSION STAFF WORKING DOCUMENT Long-Term Financing of the European Economy Accompanying the document GREEN PAPER LONG-TERM FINANCING OF THE EUROPEAN ECONOMY
Date: 2013-03-25
Institutions: European Commission
Subjects: economic growth, economic reform, financial institution, financial legislation, financial market, long-term financing, market supervision, sustainable development

EUROPEAN 
COMMISSION 

Brussels, 25.3.2013  
SWD(2013) 76 final 

COMMISSION STAFF WORKING DOCUMENT 

Long-Term Financing of the European Economy 

Accompanying the document  

GREEN PAPER  

LONG-TERM FINANCING OF THE EUROPEAN ECONOMY 

{COM(2013) 150 final} 

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TABLE OF CONTENTS 

1. 

2. 

3. 

4. 

5. 

6. 

7. 

7.1. 

7.2. 

7.3. 

8. 

9. 

10. 

11. 

Introduction .................................................................................................................. 3 

Characteristics of financing long term investments ..................................................... 4 

Demand for long-term investments.............................................................................. 4 

Investment and savings in the EU................................................................................ 7 

Financing chain: from providers to the end-users of funds.......................................... 9 

Reduced incentives for households’ long term savings ............................................. 10 

Recent dynamics in financial intermediation............................................................. 11 

Inefficiencies in the intermediation chain .................................................................. 12 

Bank lending gap........................................................................................................ 14 

Opportunities for long-term investors........................................................................ 18 

Capital markets and other sources of finance ............................................................ 19 

Public policy instruments........................................................................................... 23 

Conclusion.................................................................................................................. 24 

References .................................................................................................................. 25 

COMMISSION STAFF WORKING DOCUMENT 

Long-Term Financing of the European Economy 

Accompanying the document  

GREEN PAPER  

LONG-TERM FINANCING OF THE EUROPEAN ECONOMY 

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COMMISSION STAFF WORKING DOCUMENT 

Long-Term Financing of the European Economy 

Accompanying the document  

GREEN PAPER  

LONG-TERM FINANCING OF THE EUROPEAN ECONOMY 

1. 

INTRODUCTION 

Productive investments are important drivers to boost productivity, improve competitiveness 
and  ensure  sustainable  growth.  They  require  generally  financing  over  an  extended  time 
horizon.  In  the  EU,  there  is  a  need  for  long-term  investments  not  only  to  finance 
infrastructure,  innovation,  education  and  environmental  projects,  but  also  to  increase 
competitiveness and ensure public debt sustainability.1  

This  working  paper  accompanies  the  Green  Paper  “Long  Term  Financing  of  the  European 
Economy” (see document [...]2013) XXX) and aims to give more insight, from an economic 
perspective, on investments and saving in the EU; the need and incentives to increase long-
term savings; as well as the role that financial intermediation plays in channelling funds from 
savers to productive investments that generate capital formation and sustainable growth. The 
paper analyses the main problems in the current capital allocation and financial intermediation 
process across bank finance, which is the major financing channel in the EU (accounting for 
85%  of  total  financing  in  the  euro  area  and  the  UK),  corporate  debt  markets,  and  equity 
markets,  including  an  assessment  of  whether  these  problems  are  of  a  structural  nature  or 
temporary as a consequence of the crisis. Taking into account this analysis, the Green Paper 
puts  forward  for  public  discussion  a  number  of  policy  options,  for  example,  related  to  how 
misalignments  in  financial  intermediation  could  be  reduced  and  how  incentives  for  more 
effective  and  efficient  allocation  of  funds  to  productive  long  term  investments  cold  be 
strengthened.  

The  paper  is  organised  as  follows:  Section  2  presents  the  main  characteristics  of  long  term 
investment, while Section 3 is dedicated to the demand for long-term investments. Section 4 
examines  the  past  trends  in  investment  and  savings  in  the  EU  and  compares  these 
developments with the US and Japan. Section 5 discusses the reasons for restrained long-term 
saving, while Section 6 outlines the major intermediation channels for allocating funds from 
savers to the end-users of capital. Section 7 discusses inefficiencies and misalignments in the 
intermediation  chain  and  developments  in  bank  lending  for  non-financial  corporates.  It  also 
assesses  the  opportunities  for  institutional  long-term  investors,  such  as  insurers  and  pension 
funds. Corporate bond markets and other sources of finance, such as equity markets and IPOs 
are discussed in Section 8. The last section concludes. It is important to note that this paper 
focuses  mainly  on  the  two  major  private  sources  of  finance:  bank  borrowing  and  corporate 
bond  issuance.  However,  there  are  several  other  sources  to  finance  long-term  investments, 
including  private  equity,  venture  capital,  leasing,  hire-purchase,  supply  chain  finance, 
financing  through  internal  generated  funds  as  well  as  public  sector  initiatives.  Section  9 
presents  some  public  policy  instrument  to  enhance  financing  of  long-term  investments.  The 
last section concludes.  

1 

See MGI (2010). 

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2. 

CHARACTERISTICS OF FINANCING LONG TERM INVESTMENTS 

There is no simple or single definition of long-term financing.  
In broad terms, financing long term investments or long term financing2 can be considered as 
the  process  by  which  the  financial  system  provides  the  funding  to  pay  for  investments  that 
stretch over an extended time period.  Investors engaged in long-term financing are generally 
expected to hold onto the assets for a long time and are less concerned about interim changes 
in asset prices, focused instead on long-term income growth and/or capital appreciation.  

Descriptions tend to cover a range of features, including:  

• 

• 

The  nature  of  the  asset  classes  appropriate  for  long-term  investment. 
These assets are likely to be less liquid, have long maturities that extend over 
the  business  cycle,  yield  first  returns  only  after  some  years  and  carry 
significant risk. However, even very liquid assets can be appropriate for long-
term financing, and, conversely, long-term asset classes can also be the subject 
of short-term trades; 

The  nature  of  the  financial  intermediation  involved.  Long-term  financing 
may  require  significant  maturity  transformation,  as  the  majority  of  currently-
available funds tend to be short-term, whereas the subsequent investments are 
made  over  an  extended  time  horizon.  It  also  involves  sophisticated  risk 
assessment,  management  and  sometimes  risk  sharing,  and  the  pooling  of 
different sources of funds given the large size of investments; and 

The nature of valuation and pricing of the assets involved. The illiquid and 
long-term  nature  of  the  assets  complicates  the  risk  assessment  process.  The 
economic and social value of the assets may differ from their financial value, 
and may not be taken into account by all investors, and accounting principles, 
benchmarks  and  credit  ratings  may  measure  only  part  of  the  value  of  assets. 
The  pricing  of  risk  by  financial  markets  may  lead  to  an  increase  in  the  risk-
pricing of otherwise lower risk investments funded by public resources. 

Alternatively,  on-going  international  work  under  the  auspices  of  the  G20  on  long-term 
investment defines long-term finance more narrowly, focusing on maturities  of financing 
in excess of five years, including sources of financing that have no specific maturity (e.g. 
equities).  

3. 

DEMAND FOR LONG-TERM INVESTMENTS 

Long-term financing plays a key role in supporting productive investment, such as:  

• 
• 
• 
• 
• 
• 

R&D and innovation, education and professional training;  
Infrastructures, including transport, energy and communication networks; 
Industrial technology transformation and long-term capital-intensive projects;  
Health care and other welfare related assets;  
Environmental and climate change-related technologies and 
Enterprises,  including  in  particular  SMEs,  throughout  all  stages  of  their 
development.  

2  

The two terms “financing long term investments” and “long term financing” will be used synonymously 
throughout this paper.  

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Investments in these areas contribute to higher productivity, innovation and competitiveness 
and  involve  positive  externalities.  Whether  publicly  or  privately  delivered,  they  require 
periodical  renewal  and  upgrading.  This  type  of  investments  must  support  the  Europe  2020 
objectives  and  longer-term  priorities,  including  sustainable  economic,  social,  environmental 
and  demographic  developments.  Box  1  illustrates  the  case  for  financing  the  low  carbon 
economy. In broad terms, the provision of long-term financing is key for any strategy aimed 
at  enhancing  competitiveness  in  the  EU  through  addressing  investment  needs  for  industry, 
enterprises and public goods. The demand for long-term investments applies across the whole 
economic  cycle  (such  as  the  industrial  innovation  cycle),  affecting  the  source  and  nature  of 
financing at any one time. 

The Commission has underlined the need for significantly higher long-term investment levels 
in the future, taking into account the lack of investment in the past across a whole range of 
sectors.  Estimates  of  needs  for  financing  long-term  investments  are  very  significant.  For 
example, overall investment needs for transport, energy and telecom infrastructures networks 
of EU importance amount to EUR 1 trillion for the period up to 2020.3 Significant investment 
will also be needed in R&D, new technologies and innovation. Total estimated investment in 
the EU over the same period is around EUR 24 trillion.4  

The  overall  growth  of  investments  in  Europe,  including  long-term  investments,  is  mainly 
driven  by  developments  in  the  non-financial  corporate  sector  and,  to  a  lesser  extent,  by 
governments and households (Chart 1). Data show that private investments in 2011 were well 
below their 2007 level and the decrease in private investment was four times more than the 
drop of real GDP over the same period.5 This is both demand and supply side driven, as the 
following  sections  demonstrate.  The  overall  demand  for  investment  in  new  projects  is 
constrained by macroeconomic and financial uncertainty. For instance in terms of net demand 
for  long-term  credit  from  non-financial  companies,  recent  ECB  data  reports  a  decline.  The 
slowdown  in  economic  activity  and  uncertain  market  outlook  has  lowered  profitability 
expectations and the quality of loan applications has deteriorated following the worsening of 
macroeconomic conditions. The bank lending survey of October 2012 suggests that subdued 
lending  in  2012  was  caused  due  to  a  decrease  in  net  loan  demand  rather  than  a  constrained 
loan supply.  

Box 1: The case for financing the low-carbon economy 

Green Growth 
In the Commission's Low-Carbon Roadmap6, the EU investment needs in low-carbon energy, 
energy efficiency and infrastructure, consistent with the political objective of limiting climate 
change below two degrees, were estimated at €270 billion per year. These investments would 
result in fuel savings  of  €170  – 320 billion per y ear and monetized  health  benefits of  up to 
€88  billion  a  year  by  2050.  In  order  to  genera te  these  benefits  for  human  health,  the 
environment and the economy, it is therefore essential to mobilise more long-term investment. 

3 

4 

5 
6  

Connecting Europe Facility: About EUR 500 billion in transport, EUR 200 billion in energy and EUR 
270 billion for fast broadband infrastructures. 
The total need was estimated for the EU27, using 2011 GDP data at current prices, constant investment 
rate at 19.8% and assuming the GDP deflator of 1.6 and an average increase of real GDP of 1% until 
2020. 
See MGI (2012).  
See EU COM (2011) 112 

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Investors  and  stakeholders  have  identified7  various  policies  that  would  help  generate 
investment for green growth, including long-term regulatory certainty, a phasing out of fossil 
fuel subsidies and a strong carbon price signal, and the use of public funds to leverage private 
investment. It has also been suggested8 that reforming the financial sector would in itself have 
benefits for green investments, by dis-incentivising short-termism.  

In response, the Commission has started work on a 2030 Framework for Climate and Energy 
Policy,  one  of  the  goals  of  which  is  to  increase  long-term  certainty  for  investors.  A  Green 
Paper on this topic will be released by March 2013 to invite stakeholder contributions. On a 
stronger carbon price signal, the Commission has invited stakeholders to comment on options 
for  the  structural  reform  of  the  European  Emissions  Trading  System9,  and  proposed  a 
restructuring of the Energy Taxation Directive10.  

The  European  Council  has  also  confirmed  the  Commission's  proposal  that  climate-relevant 
expenditure  will  represent  at  least  20%  of  the  EU  spending  in  the  Multiannual  Financial 
Framework  2014  –  2020.  In  order  to  utilize  their  resources  cost-effectively,  in  a  context  of 
budgetary  constraints,  public  authorities  at  all  levels  will  need  to  develop  and  deploy  both 
proven and innovative financial instruments, in order to leverage private investment.  

Stakeholders are invited to explicitly take the investment requirements for green growth into 
account in their general comments on long-term financing of the EU economy. 

Low-carbon and climate-resilient Infrastructure investments  

Global  emissions  of  greenhouse  gases  are  to  a  large  extent  dependent  on  the  choice  and 
design  of  infrastructure  systems11.  In  2009,  power  generation,  building  energy  use, 
transportation  systems  and  waste  management  infrastructure  accounted  for  74%  of  net 
Greenhouse Gas emissions for developed countries.12 Moreover, these infrastructure systems 
are  generally  composed  of  long-term  capital  assets,  which  without  re-investment  provide 
lock-in to future emissions paths."  

The  transformation  in  the  design  of  infrastructure  is  necessary  to  address  climate  change 
goals.    Given  the  long  life  span  of  infrastructure  assets  and  their  interconnectivity  (e.g. 
infrastructure  networks  is  necessary.  Both  low  carbon  and  climate  resilience  have  to  be 
considered when infrastructure is planned, designed and constructed.  

7 See World Economic Forum (2013) 
8 See Kapoor et al. (2011) 
9 http://ec.europa.eu/clima/policies/ets/reform/index_en.htm 
10 See COM (2011) 169/3 
11 See OECD study from Kennedy C. et al. (2012) 
12 Countries referred to in Annex 1 of the UN Framework Convention on Climate Change (UNFCCC) 

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Chart 1: Contributions of sectors to the growth of nominal gross capital formation in the euro 
area (annual percentage change and percentage point contributions) 

Source: Eurostat 

4. 

INVESTMENT AND SAVINGS IN THE EU 

Economic recovery  and  sustainable growth  need  to be  investment-driven. Investment (gross 
capital  formation)  leads  to  innovations  that  improve  the  competitiveness  of  businesses  and 
markets  and  thus  also  to  income  and  jobs  being  secured  or  created.  Over  the  last  decade, 
aggregate  investment  performance  in  the  EU  has  been  slightly  better  than  in  the  USA,  but 
worse than in Japan and the world average. Before the crisis, the ratio of the total investment 
to GDP (i.e. investment rate) in the EU increased, but then it dropped significantly during the 
crisis  (approximately  by  4%-points),  mirroring  similar  developments  in  other  economies  in 
the downturn. The current investment rate in  the EU and other major economies is  close to 
20%,  its  lowest  level  since  the  1980s  (Chart  2).  However,  there  are  significant  differences 
between Member States. In countries that experienced a significant increase in investment in 
the pre-crisis period, the trend in investment has reversed sharply and declined to relative low 
shares of GDP (e.g. Ireland and Spain, both of which have experienced boom-bust cycles in 
real estate investments).  

Chart 2:  Investment rate in different  

Chart 3:  Saving rate in different  

economies in % of GDP  

economies in % of GDP 

Source:  IMF  database.  Note:  Total  investment  is  the  gross  capital  formation  that  includes  mainly  investments 
made in fixed assets.  

Aggregate  volumes  of  investment  may  also  hide  significant  differences  in  terms  of  sector 
composition and maturity profile of the investments. For example, EU annual growth rates of 
investment in equipment have trailed those in the USA in the decade before crisis. As regards 

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R&D investments, especially those in the high R&D-intensive sectors that require long-term 
investment,  the  top  400  R&D-investing  companies  in  the  EU  invested  €132  bn  in  R&D  in 
2011 compared to the €160 bn invested by 487 US counterparts. 13  

The  capacity  of  the  economy  to  finance  long-term  productive  investment  depends  on  its 
capacity  to  generate  and  mobilise  internal  savings  and  to  attract  and  retain  foreign  direct 
investment (FDI) for the long-term, as well as on its ability to effectively channel the funds 
efficiently to the right users and uses.  

As  regards  FDI,  the  development  of  FDI  inflows  in  the  EU  has  been  quite  volatile:  after 
falling  to  nearly  half  of  the  volume  of  the  previous  year,  they  picked  up  in  2009,  but  then 
shrank  considerably  again  in  2010.  In  2011,  FDI  increased  considerably,  reaching  €224  bn 
compared  to  €156  bn  in  the  previous  year.  In 
terms  of  sources  of  FDI,  inward  direct 
investments from EU Member States represented 60% of total FDI in the EU.14 In Member 
States that have suffered most from the sovereign debt crisis there has been a clear outflow of 
direct investments to other European countries. In contrast, the inflow of FDI from outside the 
EU has considerably increased on average compared to the pre-crisis period.  

As regards savings, the ratio of the aggregate savings to GDP (i.e. saving ratio) in the EU has 
stabilised  at  20%  over  the  past  decade  and,  after  a  drop  during  the  crisis  in  2008/2009,  it 
picked up again. The ratio is still higher than in USA (by 5 to 8 percentage points), and the 
gap compared to Japan has fallen in the last two years. The majority of savings (about 80%) 
results from households, the rest are corporate savings (e.g. cash and cash equivalent on the 
balance  sheets)  and  government  savings  (such  as  external  reserves  of  central  banks  and 
sovereign wealth funds). It is important to note that while household saving rates in Europe 
have  declined  due  to  a  reduction  in  disposable  income,  the  savings  of  large  corporates’  in 
many  Member  States  have  increased15  due  to  delays  in  investment  and  leading  to  an 
enlargement of cash holdings during the crisis – for example, cash and equivalent positions of 
large  firms  are  estimated  to  have  increased  by  around  four  percentage  points  from  2009  to 
2011.16 Conversely, many SMEs suffer from a continual lack of liquidity.  

A comparison between Chart 2 and Chart 3 shows that in the US the gap between saving and 
investment demand remains significant. In Japan there is excess saving over the desired level 
of  investment,  while  in  Europe  both  investment  and  saving  rates  are  at  similar  aggregate 
levels,  suggesting  that  in  principle  there  are  sufficient  funds  to  meet  investors'  needs.  It  is 
important  to  mention  that  the  aggregate  numbers  do  not  reflect  variations  in  sector 
composition and maturity profile (e.g. the stronger preference of savers for short- rather than 
long-term savings).  

Strong  increases  in  public  debt  and  deficit  levels  imply  that  today  in  Europe  there  is  less 
scope for government spending to provide the desired level of investment. Therefore, Member 
States  need  to  attract  an  increasing  amount  of  private  capital  to  offset  the  decline  in  public 
capital. Moreover, levels of savings per se are not sufficient in and of themselves. What also 
matters  is  that  they  are  channelled  to  appropriate  investments.  The  analysis  below  sets  out 

13 

14 
15 

16  

In  the  US,  over  two  thirds  of  the  R&D  investment  comes  from  R&D  high  intensity  sectors 
(pharmaceuticals,  healthcare  equipment,  biotechnology  and  ICT)  whereas  in  the  EU,  only  one  third 
comes  from  those  sectors  and  about  half  comes  from  medium-high  R&D-intense  sectors.  See  EU 
(2011): Industrial R&D Investment Scoreboard, figure 3.  
See EU (2012): Capital movements and the investments in the EU.  
See  MGI  (2011)  for  development  in  different  countries.  Note  that  cash  holding  is  the  positive  cash 
balance  that  remains  after  savings  are  used  for  investment,  acquisitions,  debt  payments  and  share 
repurchases.  
Based  on  Fitch  (2011)  and  own  estimations  of  changes  in  cash  and  cash  equivalent  positions  of  170 
large European non-financial corporates. 

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some of the reasons why this is not always the case. 

The sources and mechanisms to collect and invest savings have a significant influence on the 
ability  to  finance  long-term  investments.  The  flow-of-funds  in  Chart  4  illustrates  the 
allocation of funds from savers to the end-users and uses. 

5. 

FINANCING CHAIN: FROM PROVIDERS TO THE END-USERS OF FUNDS  

Broadly  speaking,  and  assuming  a  closed  economy  without  foreign  investment  inflows, 
savings from households, corporates and governments (on the bottom right in Chart 4) flow 
into the system through financial intermediaries to reach the end-users of funds (bottom left in 
Chart  4)  which  are:  households  that  borrow  for  housing  investment  (mortgage  lending)  and 
financing  of  consumer  goods;  governments  that  collect  funds  through  debt  issuance;  and, 
corporates.  Corporates  can  either  issue  equity  or  debt  in  the  capital  markets  to  accumulate 
funds, or they can take loans from banks, which in turn could be securitized through collateral 
loan obligations and also end up in capital markets.  

The pool of users and sources of funds are primarily linked through financial intermediation, 
which,  when  it  functions  properly,  has  the  advantage  of  providing  clients  with  maturity 
transformation, better information and lower transaction costs through economies of scale by 
pooling funds and operating large and well-diversified portfolios. 

The  leading  intermediaries  in  most  European  countries  are  banks:  retail  banks  that  are 
typically very close to their clients, both on the deposit and on the lending side. In Europe, 
85% of financing is provided through banks. Financial intermediaries and banks in particular, 
help in general to reduce the problem of asymmetric information (adverse selection and moral 
hazard).17  The  large  European  banks,  typically  "universal  banks"  that  offer  a  much  broader 
range of services, have established themselves as the key distribution channel for a number of 
non-banking products.  

The other way to channel funds from savers to end-users is through capital markets. Savings 
are used to buy/sell securities, as indicated in Chart 3 by "distribution". In addition, savings 
can  also  be  pooled  in  collective  investment  vehicles  and  can  flow  to  fiduciaries  or  asset 
managers, who in turn will manage these assets on behalf of the ultimate owners. The major 
functions of capital markets can be grouped in three categories.  

• 

• 

• 

First,  origination/  underwriting  that  brings  securities  to  the  markets.  Loans, 
which  are  originated  by  banks,  may  also  end  up  in  capital  markets  though 
securitization, e.g. asset- backed securities for credit-cards loans or collaterized 
loan obligations (CLO) for corporate loans; 

Secondly,  brokerage  and  trading,  which  might  be  client-driven,  either  for 
investors  or  for  borrower-issuer  clients,  or  proprietary  trading  for  the  firm's 
own book; and  

Third, the direct distribution of securities either to institutional investors or to 
retail end-user. 

Banks are the leading intermediaries for new product distribution, accounting for more than 
50% in countries such as Belgium, Spain, France, Sweden, Italy and Portugal. Brokers are the 
most common intermediaries in countries such as Netherlands, Slovakia, Ireland and the UK, 

17 

Adverse  selection  occurs  before  a  transaction  and  refers  to  the  fact  that  bad  borrowers  (in  terms  of 
credit risks) are the one most likely to seek loans, and moral hazard refers to the risk of the borrower's 
engaging in activities that are undesirable from the lender's perspective. For more details see Mishkin 
2012, Chapter 8. 

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while agents predominate in Germany, Poland and Slovenia.18 In addition, direct selling has 
increased  substantially  in  some  countries,  e.g.  the  Netherlands,  and  is  becoming  a  serious 
competitor to the traditional channels.  

Chart 4: Flow of funds from providers to the end-users of funds 

6. 

REDUCED INCENTIVES FOR HOUSEHOLDS’ LONG TERM SAVINGS 

Households  tend  to  be  reluctant  to  commit  to  long-term  savings  for  both  cyclical  and 
structural  reasons.  They  also  want  to  be  able  to  manage  individual  liquidity  shocks.  It  is 
important  to  note  that  the  factors  outlined  below  are  considered  from  the  perspective  of 
households. From a bank perspective, even the volume of deposits could – at least partially – 
be considered long term. 

MGI  (2010)  shows  that  the  increased  availability  of  credit  during  the  economic  boom,  the 
“wealth  effect”  of  asset  appreciation  during  the  stock  market  boom  in  the  90s  and  the  real 
estate  bubble  in  some  Member  States  after  2000  have  lowered  the  level  of  households 
savings. In an economic downturn, increased uncertainty, high unemployment and the lack of 
perspectives  have  increased  the  preference  of  savers  for  liquidity.  The  crisis  experience  has 
also  increased  savers’  distrust  in  financial  institutions  and  markets.  In  addition,  the  current 
low interest rate environment makes saving less attractive.  

As  regards  structural  factors,  studies  suggest  that  most  European  households  are  very  risk-
averse when it comes to long-term decisions.19 Most consumers prioritise returns and safety 
(predictability), and therefore they regard capital guarantees as a factor of great importance. 
Other  reasons  for  not  saving  long-term  are  the  often  poor  performance  of  financial 
intermediaries to deliver reasonable return, and costs of intermediation. Market intermediaries 

18 
19 

See BME report (2007). 
See Oliver Wyman (2012) and BME (2007). 

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have prospered and grown – both in scale and profit – often benefiting themselves more than 
the end-users.  

Taxation  also  plays  an  important  role  on  the  amount  of  savings  in  the  economy  and  their 
allocation to different assets and investments. It influences the tax burden on lifetime income 
for tax payers with similar incomes but different income patterns and it affects the welfare of 
households  by  directly  affecting  consumption  behaviour.20  Tax  regimes  sometimes  penalise 
saving  by  double-taxing  interest,  income,  capital  gains  and  inheritance.  Structural  tax 
privileges for investing in property have contributed to housing bubbles pre-crisis and draw 
private savers’ funds away from other potentially more productive uses. The housing market 
problems in some European countries, with a large build-up in household debt, have not only 
reduced income for non-housing consumption, but also for savings.  

Long-term  saving  may  also  be  discouraged  by  lack  of  knowledge  of  most  of  the  savers  in 
financial products. Customers often do not understand them, are not willing to devote much 
time to financial matters, and are unlikely to closely monitor their investment decisions over 
time.  

Due  to  population  ageing  and  the  reduced  possibilities  of  public  (pay-as-you-go)  pension 
systems  to  pay,  there  is  a  need  for  funded  complementary  pensions  and  supplementary 
individual savings for retirement. This should, in principle, increase the pool of savings and 
investable capital in the long term. The traditional way of encouraging voluntary savings for 
retirement has been through tax incentives. Member States have already put in place a number 
of  policies,  notably  with  respect  to  pension  related  savings.  However,  there  is  no  clear 
evidence  for  the  efficiency  of  using  tax  relief  to  improve  overall  retirement  savings 
outcomes.21  For instance, it is not clear that tax reliefs actually create additional saving rather 
than  simply  divert  existing  saving.  Providing  tax  relief  can  be  very  expensive,  costing 
between over 1.7 % GDP in IE and UK to less than 0.2 % GDP in SK. OECD suggests that 
the costs of tax relief will continue to outweigh revenues collected. 
As voluntary private pension coverage has been generally low22, mandatory pension savings 
might collect funds in a more regular way. They have already been implemented in a number 
of  EU  Member  States,  for  example  in  Sweden  and  some  countries  in  the  CEE.  The  latest 
example is the UK, which has been operating a mandatory scheme with automatic enrolment 
since October 2012. However, it is not clear whether such solution may be generalised for all 
EU Member States or could easily be accepted by all stakeholders. 

Once  the  economy  has  picked  up  and  confidence  is  restored,  the  recovery  is  likely  to 
positively influence saving behaviours. Nevertheless, structural problems may remain unless 
different actions are considered to reduce barriers to long-term savings. Policy actions in this 
respect are discussed in the Green Paper. 

7. 

RECENT DYNAMICS IN FINANCIAL INTERMEDIATION 

In  this  section,  inefficiencies  in  the  intermediation  chain,  the  bank  lending  gap  due  to  the 
current situation in the banking sector, as well as opportunities for other intermediaries to fill 
this gap are discussed. 

20  An  overview  of 

the  economics  of  savings 

taxation  can  be  found 

in 

the  Mirrlees-Review.  See 

http://www.ifs.org.uk/mirrleesreview/design/ch13.pdf. 

21 For an overview of tax incentives see for example The Social Protection Committee (2008), section 4.2.  . 
22 

See BME (2007).  

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7.1. 

Inefficiencies in the intermediation chain 

As set out in detail in Kay (2012), intermediation has to serve the end-users, i.e. corporate and 
other  borrowers,  who  seek  to  raise  funds,  and  savers  wishing  to  generate  returns  on  their 
savings.  Kay  (2012)  also  argues  that  the  success  of  intermediation  should  be  measured  by 
how  well  it  serves  these  two  groups  and  less  by  how  markets  contribute  to  intermediate 
objectives per se, such as liquidity and price discovery.  

Transformation  of  the  financial  system  during  the  last  decades,  be  it  through  globalisation, 
deregulation  or  other  factors,  has  changed  the  culture  of  financial  institutions  and  the 
behaviour  of  market  participants.  According  to  Kay  (2012),  a  culture  based  on  trust  and 
relationship is replaced by one that gives trading priority and price discovery, resulting in: 

• 

• 

• 

Increased  fragmentation  in  shareholder  structure,  reducing  incentives  for 
engagement  and  the  level  of  control  by  shareholders  and  leading  to  an 
explosion in financial intermediation;  

Complex  and  long  investment  chains,  raising  costs  for  end  users  and  risking 
misalignment of incentives; and 

An undue focus of some key intermediaries, such as asset managers, on their 
short-term  relative  performance  to  their  competitors,  which  is  required  from 
the  environment  in  which  they  act.  Their  decisions  are  based  on  relative 
performance, rather than on the long-term prospects and underlying business of 
the companies or products in which they invest. On the other hand, the interests 
of  savers  and  companies  are  in  absolute  performance.  This  misalignment  of 
incentives between asset managers and market users is the product of the short-
term performance horizon. The principal agent problem in asset management, 
outlined  in  Box  2,  is  one  of  the  market  failures  that  hamper  long-term 
investment. 

Inefficiencies arise also from the fact that banks are inherently vulnerable to confidence crises 
and deposit runs that are economically costly, in the sense that a fundamentally solvent and 
healthy  bank  can  be  forced  into  insolvency  through  depositors’  self-fulfilling  expectations 
(which may or may not be driven by fundamentals), causing severe economic pain (recall of 
loans  and  termination  of  productive  investments).  If  only  a  limited  number  of  depositors 
claim their money back, then no early liquidation of long-term projects is required. However, 
if many depositors run relative to what had been expected, this will force the bank to liquidate 
the  illiquid  assets  (also  loans)  at  a  loss  ("fire  sales").  To  avoid  this  well-known  scenario, 
institutions  have  been  put  in  place,  such  as  deposit  insurance,  lender  of  last  resort  facilities 
(LoLR or emergency lending assistance ELA), creditor protection, and suspension of deposit 
convertibility.  

However,  safety  nets  also  give  rise  to  excessive  risk  taking  behaviour  on  behalf  of  the 
beneficiary  banks  (and  they  create  competitive  distortions  through  an  artificially  lowered 
funding cost for beneficiary banks). Given the relatively high leverage and creditor dispersion 
(which leads to imperfect market monitoring), the usual problem of moral hazard stemming 
from limited liability takes a particularly important role in banking. In the run-up to the crisis, 
higher return for higher risk was achieved not by socially-valuable product innovation, but by 
leveraging  and  taking  excessive  risks,  leaving  the  problem  to  governments  if  and  when  the 
bad  tail  risks  materialised.  This  moral  hazard  risk  needs  to  be  curtailed  through  bank 
regulation and supervision.  

Structural  reform  may  significantly  reduce  investors'  concerns  that  many  large  banks  are  a 
complex portfolio of franchises. It is very difficult to value any individual component of that 

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portfolio, as investments are too-complex-to-price. This undermines confidence in banks and 
thus negatively affects their ability to channel long term investments to high-yield investment 
opportunities in the real economy.  

The  Green  Paper  discusses  policy  actions  to  reach  simpler,  more  efficient  and  less  costly 
financial intermediation, where incentives should align with long-term decisions. 

Box 2: Market failures and regulatory side-effects  

Markets may allocate a sub-optimal amount or composition of long-term investment (LTI) for 
several reasons, reflecting both the market failures and regulatory side-effects.  
Market  failures  include  mainly  externalities23  (where  the  marginal  benefit  to  the  investor 
does  not  include  the  marginal  social  benefit  given  that  not  all  costs/benefits  fall  to  the 
investor);  market  power  (which  could  result  in  the  overpricing  of  LTI  finance)  and 
asymmetries  of  information  which  leads  to  indirect  finance,  but  the  issue  of  information 
problems is still present. .  

Example: Asset management – principal agent problem 

Long-term  investors  ('principals')  often  invest  via  'agents'  such  as  fund  managers.  Agents 
usually  have  better  information  and  different  objectives  than  their  principals.  It  has  been 
argued  that  the  net  result  may  be  that  agents,  in  pursuing  their  own  interest,  misprice 
securities (by mimicking their counterparts in other firms to exacerbate bubbles and crashes) 
and extract rents. In principle, large investors and the authorities could address these problems 
by changing the way investors deal with agents – e.g. by requiring agents to adopt a long-term 
investment  approach  based  on  long-term  dividend  flows  rather  than  on  short-term  price 
movements. 

Regulatory  side-effects  may  arise  from  national  and  EU  regulation.  Examples  of  these 
alleged  side-effects  of  legal  frameworks  can  be  found  for  example  in  accounting,  liquidity 
regulation, Basel III and taxation. 

Example: Accounting rules  

Some commentators have alleged that fair value accounting has incentivised them to operate 
in a manner which might discourage long-term investment. In principle, fair value shows the 
market value of assets and liabilities; this information can be relevant to all types of investors 
as part of an overall appraisal, providing a sense of the relative financial condition of different 
institutions.  But  some  argue  that  through  the  use  of  fair  value,  the  volatility  in  the  market 
value  of  their  securities  introduces  volatility  into  their  P&L.  This  is  thought  to  be  to  the 
detriment  of  a  long-term  financing  horizon,  especially  for  institutional  investors  with  long-
term  liabilities,  who  for  internal  valuation  of  some  of  their  assets  may  use  other  valuation 
techniques (such as historic or book values). Therefore, there is a need for further analysis on 
the scope and relevance of fair value accounting in relation to long-term financing. 

Example: Adequate taxation 

Taxation influences considerably investment decisions. As outlined in Section 4, the current 
tax systems give a preference to debts compared to equity which influences the channels by 
which companies get funded. Adequate tax policy is necessary in order to avoid distortion in 
the allocation of savings for investment. 

23   Examples  include  where  there  is  a  'collective  action'  problem,  where  LTI  in  an  innovative  industry  may 
have ripple effects on other firms which are not 'captured' by the investing firm, and public goods (referring 
here to goods which no-one can be excluded from using, e.g. clean air). 

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Other  factors:  the  general  evolution  of  economic  conditions  seems  to  be  biased  against 
"patient"  activities.  The  development  of  information  and  communication  technologies  has 
facilitated the development of short-term and speculative transactions. In addition, a number 
of other factors may create a short-term bias. These factors include: 

 - A lack of engagement by long-term investors, which can reduce the focus of companies on 
longer-term strategies;  

-  Shareholder  value  which  currently  prioritises  the  maximisation  of  share  value  against  the 
longer-term fundamental value of the firm; and  

 -  The  nature  of  the  relationship  between  investors  and  asset  managers  and  the  way  asset 
managers'  incentives  are  structured,  which  is  argued  by  some24  to  contribute  to  increasing 
short-termism and mispricing. 

Corporate governance policies may target this suboptimal market behaviour. 

Companies investing over the long term have a clear interest in having shareholders who take 
a  long-term  view  of  the  company  and,  as  stewards  of  its  long-term  interests,  engage  in 
important strategy and investment discussions. However, some shareholders may pay too little 
heed to this crucial role. As a consequence, company directors may focus overly on its short, 
not long-term health. There are different reasons for this, including remuneration policies and 
an excess focus on the short-term share price.  Improvements in this general area require more 
realignment  of  incentives  between  shareholders  and  company  management.  Some  of  the 
actions  in  the  corporate  governance  to  encourage  long  term  engagement  and  long  term 
perspective on the company are discussed in the Green Paper. 

7.2. 

Bank lending gap  

Non-financial corporates in Europe depend on banks for most of their debt finance. The share 
of  the  banking  sector  in  Member  States  is  large  by  international  comparison,  reflecting  the 
European  economy's  greater  dependency  on  bank  intermediation.  For  example,  bank  loans 
and other advances accounted for 85% of total non-financial corporate debt outstanding in the 
euro  area  and  in  the  UK  in  2011,  while  non-financial  corporate  bonds  accounted  for  only 
15%.25 In the USA, by contrast, the proportion between bank loans and cooperate bonds was 
53% to 47%. While in Europe non-financial corporates – especially mid-caps and SMEs – are 
highly  dependent  on  banking  sector,  loans  to  non-financial  corporates  and  households 
represent about 1/3 of banks' total assets, reflecting the asymmetric dependency between non-
financial corporates and the financial sector.26  

European banks rely heavily on maturity transformation 

In the years leading up to the crisis, European banks had relatively high loan-to-deposit ratios 
in international comparison (Chart 5) and they relied heavily on (often short-term) wholesale 
creditors  and  excessive  maturity  transformation  (i.e.  borrowing  short  and  lending  long)  to 
fund  their  long-term  lending.  Although  the  crisis  changed  this,  even  after  2008  the  ratio  of 
(typically  illiquid)  loans  to  (stable)  retail  funding  (the  loan-to-deposit  ratio)  in  Europe 
remained  relatively  high  at  130%  on  average  in  2011,  while  in  the  USA  it  has  fallen  from 

24 

25 

26 

For  example,  see  the  ‘Kay  Review  of  UK  Equity  Markets  and  Long-Term  Decision  Making:  Final 
Report’, July 2012. 

See  Llewellyn  Consulting  (2012):  Financing  European  growth:  the  challenges  for  markets,  policy 
makers and investors. August 2012. 
This structural bias is highlighted in the recent report of the High-level Expert Group on reforming the 
structure  of 
the  EU  banking  sector.  See  http://ec.europa.eu/internal_market/bank/docs/high-
level_expert_group/liikanen-report/final_report_en.pdf. 

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around  95%  to  75%  since  the  onset  of  the  crisis.27  Moreover,  European  banks  have  stable 
funding ratios28 that are lower than in the USA, Japan and emerging markets, suggesting also 
that maturity transformation was, and remains, substantial for European banks' balance sheets 
(Chart 6).  

Chart 5: Loan to deposit ratios, 1997-2011  Chart 6: Stable funding ratios, 1997-2011 

Source: BIS, Annual Report 2012. 

As  confidence  vanished  during  the  crisis,  the  interbank  market  –  as  immediate  source  of 
banking  liquidity  and  funding  –  dried  up,  highlighting  the  risks  associated  with  excessive 
maturity transformation. Many banks have started to de-risk their business in order to adjust 
to pressures in their funding through deleveraging their balance sheets (by increasing equity 
capital  and/or  disposing  of  assets)  as  well  as  changes  in  funding  structures.  While  de-
leveraging  after  the  crisis  is  necessary,  this  process  may  last  for  several  years,  with  the 
consequence  that  credit  might  become  less  available  and  more  costly,  changing  the 
attractiveness  of  different  types  of  investments  and  altering  the  feasibility  of  some  banks’ 
business models.29 Seen historically, private investment was often quite low for the duration 
of deleveraging. One of the reasons why deleveraging has been relatively slow is due to the 
interventions of governments and the ECB to provide swift and abundant liquidity. As these 
interventions  are  for  a  limited  period  of  time,  the  impact  of  deleveraging  on  private 
investments might be more noticeable afterwards.  

The ECB bank lending survey October 2012 reports that net tightening of credit standards by 
euro area banks for loans or credit lines to enterprises increased (15% in net terms, compared 
to 10% in the second quarter of 2012). The responding banks expected a further tightening of 
standards for the near future. The main reasons were negative economic outlook, as well as 
the actual bank capital positions and the related on-going need for balance sheet adjustments. 
In  terms  of  company  type,  the  tightening  of  credit  standards  has  applied  more  for  loans  to 
small and medium-sized enterprises (SMEs) than to large ones; while in terms of maturity, the 
tightening of credit standards increased for both short- and long-term loans. The bank lending 
survey demonstrates that unless corporates – and especially SMEs – have access to alternative 
sources  of  finance,  any  decline  in  bank  lending  is  likely  to  have  an  adverse  impact  on 
corporates' ability to finance investment. 

Negative feedback loop between banks and sovereigns harm investments 

Particularly  challenging  is  the  simultaneity  of  the  deleveraging  pressures  on  banks  and 
sovereigns.  Sovereign  indebtedness  has  risen  to  peacetime  highs  across  several  Member 

27 
28 
29 

See BIS 2012, annual report.  
Funding ratio refers to the proportion of the sum of retail and long term funding to the total funding. 
According to MGI 2011, the past experience shows that deleveraging episodes last six to seven years on 
average and reduce the ratio of debt to GDP by 25 percent. 

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States, feeding into the balance sheets of banks. Direct exposure of banks to sovereign debt 
weakens  their  balance  sheets,  increases  their  riskiness  as  counterparties  and  makes  funding 
more costly and more difficult to obtain. In addition, higher sovereign debt risk reduces the 
value of sovereign collateral that banks can use to raise wholesale funding. Other factors, such 
as  the  reduced  value  of  government  guarantees  due  to  weaker  government  finances  or 
financial contagion (sovereign to sovereign or sovereign to banks) further affect bank funding 
conditions.  Banks  participating  in  the  ECB  bank  lending  survey  reported  increased  funding 
pressure  because  of  the  sovereign  debt  crisis  in  the  second  quarter  of  2012.  The  resulting 
additional funding pressures might in turn affect lending to non-financial corporates across all 
maturities, including the long-term ones.  

Different elements in the regulatory framework favour investments in sovereign debt. While 
sovereign debt itself in part funds long-term investments, private sector long-term investment 
may be at a relative disadvantage. This situation may merit consideration in the future, once 
market conditions allow for a comprehensive discussion.  

Long-term lending and the "home-bias" 

Several periods of liquidity squeeze have taken their toll on the volume of intermediation by 
banks. During the most severe time of the crisis from mid-2008 to mid-2009, there has been a 
dramatic  fall  in  the  volume  of  new  loans  by  monetary  financial  institutions  (MFIs)  to  non-
financial  firms  for  all  maturities  (Chart  7).  The  volume  of  new  long-term  loans,  which  are 
important  for  long-term  productive  investment,  declined  markedly  in  the  first  half  of  2012 
(Chart 7) and their stock shows a significant downward trend at the very short end (Chart 8). 
ESMA(2012)  reports  that  banks  have  restricted  credit  to  corporates  even  in  cases  where 
companies  generate  a  positive  cash  flow,  which  would  allow  for  the  servicing  of  debt.  In 
addition,  banks  have  reduced  cross-border  lending,  which  has  led  global  companies  to 
increasingly rely on their own domestic financial institutions further reducing the availability 
of debt capital for SMEs.  

Chart 7: MFI loans (flows) to non-financial  Chart 8: MFI loans (stocks) to non-financial  

corporates in the Euro Area 

corporates in the Euro Area 

Source: ECB 

Moreover,  stress  in  bank  funding,  tighter  regulation  and  risk  management  requirements  are 
also driving an increase in "home bias", impacting the cross-border financing. Note that home 
bias  is  a  well-known  phenomenon  in  finance.30  Investors  are  reluctant  to  acquire  the  full 
benefits of portfolio diversification and hold a disproportionate share of local assets. Reasons 

30 See French, K.R and J.M., Poterba, 1991 for home bias in equity markets. 

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for this are (i) asset trade costs in international financial markets (such as transaction costs or 
differences in tax treatments between national and foreign assets),( ii) informational frictions 
and behavioural biases as well as (iii) costs of hedging (e.g. real exchange rate when investing 
in/outside Eurozone and no-tradable income risk)31.  

A well- functioning Single Market for financial services can stimulate cross-border long-term 
investments.  Unfortunately,  cross-border  lending  has  fallen  substantially  as  a  result  of  the 
financial crisis. The share of cross-border loans in the money markets between mid-2011 and 
mid-2012 plummeted 33%.. Where the need for investments is greatest, lending rates in some 
countries are increasing despite the low base rate. In fact, private-sector borrowing costs have 
started to diverge substantially according to geographic location. Companies may have similar 
financial  strength  and  growth  prospects,  but  they  may  be  "punished  or  rewarded"  in  the 
markets for the budget and economic policy shortcomings of their respective home country. 
Some difference in private-sector borrowing costs is to be expected given that some Member 
States are growing whereas others are shrinking; but the current pricing differentials suggest 
market  fragmentation  (redenomination  risk)  is  partially  to  blame,  in  addition  to  the 
differentiation in fundamentals and sovereign default risks. This is potentially inefficient, as 
financially-weak  firms  in  strong  countries  are  able  to  survive,  whereas  strong  and 
fundamentally sound companies in programme countries may have to leave the market. 

Demand for long-term loans has decreased 

Negative  developments  in  long-term  lending  result  from  worsening  demand  and  supply 
conditions. It is hard to separate out whether an observed level of bank lending is the product 
of  banks  being  unwilling  to  lend  more,  or  of  the  private  sector  being  unwilling  to  borrow 
more. The slowdown in economic activity has lowered the profitability expectations and the 
quality  of  loan  applications  has  deteriorated  following  the  downturn  in  the  economic 
conditions. Therefore corporates have reduced their demand for credit owing to lower capital 
formation.  This  is  evident  from  the  ECB  bank  lending  survey,  in  which  participating  banks 
reported a further net decline in the demand for long-term loans in the third quarter of 2012, 
which  is  more  pronounced  than  the  decline  in  demand  for  short-term  loans  (24%  for  long-
term compared to 17% for short-term loans).  

Chart 9: Expected demand for loans or credit lines to non-financial corporates 

(net-% of banks reporting a positive contribution to demand) 

Source: ECB (2012) The Euro Area bank lending survey, 3nd quarter of 2012. 

31 Non-tradable income risk refers to the fact that investors receive a part of their income that cannot be traded in 
financial markets. see Lucas (1982).. 

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Lack  of  confidence  combined  with  ultra-low  interest  rates  incentivises  forbearance.  Low 
interest  rates  may,  in  a  systemic  crisis,  incentivise  banks  to  speculate  with  the  prospects  of 
resurrection by postponing the necessary balance sheet repair and engage in "ever-greening of 
loans" policies (the rolling-over of impaired loans as interest-only loans, since the opportunity 
cost of receiving payment in the future over today is lower, which allows to hide impairments 
from supervisors and creditors). Low interest rates allow banks to disguise underlying credit 
weakness and continue lending to "bad" firms (and thus avoid capital losses). This reduces the 
outlook  and  profitability  of  healthy  firms  and  thus  discourages  new  long-term  investments 
and the entry of new players. In addition, new lending is further curtailed if banks hold onto 
low return-generating loans, as they may be constrained in attracting new funding, given the 
uncertainty with respect to their true solvency. 

7.3. 

Opportunities for long-term investors 

Insurance  companies,  pension  and  mutual  funds  are  the  biggest  institutional  investors  in 
Europe. Together, they hold an estimated total of €13.8 trn of a ssets, equating to more than 
100% of the region's GDP.32 As banks are less able to meet the long-term funding needs of 
borrowers for the reasons outlined above, this creates an opportunity for insurers and pension 
funds  (the  biggest  institutional  investors),  because  they  tend  to  have  long-dated  liabilities, 
which match the part of the lending market from which banks are retreating. This advantage 
arises  from  the  economics  of  the  insurance  and pension market: insurance undertakings can 
fund loans with predictable long-term liabilities, such as annuities, and therefore will be less 
likely to face liquidity runs and be forced into a fire sale of the loans.  

In the past banks have been involved in long-term project financing (e.g. infrastructure) and 
have invested in illiquid assets. But today and in the near future, banks might need to reduce 
their  new  investments  across  different  illiquid  asset  classes,  because  of  their  funding 
constraints and in order to improve capital and liquidity positions. This creates opportunities 
for  long-term  investors,  such  as  investment  funds  and  insurance  companies,  to  re-enter  the 
market.33 Estimates show that for Germany, France and the UK, which constitute more than 
50%  of  the  total  European  insurance  market,  moving  into  illiquid  asset  classes  (such  as 
commercial mortgages, infrastructure projects, SME lending etc.) could increase the value of 
the insurance industry in these countries by 50%.34  

Long-term  projects,  which  often  require  a  considerable  amount  of  funds  and  know-how  in 
their implementation, have intrinsic risks. Insurers and pension funds are more likely to carry 
the  long  term  financing  risk,  but  not  the  project  and  the  implementation  risk.  Closer 
cooperation between investors and public authorities may help to successfully carry through 
these projects.  

In  the  context  of  asset  allocation,  insurance  undertakings  and  pension  funds  tend  to  invest 
more  in  securities  (shares  and  bonds)  than  providing  direct  loans.  EIOPA  data  show  that 
insurance undertakings remain biased towards investments in government bonds, which make 
up  25%  of  total  assets,  followed  by  financials  with  18%  and  non-financial  corporates  with 
13%  (Chart  10).  However,  in  the  last  12  months,  the  relative  share  of  equity  has  declined 
slightly, while the share of non-financial corporate has risen.  

Against this background, a better channelling of long-term resources via capital markets and 
reduced  dependence  on  bank  funding  is  required.  Nevertheless,  such  a  transformation  in 
funding structure may take some time. 

32 
33 
34 

See Fitch 2011 and EFAMA (2012). 
See Allen and Overy (2012). 
See Oliver Wyman (2012). 

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Chart 10: Asset composition of European insurance companies 

Assets of insurance  groups
( excluding unit(cid:31)linked assets)

Government bonds

18%

Corporate bonds, financials, secured

Corporate bonds, financials, unsecured

25%

Corporate bonds, non(cid:31)financials

4%

4%

1%

6%

3%

4%

Equity & participations

Property

Cash & deposits

Investment funds

7%

Loans & Mortgages

Derivatives

9%

Structured products (ABS, CDO…)

2%

4%

13%

Other investments

Other assets

Source: EIOPA (2012): EIOPA risk dashboard September 2012. 

8. 

CAPITAL MARKETS AND OTHER SOURCES OF FINANCE  

European  non-financial  companies  finance  their  investment  largely  through  bank  loans,  but 
since  the  onset  of  the  crisis  they  have  relied  more  on  market-based  funding,  including 
different financial instruments, such as equity, debt securities, inter-company loans and trade 
credit.  In  terms  of  firms’  capital  structure,  equities  are  still  the  most  important  source  of 
financing,  counting  for  about  48%  of  external  financing  sources,  followed  by  intercompany 
loans  (around  20%)  and  trade  credit  (around  10%)  during  the  crisis  period  (Q3  2008  –  Q2 
2012).35  When  non-financial  companies  are  observed  altogether,  including  small-and 
medium-size  companies  (SMEs),  debt  securities  play  a  minor  role.  However,  for  large 
corporates they are an important source of funding.  

Corporate  income  tax  (CIT)  system  influences  considerably  the  financing  of  (long-term) 
investments.  It  is  a  well-known  fact  that  CIT  in  many  Member  States  favours  debt  over 
equity, as interest payments are deductible from CIT while there is generally no such relief for 
the return on capital. Financing neutrality is a desirable design for a taxation regime that can 
be  reached  through  different  options,  such  as  a  comprehensive  business  income  tax  (CBIT) 
where the deductibility of interest payments on debt is (fully or partly) removed, an allowance 
for corporate equity (ACE) where a notional interest deduction on equity is granted, or a cash-
flow  taxation  of  companies  which  would  also  exempt  from  tax  a  notional  return  to  capital, 
irrelevant  of  the  financing  source.  The  latter  two  approaches  have  the  advantage  that  they 
would in addition not distort marginal investment and would tax economic rents. 

 In  the  current  market  context,  direct  access  to  capital  markets  seems  to  offer  European 
corporations  some  advantages  for  funding  compared  to  bank  debt.  Longer  maturities  and 
often  lower  interest  rates  than  bank  loans  are  among  the  obvious  advantages.  But  most 
importantly,  having  access  to  bond  markets  broadens  the  range  of  alternative  sources  of 
funding available to non-financial corporates in difficult times for bank lending.  

Corporate bonds markets are gaining importance  

In  contrast  to  the  tight  bank  credit  conditions,  debt  markets  have  shown  more  positive 
development.  Based  on  the  balance  sheet  information  for  161  European  firms,  Fitch  (2011) 
reported how bank debt has decreased since 2008, whereas bonds have increased over recent 
years  

35  

See ECB (2012)b, chapter 2.3. 

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The increase in corporate bond funding is also evident from the development of the aggregate 
outstanding amounts of debt securities issued by non-financial corporations in the euro area. 
These  totalled  €940  bn  in  July  2012  (90%  long- term  securities),  having  risen  from  about 
€652bn at the beginning of 2008 (Chart 11). Tota l amounts outstanding have been increased 
since  the  beginning  of  the  year,  showing  similar  trends  as  in  2009.  As  one  would  expect, 
highly-rated  companies  account  for  most  of  the  outstanding  volume.  However,  there  is  an 
increasing importance of BBB and BB rated corporates in this market.  

Chart 11: Outstanding amount of debt securities issued by euro area NFCs (€ million) 

Source: Source: ECB funding disintermediation 

Total  figures  of  corporate  bond  issuance  by  non-financial  firms  show  a  considerable 
improvement  in  the  EU  in  recent  years  compared  with  the  pre-2007  levels  (Chart  12). 
Although both in the USA and the EU, bond issuance by non-financial firms has followed the 
up  and  down  swings  of  the  business  cycle,  the  EU  new  bond  issuance  for  the  2007-2011 
period exceeded the $ 200 bn mark reaching over 400 mill in 2009. These levels had never 
been reached in the EU during the best years of the business cycle between 1999 and 2005. 
However, although EU corporate bond markets have developed in the recent years, the non-
financial  corporate  bonds  account  still  only  for  15%  of  non-financial  corporate  debt 
(compared to 47% in the US), as mentioned earlier in the paper. 

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Chart 12: 
(1999-2011) 

Annual  Bond  Issuance  by  Non-financial  Firms  in  the  EU,  USA  and  Japan 

JAPAN

US

EU

n
b
D
S
U

600

500

400

300

200

100

0

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
YTD

Source: Dealogic 

It  is  important  to  note  that  the  different  impact  that  the  financial  crisis  has  had  in  different 
Member States has also quite differently affected the balance between debt and equity finance 
between Member States.36 In the pre-crisis period, debt financing for Spanish and Italian firms 
was larger than equity financing, but debt financing decelerated remarkably during the crisis. 
By contrast, in other countries, inter-company loans and debt securities played an important 
role to replace reduced bank lending.  

Enable access to bond markets for SME 

The  evidence  shows  that  debt  capital  markets  represent  an  important  alternative  source  of 
funding, but at the moment they are accessible mainly for large corporates domiciled in larger 
countries with more developed corporate bond markets. Small-and medium-sized companies 
(SME) that face the more severe consequences of the credit crunch cannot afford the costs of 
bond issuance.  

However, in countries where the economy is faring relatively better through the crisis, there 
are  signs  that  an  increasingly  broader  spectrum  of  firms  is  gaining  direct  access  to  capital 
markets  in  Europe.  In  particular,  SME  high  yield  bond  issuance  has  become  considerably 
important in Germany. Driven by the financial crisis, family-run SMEs companies willing to 
keep  full  control  of  the  company  have  resorted  to  bond  issuance  given  the  difficulties  that 
they find in securing bank funding. Four of the eight German exchanges have started trading 
“Mittelstand  bonds”  over  the  last  two  years.  Issues  range  from  €25  to  €225  mn.  Retail 
investors acquire some of them, but institutional investors hold between 60 and 75% of these 
bonds,  as  yields  are  attractive  for  these  investors  with  7  to  9%.  In  Stuttgart,  the  BondM 
platform  gives  mid-cap  SMEs  the  possibility  of  issuing  bonds  that  can  be  directly  sold  to 
retail  investors  without  an  investment  bank  underwriting  the  issue.  Covenant  and 
documentation  provisions  and  costs  are  also  kept  to  a  minimum.  The  volume  of  corporate 
bonds  for  medium-sized  companies  is  relatively  small,  but  the  trend  to  increase  capital 
markets assess for medium-sized companies is likely to continue.  

36 See ECB (2012)b. 

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For mid-caps and SMEs, which have historically faced difficulties in accessing funding, the 
main cause is the lack of credible information about them. This results in increased costs and 
difficulty  in  evaluating  their  credit  worthiness  by  potential  providers  of  funds.  Research  on 
SMEs  is  costly  and  investors  are  generally  not  eager  to  pay  for  it.  Provisions  should  be 
implemented  to  make  existing  research  and  ratings  information  available  to  a  wider  set  of 
potential  investors  and  thus  helps  reduce  information  asymmetries  associated  with  smaller 
companies.  In  some  countries,  such  as  the  US,  the  SME  market  is  sustained  by  a  market 
maker  model  based  on  spreads.  Other  models  exist  as  well,  as  some  market  participants 
believe that the market maker model does not propose enough transparency.37 

In order to facilitate outreach to SMEs, their visibility might be facilitated through evaluations 
and  improved  information  provided  by  credit  scoring  companies.  Knowing  their  own  score 
and understanding how it has been calculated may help SMEs to negotiate with their banks or 
other financing solutions. Moreover, the demand for external credit worthiness evaluation has 
increased,  as  in  some  countries  midsize  companies  have  and  will  continue  to  develop  a 
stronger  capital  market  orientation.  Demand  for  rating  equivalencies,  credit  standing 
certificates  is  also  increasing  in  the  ‘customer-supplier-relationship’,  e.g.  in  the  automotive 
and  construction  industry.  Developing  harmonised  minimum  quality  standards  on  external 
credit  scoring  for  SMEs  would  facilitate  (cross  border)  financing  of  their  investments  and 
deepen market integration. Options in this regard are discussed in the Green Paper. 

Equity markets and IPOs  

Many  claim  that  the  economy,  businesses  and  investment  projects  need  more  equity,  than 
debt. Equity can be a better financing instrument for long-term, high-risk investments, as well 
as for investments with significant information asymmetries and moral hazard. Given that the 
crisis  was  fuelled  by  overreliance  on  debt,  equity  is  probably  a  more  appropriate  financing 
instrument  at  present.  However,  since  the  crisis,  macroeconomic  uncertainty  and  the  low 
interest  rate  environment  may  have  affected  companies’  demand  and  risk  appetite  for  long-
term equity capital. Investors have instead sought refuge in government debt instruments with 
strong creditworthiness. In addition, preference for debt over equity investment continues to 
be affected by the differing tax treatment (see below). These developments appear to have had 
a bigger impact on mid-caps.  

The financial crisis appears to have accelerated a long-term trend increase in bond purchasing 
that started at the beginning of the last decade. The cost of equity capital has remained high 
while  the  cost  of  debt  finance  has  fallen.  Overall,  this  highlights  the  equity  gap  in  Europe, 
which is likely to take time to address. 

In  the  recent  years,  exchanges  have  tended  to  act  more  as  providers  of  liquidity  rather  than 
sources  of  additional  capital.  For  example,  in  some  cases  equity  markets  are  used  for  fast 
"exit", i.e. to extract cash from companies, rather than for cash injection. This trend became 
quite  pronounced  during  the  crisis,  where  the  number  of  listed  companies,  as  well  as  the 
amount of capital injected, experienced a considerable fall. According to FESE, the number of 
listed companies in the last five years has been reduced by 27% (from 11,914 in 2007 to 9,031 
in 2011), while the capital injected to them experienced a sharp drop by 65%.38 Currently, just 
a small part of capital (ca. 5%) is used for IPOs, whilst before crisis this was around 20%.  

Besides the weak economy, and the low level of share prices that makes IPO unattractive for 
the  listed  firms,  there  might  be  other  structural  factors  that  explain  low  capital  flows.  One 
reason is that the business models of exchanges are based mostly on trading blue chips; hence 

37 
38 

See ESMA 2012. 
See FESE: http://www.fese.be/  

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there are little incentives to raise new capital and attract new IPOs. Concentrated trading on 
blue  chips  might  crowd  out  mid-caps.  Kay  (2012)  reports  that  corporates  in  the  UK  are 
financed  either  through  internal  funds  or  alternative  means,  such  as  private  equity  or  debt 
issuance and mainly loans for mid-caps and SMEs. 

However, providing liquidity is an important function of secondary markets. Liquid and well-
functioning secondary markets encourage investments in primary markets too, as this enables 
investors to sell their investments quickly and at low costs when needed.  

9. 

PUBLIC POLICY INSTRUMENTS  

Public-Private  Partnership  (PPP)  is  one  instrument  to  facilitate  financing  of  long-term 
investments,  especially  for  those  projects  with  public  good  character.  However,  the  use  of 
PPS  decreased  despite  a  number  of  steps  that  have  been  taken  following  the  Commission 
Communication in 2009.39 The revival of this market, notably for trans-border investments, is 
important. Some sectorial regulations (e.g. the unbundling directive or those on feed-in tariffs, 
both  in  the  energy  sector)  may  create  disincentives  for  long-term  investments.  In  addition, 
Member  States  lack  a  credible  long-term  pipeline  of  potential  PPP  projects.  A  European 
framework for PPPs promoting transparency, appropriate risk transfer arrangements and deal 
structuring, and learning from the past experience and public finance initiatives could support 
their enhanced use and impact. 

Public procurement sets the demand from the state (and local actors) for products, services 
and infrastructure. It may help public authorities to give incentives for innovation and attract 
investors  into  long-term  projects.  However,  existing  legal  uncertainty  arising  from  the 
absence of clear rules on the award of concession contracts creates constraints. Therefore, in 
December 2011, the Commission proposed a directive40 with the aim of providing a clear and 
simple framework for the award of such contracts. 

State Aid rules provide frameworks for public support to make investments more attractive 
for private investors. Examples include aid to infrastructure; support to R&D and innovation; 
regional development; efforts to stimulate low-carbon energy or broadband investments; and, 
measures  to  stimulate  risk  finance.41  The  2012  State  Aid  Modernisation  initiative  aims  to 
orient  scarce  public  funds  towards  efficient  and  well-designed  aid  which  promotes  growth-
enhancing objectives, addresses proven market failures, has an incentive effect, while keeping 
distortions of competition limited.  

Export credit. Several national public export credit guarantee schemes exist in Europe today, 
which  provide  support  to  capital-intensive  investments  requiring  long-term  finance  for 
projects  in  the  EU.  It  could  be  useful  to  analyse  whether  an  EU  Export  Credit  Mechanism 
could help the financing of long-term investment, in particular outside the EU and in non-EU 
currency denominated projects, in complement to those national approaches. 

10. 

CONCLUSION  

A range of factors should be considered in order to effectively finance long-term investment 
and  growth  in  the  European  economy.  These  include  accumulating  sufficient  funds  for 
productive long term investment; addressing misalignments and inefficiencies in the financial 

39 
40 

41 

See http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2009:0615:FIN:en:PDF. 
See 
http://ec.europa.eu/internal_market/publicprocurement/modernising_rules/reform_proposals_en.htm. 
See http://ec.europa.eu/competition/state_aid/legislation/horizontal.html. The Guidelines on State aid to 
promote risk capital will be revised in 2013, in the context of the State aid modernisation initiative.  

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intermediation process; as well as encouraging and fostering positive trends in intermediation, 
such as the latest developments in corporate bond markets. However, bank credit has been the 
predominant  source  of  funding  for  the  real  economy  in  Europe  and  banks  will  continue  to 
play  a  very  important  role  in  the  financing  landscape  in  the  future.  A  well-functioning 
banking  system  remains  important  for  successful  intermediation.  At  the  same  time,  market-
based financing will slowly increase in importance, helping to bring the loan to deposit ratio 
in  Europe  to  levels  comparable  to  other  regions  of  the  world.    Market-based  financing 
increases  diversification  of  external  funding  sources  for  companies  and  from  a  financial 
stability  perspective  increases  the  robustness  of  financing  investments  to  negative  shocks. 
Bond issuance seems to have become a viable alternative source of funding for the bigger and 
best  placed  financial  corporations,  as  the  crisis  has  put  pressure  on  firms  to  find  alternative 
funding  sources.  Developing  and  deepening  the  capital  markets  is  another  step  forward 
required to support effective financing of long-term investment.  

There  is  no  "one  size  fits  all"  solution  to  boost  the  long-term  financing  of  the  European 
economy.  As  discussed  in  the  Green  Paper,  a  debate  is  needed  to  address  a  broad  range  of 
interconnected factors:  

• 

• 

• 

• 

The capacity of financial institutions to channel long-term finance; 

The  efficiency  and  effectiveness  of  financial  markets  to  offer  long-term 
financing instruments; 

The role of public policies in catalysing long-term saving and financing; and 

The ease of SMEs to access equity.  

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11. 

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• 

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• 

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