EUROPEAN
COMMISSION

Brussels, 8.6.2017
SWD(2017) 224 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
on the Mid-Term Review of the Capital Markets Union Action Plan
{COM(2017) 292 final}
{SWD(2017) 225 final}

EN

EN

Contents
List of abbreviations ................................................................................................................................ 4
Executive Summary ................................................................................................................................ 5
Introduction ............................................................................................................................................. 7
1

CMU: a general framework ............................................................................................................. 8
1.1

1.1.1

Overarching objectives .................................................................................................... 8

1.1.2

Strategic objectives........................................................................................................ 12

1.1.3

Operational objectives ................................................................................................... 13

1.1.4

Completed actions so far ............................................................................................... 16

1.2

Pan-European enforcement and supervisory convergence ............................................ 18

1.2.2

Building capacity for Europe's regional markets ........................................................... 20

Markets and banks along the funding escalator .................................................................... 23

2.1.1

Interaction between bank and market-based funding .................................................... 24

2.1.2

The SMEs funding jigsaw ............................................................................................. 24

2.2

Characteristics of Europe's funding escalator........................................................................ 26

2.2.1

Funding with risk concentration .................................................................................... 26

2.2.2

Funding with risk dispersion ......................................................................................... 30

2.3

General policy implications ................................................................................................... 33

2.4

Key indicators........................................................................................................................ 34

Making it Easier for Companies to Enter and Raise Capital on Public Markets ........................... 36
3.1

Access to public markets: long-term trends .......................................................................... 36

3.1.1

Financial structure of EU firms ..................................................................................... 36

3.1.2

Developments in public equity and debt markets .......................................................... 38

3.2

4

Key indicators........................................................................................................................ 21

Financing for Innovation, Start-ups and Non-listed Companies ................................................... 23
2.1

3

CMU mid-term review: focus on supervision and capacity building .................................... 18

1.2.1
1.3
2

The design of the CMU action plan ........................................................................................ 8

Drivers of going public.......................................................................................................... 42

3.2.1

Equity ............................................................................................................................ 42

3.2.2

Corporate bonds ............................................................................................................ 47

3.3

General policy implications ................................................................................................... 49

3.4

Key indicators........................................................................................................................ 50

Strengthening banking capacity to support the wider economy .................................................... 51
4.1

Asset securitisation ................................................................................................................ 51

4.1.1

Trends in securitisation markets in Europe ................................................................... 51

4.1.2

Levers to revive securitisation in the EU ...................................................................... 53

4.2

Covered bond markets ........................................................................................................... 54

4.2.1

Market trends ................................................................................................................. 54

4.2.2

Market barriers and challenges ...................................................................................... 56
2

5

4.3

European Secured Notes (ESNs) ........................................................................................... 57

4.4

Improving the functioning of a secondary market for NPLs ................................................. 58

4.4.1

The stock of non-performing loans ............................................................................... 58

4.4.2

Developments in loan sales markets.............................................................................. 59

4.5

General policy implications ................................................................................................... 61

4.6

Key indicators........................................................................................................................ 62

Institutional investment: Investing for Long-term, Infrastructure and Sustainable Investment .... 63
5.1

6

Long-term institutional investments at the forefront ............................................................. 63

5.1.1

Trends ............................................................................................................................ 63

5.1.2

Drivers ........................................................................................................................... 65

5.2

Infrastructure ......................................................................................................................... 66

5.3

Sustainable finance ................................................................................................................ 68

5.4

General policy implications ................................................................................................... 69

5.5

Key indicators........................................................................................................................ 70

Fostering retail investments........................................................................................................... 72
6.1

Key trends in retail investments ............................................................................................ 72

6.1.1

Saving Rates .................................................................................................................. 72

6.1.2

Household Financial Assets: a balance sheet analysis .................................................. 73

6.1.3

Europe's retail market structure ..................................................................................... 75

6.2

Characteristics of retail investment services markets ............................................................ 77

6.2.1

Structural information asymmetry ................................................................................. 78

6.2.2

Transaction costs in cross-border provision of retail financial services ........................ 79

6.2.3

Behavioural Aspects: biases in retail investment decision-making ............................... 82

6.3

General policy implications ................................................................................................... 88

6.4

Key indicators........................................................................................................................ 89

References ............................................................................................................................................. 90

3

List of abbreviations
AIM
CCP
CCTB
CESEE
CMU
CR-3, CR-5
CSD
ECB
EDGAR
EEA
EFSI
EIB
ESA
ESMA
ESRB
ETF
EU
EU-27
EUR
EA
EuSEF
EuVECA
GDP
IPO
M&A
MFI
MiFID
MiFIR
NFC
P2P
PP
PPP
RES
SAFE
SEC
SME
STS
SWD
USD
T2S
VC

Alternative Investment Market
Central Counterparty (clearing)
Common Consolidated Corporate Tax Base
Central Eastern and South-Eastern Europe
Capital Markets Union
Concentration Ratio top-3 and top-5 companies
Central Securities Depository
European Central Bank
Electronic Data Gathering, Analysis and Retrieval system
European Economic Area
European Fund for Strategic Investment
European Investment Bank
European Supervisory Agency
European Securities and Markets Authority
European Systemic Risk Board
Exchange-Traded Fund
European Union
European Union 27 Member States (excluding United Kingdom)
Euro
Euro area
European Social Entrepreneurship Funds
European Venture Capital Funds
Gross Domestic Product
Initial public Offering
Mergers and Acquisitions
Monetary Financial Institution
Markets in Financial Instruments Directive
Markets in Financial Instruments Regulation
Non-Financial Corporations
Peer-to-Peer
Private Placement
Public-Private Partnership
Renewable Energy Sources
Survey on the Access to Finance of Enterprises
Securities and Exchange Commission
Small and Medium Enterprise
Simple, Transparent and Standardised
Staff Working Document
United States Dollar
TARGET2-Securities
Venture Capital

4

Executive Summary
This Commission Staff Working Document (SWD) accompanies the Communication on the Mid-term
Review of the Capital Markets Union (CMU) Action Plan. The document provides an in-depth
economic analysis of underlying long-term trends and capital market failures to underpin the policy
priorities of the Mid-Term Review. Each chapter includes an introduction about long-term trends and
main indicators. This is followed by a discussion about the drivers of those trends and the general
policy implications.
Chapter 1 proposes a coherent economic framework underpinning the CMU long-term objectives and
provides aggregate indicators about measures of financial integration, as well as investments. The
diversification of the financial system in Europe is still far from optimal, but there are signs in the
post-crisis recovery that the financial integration process is moving towards a more sustainable path.
Based on the economic framework the chapter identifies a number of indicators to measure progress
towards the completion of CMU, also leveraging on internal empirical work conducted by the Joint
Research Centre (JRC). Particular attention, as key highlights of the Mid-Term Review, is paid to
cross-cutting policy issues such as supervisory convergence and capital market capacity building for
the Central, Eastern and South Eastern (CESEE) region.
Chapter 2 reviews developments in the pre-IPO (initial public offering) ecosystem for unlisted
companies, such as start-ups, scale-ups and other Small and Medium sized Enterprises (SMEs), to
review the areas of non-bank funding for innovation that may call for action. Market-based finance
and bank financing complement one another - the banking sector and capital markets have
complementary roles and comparative advantages in different stages of development of an economy.
Nonetheless, financing constraints remain, in particular for start-ups, scale-ups and non-listed
companies. On the one hand, banks tend not to lend to young companies without collateral and certain
future cash flows. On the other, capital markets are under-developed in several Member States,
leaving SMEs vulnerable to stress in the banking sector. Market-based solutions in this area include
business angels, private equity and venture capital, which rely on risk concentration and strong
influence on the governance of the firm, as well as crowdfunding and private placement, which rely on
risk dispersion and information disclosure by the company seeking funds. These forms of funding
need a more holistic approach to help them develop a better ecosystem. Moreover, many
entrepreneurs, start-up and small businesses fail due to cash flow problems although having a viable
business model. Solutions such as supply chain finance (invoice trading) can help companies
overcome temporary cash flow problems.
Chapter 3 focuses on raising equity and debt finance on public capital markets. Access to bond and
equity markets occur in waves, depending on macro-economic, firm-specific and institutional factors.
Initial access to equity markets facilitates subsequent access to finance (equity, bond, and bank
financing) and mergers and acquisition (M&A) activity. Firms' financial structure and access to public
markets differs depending on the firm's size (large firms versus SMEs) and across Member States.
Dependency on bank-based financing decreased following the financial crisis but still remains high on
average. SMEs overall access to external finance shows signs of improvement, but SMEs still face
structural barriers to access public markets due to higher information asymmetries, high fixed costs,
underdeveloped ecosystems and relatively low demand from institutional and retail investors.
Proportionate regulation could help targeting those firms for whom access to public markets is
relevant – like fast-growing young SMEs – while ensuring investor protection to preserve sufficient
demand from investors.
Chapter 4 reviews how banks can use capital markets to support bank lending. STS securitisation
aims to support the revival of the EU securitisation market, which will provide banks with an
important tool to manage their balance sheet and transfer risk. Market practices to achieve greater
standardisation and transparency of deals can support this process. Covered bonds have proven to be
an effective long-term funding instrument for the mortgage loan and public sector loan portfolio of
banks. A larger EU market for covered bonds, based on existing covered bond frameworks, would
reduce issuance costs for banks and offer an asset class to investors. The development of a new dual
5

recourse instrument similar to covered bonds – a European Secured Note (ESN) – could provide a
focused way of financing SME and infrastructure loans. As several banks across the EU have built-up
a large stock of non-performing loans (NPL), improvements to the functioning of the NPL secondary
market would benefit from the expansion of the investor base to specialised buyers such as hedge
funds and investment firms, helping banks to refocus on their core business.
Chapter 5 discusses long-term institutional investors' participation in capital markets and to support
infrastructure and sustainable investments. Equity finance is an important source of long-term
investments. The corporate sector in some Member States remains highly leveraged and start-ups, in
particular, ask for equity rather than loan finance to support their growth. Equity investment by
insurance undertakings and pension funds however remains low. Capital markets could support
sustainable finance by redirecting private funds to environmentally-friendly production processes and
help to generate financial returns with positive social externalities.
Chapter 6 argues for greater engagement of retail investors in capital markets. EU households have
one of the highest savings rate worldwide, but those savings are held predominantly in cash deposits,
which may generate insufficient returns to meet long-term liabilities, such as education, health and
ageing population. Retail investors are important to support market liquidity for stocks and bonds and
thereby reduce the cost of finance for EU businesses, including SMEs. Lack of retail investors'
participation relates to market frictions in the forms of explicit transaction costs, information
asymmetry and behavioural biases. On the supply side, a lack of (domestic and cross-border)
competition may lead to rent-seeking behaviour by service providers. New market entrants, such as
FinTech companies, could put competitive pressures on incumbents in the years to come. On the
demand side, investors' deviation from the optimal portfolio choice can be minimised through more
effective transparency of retail investment products (information disclosure) and ability to deal with
behavioural frictions.
This SWD analyses and monitors trends in capital markets that are relevant to the objectives of the
CMU action plan. Building on its 2016 commitment to further develop and update indicators to
measure CMU objectives,1the SWD includes a section at the end of each chapter with a recap of the
indicators used in the text. While other factors beyond CMU actions have a sizable impact on the
evolution of capital markets in Europe, these indicators offer an insight on the state of development
and integration of European capital markets that will inform current and future policy actions.

1

The Economic and Financial Stability and Integration Review (EFSIR) released in April 2016 presented a set of indicators
to help analyse the relevant trends in capital markets' development relevant to the objectives of the CMU Action Plan.
Compared to the work undertaken in 2016 EFSIR, only a few indicators have changed by new indicators found to be fitter for
the purpose.

6

Introduction
This Commission Staff Working Document (SWD) accompanies the Communication on the Mid-term
Review of the Capital Markets Union (CMU) Action Plan. The economic analysis on the functioning
of capital markets in the European Union (EU) in this SWD provides the economic context for the
policy actions in the mid-term review. The SWD provides a general context for identifying
weaknesses and market failures in the functioning of EU capital markets, some of which may be
suitable candidates for action in the CMU mid-term review. The SWD seeks to review the main
structural shifts in EU capital markets, understand the drivers of change building on insights from
economic theory and conclude, where possible, with key messages for implications on policy. It
analyses and monitors trends in capital markets that are relevant to the objectives of the CMU
initiative through the use of indicators.2
This SWD extends and complements the economic analysis done previously. In particular, the SWD
that accompanied the CMU Action Plan of September 2015 provided a thorough rationale for the
objectives of the CMU. The 2016 European Financial Stability and Integration Review (EFSIR)
provided an extensive statistical overview of the EU financial system, including capital markets.
The SWD starts by introducing a general framework underlying the CMU in Chapter 1 and is then
followed by five thematic chapters reflecting the CMU policy areas. Chapters 2 to 4 focus on funding
sources and chapters 5 and 6 look at asset allocation.

2

The use of key indicators should not necessarily be interpreted as an attempt to establish a causal relationship between the
indicators and the CMU actions.

7

1

CMU: a general framework

This chapter presents a general framework for the CMU based on economic theory. The framework
identifies relevant indicators to measure the progress of the CMU action plan in the long term. It also
provides a framework to prioritise actions. The first section looks at the potential design of the plan
and its objectives, which help to identify the long-term indicators. The second section reviews the
implementation of the plan so far and its main actions. The last section discusses the future challenges
of the CMU mid-term review, with special focus on the institutional architecture.

1.1 The design of the CMU action plan
The CMU action plan builds upon three levels of objectives: (1) Overarching objectives, which set
the long-term goal of a single market for capital; (2) Strategic objectives, which set the direction on
how to create a single market for capital; and (3) Operational objectives, which define what is the
scope of individual policy actions to be effective.
1.1.1

Overarching objectives

Capital markets are a fundamental part of the financial system. They provide funding to firms and
returns to millions of households that have to meet long-term liabilities, like health, education and
retirement. A single market for capital would contribute to two overarching objectives in the
Commission's agenda for the years to come:
1) Greater support to private and public investments through the development of a capital market
architecture that supports all European countries; and
2) More sustainable financial integration process to stabilise and improve the functioning of
Europe's financial system.
Greater support to public and private investments
Since the crisis, European economies are still struggling to get back to normal. The difference between
actual and potential GDP (i.e. output gap) is constantly below zero and the economy is performing
below its potential (see Figure 1.1).
Figure 1.1. Output gap (actual minus potential GDP, %)
4
3
2
1
0
-1
-2
-3
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018

-4

EU 27

EU 28

United States

Source: European Commission calculations from AMECO.

The weakness of public and private investments is playing an important role in this output gap,
compared to other advanced economies. In particular, assuming investment growth and GDP growth
at the rates forecasted for 2017, it would take until 2023 for the investment share to recover to 22%, its
level in the years 2000-05 (European Commission 2017). At net of its consumption, the creation of

8

fixed capital has been constantly dropping since early 2000s and only slightly recovering after the
recent financial crisis, both in absolute value and returns.
Figure 1.2. Net fixed capital formation (% of GDP)

Figure 1.3. Net returns on net capital stock
(2010=100)

10%
140
8%
130
6%

120

4%

110

2%

100
90

0%

80
-2%
70

United States

Japan

EU 27

60

EU 28

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018

-4%

United States

Japan

EU 27

EU 28

Source: European Commission calculations from AMECO.

Capital markets can provide a strong support for both public and private investments. For instance,
public-private partnerships (PPP) are important tools for infrastructure investments to complement
public investments. Capital markets allow the use of risk premia to evaluate public and private
investments (risk evaluation). Greater capital markets activity also stimulates private and public
investments by providing an exit to investments, especially illiquid ones. Their development across
regions in the EU would rely on actions to build capacity in terms of investor base, market
infrastructure and supervisory practices.
Finally, the Commission is already working to use capital markets to foster public and private
investments. The European Fund for Strategic Investment (EFSI) is one of the three pillars of the
Commission's Investment Plan for Europe and helps to finance strategic investments in key areas such
as infrastructure, research and innovation, education, renewable energy and energy efficiency. The
European Fund for Strategic Investment has the goal to mobilise at least EUR 315 billion in additional
investment over the period 2016-2018. Its success is therefore relevant for areas of interventions
discussed in the following chapters (in particular, 'Make it easier for companies to raise funds on
capital markets' and 'Promote investment in long-term, sustainable projects and infrastructure
projects'). The take up of infrastructure or innovation projects under the EFSI instrument represents a
useful indicator to assess the extent to which this instrument is boosting long-term investment in
Europe. The approval process by the European Investment Bank (EIB) Group having started in April
2015, the number of approved transactions as of April 2017 reached 477. This represented approved
financing from the EIB Group of EUR 33.9 billion, expected to trigger a total investment of EUR
183.5 billion.3
A more sustainable financial integration process
A well-functioning single market for capital relies on a sustainable financial integration process to
efficiently allocate resources (Monti Report 2010). The crisis, and following financial fragmentation,
suggested that diversification of financial flows is key for a sustainable financial integration process
3

For a summary of key indicators, please see the end section in Chapter 5.

9

(Five Presidents’ Report 2015). Europe’s financial system is heavily reliant on bank financing, while
the economy may need the support of a financial system that adapts better to the needs of all the firms
developing across the funding escalator. The lack of diversification manifested itself via limited
geographical risk diversification (see Figure 1.4), i.e. deviation from the optimal allocation, as well as
limited portfolio diversification (see Figure 1.5).
Figure 1.4. Geographical risk diversification index (2000-2015)4
0,60
0,55
0,50
0,45
0,40
0,35
0,30

EMU

EU27

EU28

Source: European Commission (JRC) calculations from the JRC-ECFIN FinFlows dataset. Note: outward diversification
index (equity and debt).

Figure 1.5. Debt and equity portfolio investments intra EU (EUR billion; portfolio risk diversification)
14.000
12.000
10.000
8.000
6.000
4.000
2.000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Portf. Equity (EU27)
Portf. Debt (EU27)
Portf. Equity
Portf. Debt

Source: European Commission (JRC) calculations from the JRC-ECFIN FinFlows dataset. Note: Bilateral country flows
within the EU.

This integration process based on low risk diversification (geographical and portfolio risk
diversification) resulted in lower cross-border risk sharing and did not prevent massive consumption
drop across Europe, and more prominently in the euro area, when the GDP shock hit Europe's
economy. In particular, investment portfolio flows are largely allocated to debt instruments (let alone
the system’s overreliance on bank lending; ESRB 2014), while the equity component (which is the one
that absorb risk most effectively) is very low on average in the last decade but increasing in the postcrisis. Additionally, home bias (measured as the holding of domestic assets versus their optimal intra4

The index is equal to one, if the domestic portfolio is perfectly geographically diversified and lower than one otherwise.
Portfolio theory suggests that a country should optimally allocate its investments abroad according to the “importance” of the
partner country, importance being measured as the proportion of this country’s assets in the combined pool of assets of all the
foreign countries considered. This diversification index is based on Schoenmaker and Wagner (2011).

10

EU allocation) also remains very high, especially in equity instruments, even though experiencing a
declining trend in the last two years (see Figure 1.7). In effect, the geographical and portfolio
diversification of the financial system in Europe is still far from optimal and there are only timid signs
in the post-crisis that the financial integration process is moving towards a more sustainable path,
measured by the level of co-movement between price and quantity-based indicators of integration (see
Figure 1.6 and Figure 1.7).
Figure 1.6 Price-based integration in Europe5
Equity markets

Bond markets

EA

EU28

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016

1,0
0,9
0,8
0,7
0,6
0,5
0,4
0,3
0,2
0,1
0,0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016

1,0
0,9
0,8
0,7
0,6
0,5
0,4
0,3
0,2
0,1
0,0

EU27

EA

EU28

EU27

Source: European Commission (JRC) calculations.

Figure 1.7 Quantity-based integration (home bias) in Europe6
Equity markets

Bond markets

Source: European Commission (JRC) calculations. Note: No data for Croatia.

5

The price-based indicator is a measure of financial integration based on the sensitivity of domestic European stock and bond
markets to global, US or European drivers. It measures the domestic returns' co-movement with global factors across the EU.
The closer the indicator is to 1, the greater integration can be seen in the market. The indicator is estimated via a Principal
Component Analysis. Data for bond markets is the yield of generic benchmark sovereign bonds with maturity 10 years, while
we use local stock indexes for equity markets. For more details about the estimation procedure, please see Nardo et al.
(2017).
6
This indicator is a weighted average of all EU Member States (except Croatia, for which we do not have sufficient data) and
measures the extent to which domestic equity/bonds, held by EU residents in their country, are overweighing their domestic
investment portfolio (i.e. holding a proportion of domestic assets that is higher than the relative importance of local equity
and bond markets over the total in the EU). The higher the value of the indicator the more home bias is observed (i.e. 1 being
that the entire portfolio is invested within the domestic country of the EU). This measure follows the methodology developed
in Bruegel (2016).

11

1.1.2

Strategic objectives

In order to achieve the overarching objectives mentioned above and deal with the long-term issues to
create a single market, as highlighted by the Monti report (2010), capital markets would need to be
more:
1) Competitive and efficient (to deal with 'market fatigue').
CMU should deliver greater access to finance (private investments) and a better framework for public
investments (for demand-side policies). Liquidity and market microstructure are also part of the
market functioning and efficiency. Increased competition between funding sources and within the
financial sector would result in more diversified asset side for capital providers and liability side for
capital seekers. A more competitive market and industry structure are key to overcoming ‘market
fatigue’. Technologies applied to financial services (FinTech) provide an indispensable toolkit to
promote access, efficiency and competition among capital markets service providers.
2) Financially stable and integrated (to deal with 'integration fatigue').
Improving channels of private risk sharing (i.e. cross-border holdings of financial assets), through the
risk dispersion provided by cross-border capital market transactions, is key for financial stability. In
effect, on a cross-border basis, capital (and credit) markets are the main channel of risk absorption in
case of asymmetric shocks like the last financial crisis (Asdrubali et al. 1996, among others). 7 Stability
also includes sounder investor protection to be enforced at EU level. As Figure 1.8 and Figure 1.9
suggest, both greater geographical risk diversification and lower home bias (i.e. propensity to hold
domestic assets over other EU foreign ones) could be associated with greater risk sharing via crossborder credit and capital markets (obtained from the net factor income).8 This means that the more the
financial system is diversified according to the 'importance' of the partner country (geographical risk
diversification)9 and according to the 'importance' of the local capital markets vis-à-vis the total EU
markets (home bias), the greater is its overall stability, resulting from the greater ability to absorb risk
(see Figure 1.8 and Figure 1.9).

7

In the US, for the period 1964-1990, public intervention is worth 13% of the absorption capacity in case of a shock,
compared to a 23% contribution from credit and 39% from capital markets. Geographical and portfolio diversification
ultimately stabilises the financial system. For a more extensive discussion and literature review, please see Valiante (2016). A
recent estimation for OECD industrialised countries (Poncela et al. 2016, data range 1999-2014) shows an absorption
capacity of around 24% for the saving channel, negligible for the public intervention and around 4% for cross border credit
and capital markets. It is also important to note that capital gains on cross-border capital markets transactions are not capture
by this methodology in the international factor income (cross-border credit and capital markets), but in the saving channel
(see Balli et al. 2012).
8
Also called 'international factor income'. Net factor income is the portion of the Gross National Income coming from crossborder investments (essentially interests and dividends), but it does not include income from capital gains (see the European
System of Accounts ESA2010). According to the methodology developed by Asdrubali et al. 1996, this link absorbs the most
of asymmetric shocks to GDP among the available channels.
9
Our analysis, not reported in the SWD, suggests that geographical risk diversification is negatively correlated with home
bias within the EU, as confirmation that intra-EU flows move together with diversification.

12

Figure 1.8. Geographical risk diversification and risk
sharing (EU28)

Figure 1.9. Home bias vs risk sharing (EU28)
60

60

y = -17,175x + 20,524

y = 26,905x - 3,663

40
Risk Sharing (1995-2015)

Risk Sharing (1995-2015)

40
20
0
-20

20
0
-20

-40

-40

-60

-60
-80

-80
0,0

0,1

0,2
0,3
0,4
0,5
Diversification of assets, average 2000-2014

0,6

0,0

0,7

0,2

0,4

0,6

0,8

1,0

Home Bias, average 2004-2014

Source: European Commission (JRC) calculations. Last available estimate is for 2015. Note: For illustrative purposes,
Figure 1.9 does not include Ireland and Luxembourg where home bias is close to zero.

Diversification also involves funding sources. In effect, lack of financial diversification exposes the
system to further instability caused by the volatility of some financial flows when there is a structural
shock (see Figure 1.10).
Figure 1.10. Financial flows to non-financial corporations (EUR billion, net amounts)
600
500
400
300
200
100
0
-100
-200
1999

2001

2003

2005

Bank loans

2007

2009
Bonds

2011

2013

2015

2017

Listed shares

Source: ECB and European Commission calculations.

Bank loans do usually have a much higher volatility, compared to listed shares and debt instruments,
which are more resilient to asymmetric shocks.
3) Cohesive (to deal with 'eroding consensus').
CMU also helps to strengthen the cohesion of the single market plan, as: it is a multi-currency project;
it does not need public risk sharing; it does not need an institutional overhaul (like for banking union),
beyond the upgrade of the current institutional framework. It also interacts well with banking union, as
it complements the importance of greater cross-border credit markets.
1.1.3

Operational objectives

A capital market transaction is a market-based financial transaction that typically involves several
capital providers (investors). Compared to a traditional bank lending operation, where there is one
institution as the capital provider, which directly collects and processes information, market-based
transactions involve multiple capital providers in every transaction (typically through the issuance of a
13

financial instrument), who do not have the size and cost structure to undergo complex due diligence to
collect and process information about the capital seeker. As a result, a system of rules and procedures
is usually designed and enforced, in order to give investors and capital seekers the certainty that the
transaction will take place and sufficient information will be available, if they do not have the scale to
produce the information themselves. For instance, regulators typically foresee disclosure rules to
complement the voluntary disclosure of information by the issuer. Components of a capital market
transaction are thus:
(1) Information flows that allow price discovery and so pricing;
(2) The execution infrastructure that allows access to markets and products; and
(3) The rules and contracts that allow uniform rules to be applied with a high degree of legal certainty
across the EU.
On a pan-European scale, the CMU action plan therefore promotes the following operational
objectives:
1. Greater data availability and comparability on a cross-border basis (for price discovery);
2. More accessibility to markets and product (with fair access);
3. Stronger enforcement of rules and procedures (to achieve greater legal certainty and
investor protection).
As specified in Figure 1.11, once defined the three levels of objectives (overarching, strategic and
operational), the CMU action plan has identified one general area of intervention on supervision and
capital market capacity building and six specific areas of intervention according to the developing
phases of the funding escalator and investment, which are defined as follows:
1.
2.
3.
4.
5.
6.
7.

Strengthening supervision and building capital markets capacity in the EU;
Financing for innovation, start-ups and unlisted companies;
Making easier for firms to raise money on public markets;
Strengthening banking capacity to support the economy;
Investing for long-term, infrastructure and sustainable investments;
Fostering retail investment; and
Facilitating cross-border investments.

14

Figure 1.11. The CMU Action Plan

15

1.1.4 Completed actions so far
Over the past 18 months, the Commission has delivered the following 20 actions (out of 33) in accordance with the list announced in the 2015 CMU Action
Plan.
Note: legislative actions are shaded in grey; Tick '√' means that the measure has an impact on that dimension of
capital markets and 'X' otherwise

Financing for
innovation, start-ups
and non-listed
companies

Making it easier for
companies to enter and
raise capital on public
markets

Institutional investors Investing for long term,
infrastructure and
sustainable investment

Price
discovery

Market and
product access

Enforcement

1. Pan-European venture capital fund-of-funds and multi-country funds (proposal and
adopted and selection of managers to be finalised in Q2 2017)

X

√

X

2. EuVECA and EuSEF legislation review (proposal adopted in July 2016)

X

√

X

3. Study on tax incentives for venture capital and business angels (adopted in June
2017)

X

√

X

4. Industry high-level principles for banks' feedback to declined SME credit
applications (adopted in May 2017)

√

√

X

5. Map out existing local or national support and advisory capacities across the EU to
promote best practices (staff working document adopted in June 2017)

X

√

X

6. Report on crowdfunding (published in May 2016)

√

√

√

7. Regulation to modernise the Prospectus Directive (agreement reached in December
2016)

√

√

X

8. Common Consolidated Corporate Tax Base (CCCTB) and debt-equity tax bias
(proposal adopted in October 2016)

X

√

X

9. Review of infrastructure calibrations for banks through the CRR proposal (proposal
adopted in November 2016)

X

√

X

10. Solvency II calibrations for insurance companies' investments in infrastructure and
European Long Term Investment Funds (proposal adopted in April 2016)

X

√

X

11. Call for evidence on the cumulative impact of the financial reform (Communication
adopted in November 2016)

√

√

X

16

Fostering retail
investment

Leveraging banking
capacity to support the
wider economy

Facilitating crossborder investment

12. Following the Green Paper on retail financial services and insurance, the
Commission adopted on 23 March 2017 the 'Consumer Financial Services Action
Plan: Better products and more choice for EU consumers.'

√

√

√

13. Consultation on the main barriers to the cross-border distribution of investment
funds (consultation closed in October 2016)

X

√

X

14. Assessment of the case for a policy framework to establish a European personal
pension product (legislative proposal due by end of June 2017)

X

√

X

15. Credit unions' authorisation outside the EU's capital requirements rules for banks
(proposal adopted in November 2016)

X

√

X

16. Simple, transparent and standardised (STS) securitisations and revision of the
capital calibrations for banks (proposal adopted in September 2015)

√

√

X

17. Consultation on an EU-wide framework for covered bonds and similar structures
for SME loans (consultation closed in January 2016)

X

√

X

18. Report on national barriers to the free movement of capital (adopted in March 2017)

X

√

√

19. Business restructuring and second chance framework (proposal adopted in
November 2016)

X

√

√

20. Assisting ESMA in developing and implementing a strategy on fostering
supervisory convergence (Supported ESMA in implementing its first and second
annual work programme on supervisory convergence in 2016 and 2017).

√

√

√

17

1.2 CMU mid-term review: focus on supervision and capacity building
The CMU action plan is a structural reform programme, which is being implemented and reviewed
over a long time span. Since its launch in September 2015, the action plan mostly focused on measures
to improve access to markets and products (see Section 1.1.4), via lowering direct costs. Actions, such
as the revised Prospectus rules or the regime for standardised and transparent securitisation, aim to
reduce fixed costs of access to markets by lowering listing costs. Other actions to fine-tune prudential
treatment of transparent and standardised securitised instruments seek to improve product market
access. Actions to address availability of information flows (price discovery) or strengthen rule
enforcement to ensure legal certainty are less prominent.
The review of the CMU action plan broadens the policy agenda by adding actions to promote greater
price discovery and enforcement across the EU. Among those actions, a key development is the intent
to ensure the well-functioning of the capital markets’ supervisory architecture. This will ultimately
benefit market and product access, price discovery and enforcement of EU rules and private contracts
altogether. A sound supervisory architecture would then implement and enforce the Single Rulebook
across Europe. Finally, the plan foresees actions to support capacity building for local or regional
capital markets that have limited scalability, which would have beneficial impact on the three
functions mentioned above.
1.2.1

Pan-European enforcement and supervisory convergence

Capital markets comprise a wide spectrum of market segments ranging from local financial providers
that sell products to retail investors to large and complex wholesale market providers like stock
exchanges and CCPs that might hide cross-border financial contagion risk. The supervisory approach
for EU capital markets needs to be pragmatic and combine supervisory convergence and direct
supervision in the most effective and proportionate manner. The ability to enforce contracts with a
common supervisory treatment across the EU is key component of a well-functioning capital market,
as it is the case for the US (see Box 1). Supervision of capital markets in a complex multilateral
environment, as the EU, has to deal with two types of economic costs: monitoring costs and
coordination costs.
First, every financial transaction generates monitoring costs. The cross-border dimension of European
markets raises this cost even further for national supervisors, who may be discouraged or not allowed
to expand their supervisory activity cross-border, while many financial services firms nowadays do
operate cross-border. The inability to monitor the counterpart effectively, especially in a dispersed
environment like capital markets, requires risk signalling mechanisms that are also delivered by the
supervisory infrastructure, such as minimum licensing requirements to enter a market and ongoing
monitoring. A well-functioning supervisory mechanism also reduces other monitoring costs by
interposing itself between investors and capital seekers in the enforcement of rules and contracts.
Enforcement tools include effective and uniform sanctions, redress procedures and proper
implementation of EU rules. The credibility of capital market operators is the driving force of capital
market integration and a sound supervisory architecture contribute to that too. As a consequence,
strengthened pan-European supervision would need to consider areas where to expand the exclusive
powers of the pan-European supervisor.
Second, supervision in a community of sovereign states may also face significant coordination costs,
due to a collective action problem. As a result, some member states may decide to not align
themselves, via 'gold plating' EU rules, with others that cooperate via strictly implementing EU
legislation. Supervisory convergence could minimise the risk of a ‘race-to-the-bottom’ in enforcing
EU rules, as well as forum shopping and regulatory arbitrage by private entities operating crossborder. A more solid supervisory architecture at EU level would therefore ensure the implementation
of a Single Rulebook for capital markets in the EU, reducing compliance costs for firms and investors,
as well as operational costs for supervisors. The latter implies a greater binding role of the panEuropean supervisor in solving conflicts among national authorities and more representation of the EU
interests in the decision-making bodies of the key European agencies.
18

Enforcement and supervision in the EU
The underlying rationale for setting up the European Supervisory Agencies (ESAs) was to deepen the
EU financial Rulebook, ensure closer cooperation and exchange of information among national
supervisors and advance the coherent interpretation and application of rules. By contributing to the
promulgation of common rules and ensuring supervisory convergence and coordination the ESAs
should shape the further development of a single rule book applicable to all EU Member States and
thus contribute to the functioning of the Single Market. To this end, the ESAs have been assigned in
the founding Regulations and subsequent secondary Union legislation regulatory, supervisory,
financial stability and consumer protection roles and powers.
The creation of a common supervisory culture, with convergent supervisory practices, is a long term
process. The ESAs have so far focussed principally on their regulatory role, as deepening the common
rule-book was the upper-most priority in the wake of the crisis. Their supervisory and enforcement
role may produce even greater impact in the long-term and needs to be stepped up to achieve more
consistent implementation and supervision of new EU rules.
Correct and consistent implementation of EU law at national level is essential to enforce a single
rulebook, particularly when transposing EU Directives into national law. Significant compliance costs
may result from divergent and/or inconsistent transposition of EU Directives into national legislation.
When transposing EU Directives, Member States may deviate from the text of the Directives or
interpret the rules (including definitions) in different ways. Such divergences undermine the single
rulebook and the level playing field and create complexity and additional compliance costs for firms
operating cross-border. In addition, in several areas, some Member States go beyond what is required
by EU law when implementing legislation at national level. In this context, the ESAs have started
conducting peer reviews,10 but their scope is often very limited and more intrusive powers (such as the
'breach of EU law') have been rarely used.11
The need to reinforce the EU dimension of supervision and to strengthen the supervisory framework
has been stressed in the Commission Communication on Capital Markets Union – Accelerating
Reform of September 2016. The Five Presidents' Report has also acknowledged the need to strengthen
the supervisory framework to ensure the solidity of all financial actors.
Role and functioning of ESMA
The European Securities and Markets Authority (ESMA) is the capital market supervisor for Europe’s
capital markets. The decisions are taken by the Board of Supervisors (BoS), consisting of national
competent authorities (peers). Currently ESMA exercises direct supervisory powers only over trade
repositories and credit rating agencies. As capital markets deepen and get more integrated, there is a
need to ensure that the capacity to supervise and manage risks, especially cross-border, keeps pace.
This gives rise to questions on whether ESMA's current toolbox and powers are sufficient and
appropriate to underpin efficient and cost effective supervision also in a deeper CMU. The growing
cross-border component increases monitoring and coordination costs that cannot be dealt with at
national level. For example, the development of more integrated capital markets could justify the
centralisation of supervision in certain areas where risk emerges from this cross-border dimension.
Reflections on a stronger role for ESMA could most productively focus on those market segments or
functions where the degree of integration creates strong spill over effects or synergies that cannot be
effectively overseen by nationally segmented operators. Strengthened powers for ESMA would ensure
that market participants with a similar business model, size or risk profile are subject to the same
intensity and extent of oversight to ensure a level playing field among market participants and equal
10

Informal investigations into the supervisory practices of National Competent Authorities (NCAs) in defined areas of
intervention.
11
Since 2015, ESMA only conducted five peer-reviews and there are only two ongoing peer-reviews in the first quarter of
2017. These reviews cover limited areas of EU rules implementation. No 'Breach of Union law' procedure (under article 17,
Regulation n. 1093/2010) has been formally launched by ESMA since its inception.

19

protection for domestic and cross-border investors. It would also ensure that potential risks to financial
stability that might arise, following the integration of the markets, would be monitored and mitigated
in an effective manner across Member States.
Moreover, there are general market support services with a 'public good' dimension that have strong
economies of scale and are capable of reducing costs for Member States and supervised entities. These
services are mainly data collection, management and publication. This centralisation process is
applicable to all sorts of data reporting, including transaction reporting, accounting, business registry
information. The simplification that centralisation brings about will improve cross-border data
accessibility via greater standardisation and streamlined submission procedures. This process would
benefit supervised entities, supervisors and investors at large.

Box 1.

Powers of the U.S. Securities and Exchange Commission (SEC)

The U.S. Securities and Exchange Commission (SEC) is responsible for enforcing federal securities
laws, proposing securities rules, and regulating the securities industry including stock and options
exchanges and the electronic securities markets in the US. The mission of the SEC is to protect
investors, maintain fair, orderly, and efficient markets, and to facilitate capital formation.
The SEC has several key powers. First, the SEC interprets and enforces federal securities laws. It
investigates violations of securities laws and regulations and takes actions when violations have been
uncovered. The SEC can bring a civil action, or an administrative proceeding which is heard by an
independent administrative law judge. The SEC does not have criminal authority, but may refer
matters to state and federal prosecutors.
Second, the SEC oversees the disclosure made by public companies, as well as the registration of
transactions, such as mergers, made by companies. The SEC requires public companies to disclose
meaningful financial and other information to the public, providing a common pool of knowledge for
all investors. It maintains an online database called EDGAR (the Electronic Data Gathering, Analysis,
and Retrieval system). EDGAR provides investors with access to the information filed with the
agency. It is also possible to file complaints and report violators of securities laws via EDGAR.
Third, the SEC oversees securities trading and markets. It oversees the inspection of securities firms,
clearing infrastructure, brokers, investment advisers and ratings agencies, as well as private
regulatory organizations in the securities, accounting and auditing fields. The SEC interprets
proposed changes to regulations and monitors operations of the industry.
Fourth, the SEC oversees registered investment companies, which include mutual funds, as well as
registered investment advisers. The SEC focuses on ensuring that disclosures about mutual funds,
ETFs and other such investments are useful to retail customers, and that the regulatory costs which
consumers must bear are not excessive.
Finally, the SEC can make use of no-action letters to issue guidance in a more formal manner. A
company seeks a no-action letter from the staff of the SEC when it plans to enter uncharted legal
territory in the securities industry. For example, if a company wants to try a new marketing or
financial technique, it can ask the SEC staff to write a letter indicating whether it would or would not
recommend that the SEC take action against the company for engaging in its new practice.
1.2.2

Building capacity for Europe's regional markets

The importance of geographical location proximity in complex financial ecosystems is an unsettled
discussion in economic literature. In order to create liquidity, capital markets need volumes and so rely
on strong economies of scale. As a result, also due to technological developments in recent years,
capital markets tend to consolidate around big clusters of liquidity, which are usually big Member
States or regional trading hubs, due to benefits that spill over the entire economy (Pandit et al. 2002).
Nonetheless, not all forms of finance need centralisation to develop. Geographical proximity still
matters for many of them and for specific categories of users, such as start-ups. For instance, despite
its ability to make geographical proximity less important, crowdfunding is not able to overcome all the
distance-sensitive costs related to information (Agrawal et al. 2015). It is less clear whether public
20

equity markets for SMEs at national level or more locally are more beneficial than centralised regional
hubs in any given area (Klagge & Martin 2005). While trading of listed blue chips becomes
increasingly international, cost of equity is higher for firms that come from countries with a weak
governance and institutional design (Boubakri et al. 2016). Spatial proximity between financial
intermediaries and SMEs facilitates information exchange to lower transaction costs and non-cost
barriers for capital provision (Klagge & Martin 2005). Some specialised regional stock markets can
also attract the interest of other forms of finance (like private equity), which finds in these markets
either an exit or a guide to price SME risk. There is also evidence that firms’ propensity in looking for
external finance grows in proximity of venture capital markets (Colombo et al. 2016).
The development of capital markets across the EU should consider the different maturity of capital
markets across Member States. For market based finance to be a viable and sustainable alternative to
bank lending, the CMU needs to build the financial circuits, market conventions and technical and
legal infrastructures that will allow market participants to operate at local, regional or national level
while, at the same time, to transact confidently on a pan-European scale. There is a need to broaden
the geographical reach of capital markets so that all Member States reap the benefits of deeper and
more integrated capital markets. Mobilising the local investor base in regional markets requires more
than the presence of a regional market. Some Member States would need to strengthen their capacity
also in other areas than access and competitiveness of financial intermediation, such as supervisory
capability or other policy areas that help to create an environment conducive to capital mobility in the
region, as well as clustering of specific forms of finance (e.g. venture capital, private equity or SME
crowdfunding tools). Technical assistance may help these Member States. The Central Eastern and
South-Eastern Europe (CESEE) region is an area where some capacity building for the development of
a regional hub in specific forms of finance can be achieved. The incidence of bank finance in this area
is lower than the rest of the EU (154% of GDP versus 410% of GDP). Banks are mainly foreignowned and they operate under limited interference by local governments, thus with a more marketoriented behaviour. Non-financial firms’ access to capital markets is lower that the EU average (6%
versus 21% for the EU). Issuance of debt securities is considered irrelevant for SMEs in the CESEE
region (ECB Safe Survey on Access to Finance). Insurance and pension funds are only partially
involved in capital markets activities, often because the national regulatory framework creates
additional constraints. Households exhibit strong bias towards cash or deposit instruments, but their
participation in equity investments is mixed across countries.

1.3 Key indicators12
Support to public and private investments

Indicator
Ouput gap (actual minus potential GDP, % of GDP)
Net fixed capital formation (% of GDP)
Net returns on net capital stock (index value rebased
in 2010 as equal to 100)

Last 5-year
average

Latest
observation

Value

-1.83%
2.42%

2016
2016

-0.69%
2.63%

101.6

2016

105.8

Last 5-year
average

Latest
observation

Value

0.5

2015

0.5

A sustainable financial integration process

Indicator
Geographical risk diversification index (outward
flows, equity and debt; index value between 0 and
12

EU, unless indicated otherwise.

21

1)
Debt portfolio investments intra EU (end of period;
EUR trillion)
Equity portfolio investments intra EU (end of
period; EUR trillion)
Price-based integration in EU (bond markets; index
value between 0 and 1)
Price-based integration in EU (equity markets;
index value between 0 and 1)
Quantity-based integration in EU (home bias; index
value between 0% and 100%)

EUR 8.71
trillion
EUR 4.22
trillion

2015
2015

EUR 8.25
trillion
EUR 4.98
trillion

0.31

2016

0.4

0.51

2016

0.46

82%

2015

80%

22

2

Financing for Innovation, Start-ups and Non-listed Companies

Access to a diversified pool of funding options is critical for financial stability and economic growth.
Successful entrepreneurs, start-ups, scale-ups and firms need access to different types of financing to
fund innovation and their expansion. This chapter reviews the funding channels via capital markets for
innovative and growing firms seeking to raise equity or debt outside the banking system, and explores
the overall challenges to improve the pre-IPO environment in the EU.

2.1 Markets and banks along the funding escalator
A company's financing needs evolve with its growth in size and specialisation over time. Its stage of
development, growth objectives, innovativeness, operations, and credit profile determine its financing
needs. This is generally defined in corporate finance as the 'funding escalator'. In the start-up phase, a
company needs mostly cash to develop its business idea. Most founders begin by investing their
savings, making use of personal credit facilities, and tapping family and friends for funds (Robb and
Robinson (2014)). For founders who have exhausted such ‘personal’ finance, raising outside finance is
a considerable challenge. For instance, start-ups generally do not generate steady cash flows to pay
interest and—beyond re-mortgaging the founder’s personal assets — they lack other kinds of
collateral (Schmalz et al 2013). This makes them unattractive candidates for standard corporate debt
financing (e.g. loans) (Berger and Udell 1998; Aghion et al 2004).
Figure 2.1. Funding escalator

Source: Commission services.

Although retained earnings increase when a company is successful and grows, a firm's external
financing stays typically high in the growth stage. Once the firm enters the mature stage, financing
structures adjust to the pace of earnings, business growth and 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.13 If a firm cannot or does not want to put all retained
earnings to operational use, it may decide to buy back its debt or equity.

13

For a discussion on the respective advantages/disadvantages of debt and equity in the financial structure, we refer to the
European Commission Staff Working Document SWD(2015) 183.

23

There are various ways in which funding other than bank lending is provided. 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 (especially in the form of venture capital).
2.1.1

Interaction between bank and market-based funding

Banks and capital markets are two vital components of the financial system, complementing each
other. Bank and market funding offer different mechanisms to overcome information problems, such
as adverse selection and moral hazard.
Bank-based financial systems enjoy economies of scale and scope in information gathering and
processing, ultimately giving the bank an informational advantage in its relationship-based activity.14
Traditional credit channels, based on bank loans, rely on the heavy cost structure of the credit
institution, which can collect much information on the credit risk of a borrower and/or ask for
collateral to overcome information barriers because it can internalise the legal costs of such
procedures. As a result, banks are in a better position than capital markets to address the inherent
agency problems between debtors and creditors in long-term funding relationships (Leland and Pyle
(1977) and Diamond (1984)). The relationship-based funding allows a firm to develop a reputation for
good creditworthiness and ultimately to access finance at a lower cost (the "certification effect"). This
way, banks also gain special knowledge from performing complementary functions on a large scale
(e.g. account keeping for borrowers, provision of payment instruments). As a result this funding tool is
more suitable for firms that already have a history of cash flows and business operations.
Market-based funding fills the funding gap left by traditional credit channels. The availability (or not)
of collateral and future cash flows are typically priced-in the overall cost of financing and not
necessarily a barrier to access funding. As a result, the strength of capital markets is to provide
services to finance novel, longer-duration and high-risk projects. Non-bank finance at early stage of
firm development is generally more flexible than bank finance (e.g. as regards repayment schedules or
providing finance based on expected future earnings). Therefore, by complementing bank funding,
capital markets enlarge the potential investor base.
Using US data, Adrian et al. (2013) find evidence that bonds and banks were substitutes during the
2007-09 crisis. For Europe there is evidence that the bond market, to some extent, had filled the
funding gap left by the banking sector. Cariboni et al. (2017) find an increase in the access to the bond
market by the corporate sector (amount issued, number of issuance, first time issuers, even by riskier
and unlisted companies) in the period 2012-2014. Thus a more balanced funding structure between
bank and market sources can make the real economy more resilient to shocks hitting the banking
sector or the public markets.
2.1.2

The SMEs funding jigsaw

Firms' financing constraints affect their investment decisions and growth prospects. Empirical
evidence suggests that financing constraints affect particularly small, young, or single-unit firms.
Their business prospects are more difficult to evaluate for investors, as they are perceived as riskier
due to the lack of business diversification and collateral. Indeed, information asymmetries are often
more pronounced for small firms in their early stages, namely from Stage 1 (inception) until stage 3
(expansion) in the funding escalator model.15 According to the 2016 ECB Survey on the Access to
Finance of Enterprises (SAFE), market-based sources of finance such as equity and debt securities
14

An alternative view is provided by Dang et al (2017) stating that the allocation of projects between banks and financial
markets does not rely on any comparative advantage that banks may have in evaluating and overseeing its assets. The key
distinction between banks and capital markets is the way the two institutions process the information.
15
See Chapter 3 for the assessment of information barriers for bigger firms' decision to access public markets.

24

account only for respectively 12% and 3% of the total funding of a SME. The use of alternative
financing sources increases with the size of the firm, even though multiple tools alternative to bank
lending exists in the early stage of business development (Table 2.1). In effect, most start-ups fail, so
funding a start-up is a risky endeavour. It is not uncommon that the company doesn't have a product
yet when it asks for funding. Even if the company had a product, they often need to develop the
market for it. To forecast cash flows and therefore putting a valuation on such a firm is not an easy
task as production costs and market size have to be estimated. These factors greatly intensify the core
problems of any business financing arrangement—namely, uncertainty, information asymmetry, and
the risk of opportunism (Gilson (2010)).
Table 2.1. Use of financing instruments by Euro-area non-financial corporations (average; % of total sample
over 2009-2014)
Retained earnings
Grants/subsidised loans
Banks overdrafts
Bank loans
Trade credit
Other loans
Leasing
Debt securities
Mezzanine
Equity

Micro %
24
12
38
28
26
9
19
1
1
4

Small %
30
16
43
39
30
12
40
1
2
6

Medium %
38
20
40
43
35
19
50
1
4
8

Large %
46
22
42
48
38
28
56
4
6
9

Sources: ECB and European Commission Survey on the access to finance of enterprises.
Note: More than one funding source possible.

Insufficient financial knowledge is an obstacle restricting SMEs' access to external funding. SMEs
tend to lack general familiarity on how to finance their business and how to tap alternative sources of
finance, including the relevant information to submit to potential investors or lenders. A 2016 British
Business Bank survey shows an increase in awareness of peer-to-peer lending platforms amongst
smaller businesses. For equity crowdfunding, the increase in awareness appears to have plateaued after
several years of rapid growth. Awareness was higher amongst scale-ups compared to the start-up and
stay-ahead groups. However, the gap between awareness of the existence of finance types and
awareness of specific providers (i.e. who to contact) is increasing. Although awareness of venture
capital has increased to 64% in 2016, the results of the survey suggest that less than one in five smaller
businesses can name a specific provider. Only a minority of SMEs (13%) reported using external
advice when applying for finance in 2016 and this figure has fallen from previous years (around 19%
in 2015). A Call for proposals on improving access by innovative SMEs to alternative forms of
finance under Horizon 2020 has been published on the Research Participant Portal of DirectorateGeneral for Research and Innovation's Europa site16.
A lack of awareness about credit reports and credit history and their importance for funding purposes
also restricts the external finance options. Many SMEs are not able to get their own credit history to
justify funding. The lack of transparency on banks’ feedback to SMEs about their creditworthiness
makes it even harder for SMEs to build their financial knowledge and, most importantly, for investors
to gather information on the risk profile of the company. Banks' feedback to borrowers varies in
quality in Europe. The lack of verifiable information about SMEs restricts access to multiple marketbased funding sources. Investors and lenders need some level of verifiable information about a
company and financial statements, as well as a firm's credit history and payment behaviour, are
essential to assess the repayment capacity of an SME. Credit information services are also useful to
assess the creditworthiness of clients or suppliers. Credit institutions also share only partial data with
other market participants (such as business registries, credit bureaus and business information and
scoring firms) varying significantly across Member States. The lack of standardised, verifiable and

16

http://ec.europa.eu/research/participants/portal/desktop/en/opportunities/h2020/topics/altfi-01-2017.html

25

accessible credit information about SMEs represents a significant barrier for alternative finance
providers to invest into European SMEs.
This funding gap is further widened by the general constraints on access to finance for SMEs in
Europe. The 2016 ECB SAFE survey states that SMEs continued to signal improvements in the
availability of external sources of finance and that banks show increased willingness to provide credit
at lower interest rates facilitating further access to bank financing for SMEs. However, there is still
significant divergence across countries regarding the difficulties in accessing external sources of
finance. Some 24% of SMEs in Greece, 12% in Ireland and 11% in Italy, Portugal and the
Netherlands, respectively, mentioned that access to finance was the most significant problem,
compared with 7% of SMEs in Austria, 7% in Slovakia and 6% in Germany. While different
productivity levels can justify some of these divergences, the results of the 2016 European
Commission's Innobarometer survey also confirm that access to funding is a key obstacle for spurring
R&D and the commercialisation of innovative products or services. 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 may be easier, instead, for firms that are able
to resort to foreign capital markets, such as firms that are part of a multinational group. However,
unlike large corporations, small companies have very limited access to foreign capital markets.

2.2 Characteristics of Europe's funding escalator
In the pre-IPO space, the level of information that is required for the fund provider changes with the
degree of risk concentration in funding. Business angels, venture capitalists and private equity funds,
which rely on risk concentration, often operate with information mainly on the business idea and its
development, exercising active control on the governance of the firm. Private placement for mid-caps
and crowdfunding, instead, relies much more on the information provided by the entrepreneur and
there is limited expertise and possibility for the fund provider to have a strong influence on the
governance of the firm.
2.2.1

Funding with risk concentration

Venture investments are long-term investments in private, unlisted companies with the potential for
growth. Investment is concentrated in one or few investors. In return for investment into the company,
business angels, venture capital and private equity funds receive equity stakes in the business and
partner with management teams to support growth plans and make improvements to the business with
the aim of increasing its value. The returns on investment are realised either through a sale (or exit) of
the business or through the distribution of the firm's profits. This kind of equity investments are
typically made in less mature companies, like seed or start-up companies (especially for business
angels and venture capitalists) and scale-up firms (mainly for venture capitalists and private equity
funds). These market-based investments are often characterised by a high degree of proximity between
the investor and the entrepreneur, as the investors often adopt a very hands-on role in the deals in
which they invest, providing entrepreneurs with advice and contacts.
Business angel investment
'Business angels' are private individuals that provide financial support and often operational counsel
mainly to start-ups, without relying on financial intermediaries. With their know-how, capital and
contacts, business angels provide support throughout the growing phase of the company they invest in.
Kerr et al (2011) suggest that ventures funded by successful angel groups experience superior
outcomes to rejected ventures, by improving survival rates, exits, employment, patenting, Web traffic,
and financing. They confirm the positive effects for venture operations, combined with a higher
likelihood of successful exits. The main exit strategy for business angels is acquisitions by larger
companies.
The visible part of the angel investment market is those investments made through an angel network or
syndicate (OECD (2016)). Due to the informal nature of the investment and the absence of any official
definition of angel investment, the overall size of the market of business angel investments is a
26

difficult estimation. Available figures suggest that the amounts invested by business angels in the EU
are small and highly concentrated. The 2015 statistics compendium by the European Trade
Association for Business Angels, Seed Funds and Early Stage Market Players (EBAN) show that the
visible part of business angels' outstanding investment in the EU amounted to EUR 607 million in
2015 (a growth of 5.0% from 2014). The investors’ community grew to 303 650 investors closing
32 940 deals (EBAN 2016).
The United Kingdom is the largest European business angel market with EUR 96 million of
investment in 2015. Spain, Germany and France are the following biggest players, while Finland,
Denmark and Sweden are continuing to grow at steady rates (Figure 2.2). Business angel activity is
increasing in the CESEE (including Baltic) regions, but the markets remains very small.
EU Member States use personal income tax incentives for business angel investments in different
ways, partly explaining significant cross-country differences. Most incentives are not applicable to
cross-border investments in the EU amplifying fragmentation of local business angel ecosystems and
national or European networks.
Figure 2.2. Evolution of angel investment by country (2013-2015, EUR million)
100
90
80
70
60
50
40
30
20
10
0

2014

2013

United Kingdom
Spain
Germany
France
Finland
Turkey
Russia
Portugal
Denmark
Sweden
Austria
Switzerland
Ireland
Poland
Italy
Netherlands
Belgium
Estonia
Norway
Bulgaria
Greece
Luxembourg
Serbia
Slovenia
Slovakia
Lithuania
Macedonia
Latvia
Kosovo
Cyprus
Croatia

2015

Source: EBAN European Early Stage Market Statistics 2015

Venture capital
An important source of finance for start-ups is also venture capital. This category of investors manages
the high risk of failure by diversifying their investments across a portfolio of companies, and through
careful selection of the firms in which they invest, using specialist expertise to assess the quality of the
entrepreneurial team and their proposed product (Gompers and Lerner (1999)). They take – often
substantial – control rights and use them to enhance the quality of decision-making and mitigate the
potential for opportunism by the entrepreneur (Kaplan and Strömberg (2003)). Venture capital is
usually invested through funds, often provided by institutional investors. Venture capital requires
geographic proximity for the investor to be able to participate actively in decision-making (Lerner
1995). Consequently, venture capitalists tend to be based in areas where there are large ‘clusters’ of
new firms, typically near a source of technological innovation such as a university (Martin et al 2002).
Despite positive effects on economic growth, venture capital constitutes a small part of total SME
external financing. Venture capital represents a very small percentage of GDP in EU Member States
(less than 0.05% of GDP). The amount of venture capital invested was EUR 4.4 billion across 3 134
deals in 2016 (Invest Europe 2017). Companies active in growing business sectors such as life
sciences, communications and electronics attract the majority of the available funds (KPMG 2016).
The venture capital industry in Israel and the US is more mature, representing in 2015 around 0.38%
27

and 0.33% of GDP respectively. Europe also lacks "unicorns" in the EU, i.e. young private companies
with limited performance record that are valued at over EUR 1 billion). The EU has only 17 unicorns
in just a handful of Member States (as of July 2016), compared to 90 in the US and 40 in Asia.
EU venture capital funds remain fragmented and lack scale (the average size of EU venture capital
funds is half the average size of US funds) and geographical reach (around 90% of venture capital
investment is concentrated in eight Member States17 and venture capital investment is virtually nonexistent in some Member States). Similar to trends experienced elsewhere in the world, European
venture capital investors have become more selective. The evaluation of investment decisions takes
longer and due diligence is more extensive. The EU venture capital market needs to stimulate private
VC funding as government agencies have been the most important contributor to the EUR 40 billion
that the EU venture capital market has raised since 2007 (Invest Europe 2017).
Established or growing technology hubs exist across Europe (London, Berlin, Madrid, Paris, Dublin
and Stockholm). Europe’s varied technology hubs may be an important advantage when it comes to
stability. At the same time, the complexity of this diversity creates challenges for start-ups when they
reach a scale that surpasses the initial domestic scale. Different regulatory environments, cultures and
languages all add to the complexity. This leads some of the start-ups to abandon the option to grow
internationally within Europe and target the US or China first.
Figure 2.3. Venture capital investments (% of GDP, 2015)
0,5
0,4
0,3
0,2
0,1

ISR
USA
CAN
ZAF
KOR
FIN
CHE
SWE
IRL
GBR
AUT
PRT
FRA
DNK
DEU
NZL
JPN
NLD
AUS
HUN
EU
EST
NOR
BEL
ESP
SVK
LUX
POL
RUS
SVN
ITA
CZE
GRC

0,0

Seed/start-up/early stage

Later stage venture

Total

Source: OECD. Note: 'Total' for those countries that have no breakdown.

During the fourth quarter of 2016, the governments of Germany and France took a major step toward
growing their innovation ecosystems. The two governments announced the creation of a joint EUR 1
billion fund to assist start-ups in their countries to evolve beyond the seed-stage, which is the most
difficult challenge.

17

UK, Germany, France, Sweden, the Netherlands, Spain, Austria and Finland.

28

Figure 2.4. Investments by stagein the EU – 1Q2011 – 4Q2015 (EUR billion)
0,6
0,5
0,4
0,3
0,2
0,1
0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2011

2012
Seed

2013
Start-up

2014

2015

Later-stage venture

Source: Invest Europe

The maturity level of various tech hubs throughout Europe is rising, with new centres like Scandinavia
and France emerging, while established hubs in Germany, the United Kingdom and Ireland continue to
evolve. Creating the conditions for these ecosystems to develop and integrate across Europe is an
essential pre-condition for capital markets to support innovative firms. Moreover, consolidation
among start-ups in Europe is expected, particularly with acquisitions led by corporate investors
looking for strategic investments. There are a number of well – capitalized companies in the region,
which are actively looking for M&A. FinTech and health-tech are expected to continue to be major
investment areas for VC investors in Europe, while emerging areas, such as Artificial Intelligence,
machine learning and deep tech, are expected to take on a higher investment priority.
Main obstacles to the development of venture capital investments 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 United Kingdom 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.
Private equity
Private equity refers to investments in the equity of a company provided on a private basis, typically
by funds that collect funds from multiple entities, including banks, NFCs, institutional investors (e.g.
pension funds or asset managers), high net worth individuals (HNWI) and governments. By investing
in private equity funds, banks and NFCs typically aim at acquiring an indirect strategic interest in
entities that could generate synergies for their businesses. Public authorities, on the other hand, invest
in private equity funds as a mean of achieving public policy goals, such as supporting specific sectors
of the economy, activities that are ultimately expected to boost productivity, growth and employment.
Common investment strategies in private equity investments include: leveraged buyouts, venture
capital, growth capital, distressed investments and mezzanine capital.
In 2016, the total amount of equity invested in European companies remained stable at EUR 53.7
billion compared to 2015, representing the second highest level since 2008. The number of companies
decreased by 7%, but remained over 5 900, of which 83% are SMEs. Over a third of the total amount
invested in European companies came from cross-border investments. Almost 400 funds raised new
capital. This decrease by 9% compared to 2015 indicates a trend towards larger funds in 2016. In the
last four years, European private-equity funds have raised over EUR 240 billion to invest into
companies in Europe, more than twice the amount raised in the four years following the financial
29

crisis (Invest Europe 2017). Half of the total private equity investments in Europe are managed out of
the United Kingdom. Most of that cash comes from overseas firms and investors that access the bloc
via the United Kingdom. Moreover, the sector is heavily reliant on access to talent from across the EU
and to the single market. France and Sweden follow in importance. As regards the type of private
equity investors, over one third of private equity funds raised in 2016 came from institutional
investors, in particular pension funds (34%), investment funds (18%) and insurance companies (12%).
Private equity investment is considered particularly attractive by some insurance corporations and
pension funds as the long-term nature of their liabilities allows them to invest in long-term and less
liquid assets, with the objective of generating a higher return. Private equity investment by public
authorities reached 10% of the total. Regulatory or self-imposed constraints on asset allocation of
investors into private equity funds, such as banks, insurance or pension funds may create barriers to
investments in this type of funding, which is a key element for the scaling-up of innovative firms.
2.2.2

Funding with risk dispersion

Funding in the pre-IPO space can also take the form of a dispersed funding tool, with different barriers
hampering its cross-border developments. These barriers are mainly informational ones for proper
price discovery or transactional costs, in the form of compliance or other listing-type costs.

Box 2.

Supply Chain Finance (SCF): the role of market-based solutions

On-time payment is essentially what corporations would like, even if prompt payment cannot always
be managed. Supply Chain Finance management solutions allow companies to optimize their working
capital effectively. SCF is not a static concept but is an evolving set of practices using or combining a
variety of techniques.
In 2015, the Receivables Finance industry in the EU provided over EUR 168 billion of working capital
financing to over 171,000 businesses, about 85% of which are SMEs. Revenues generated by reverse
factoring solutions are expected to grow at an annual rate of 20%, approximately. Payables finance or
reverse factoring could offer access to an untapped market worth USD 800 billion in unrealized profits
as of today. This figure only takes into account the solutions offered to purchasing companies rated as
investment grade (McKinsey 2015).
Efficient supply chain is an important part of any business establishment that can have a significant
impact on operations and the very survival of the venture. Faced with increasing pressure to meet
short-term liquidity needs, companies are looking for easy and convenient ways to manage their
working capital and supply chain. As a result, the need for innovative financial supply chain
management solutions has been increasing. And that is where financial technology companies have
recently been triggering a transformation towards greater efficiency and seamless solutions. A growing
number of Fintech start-ups are enabling SMEs to access payment services that were previously the
domain of large corporates.
Supply chain finance enables buyers to ease payment terms while also ensuring the cash flow of their
suppliers is improved, thereby reducing instability within the supply chain. The enabling of
transparency across the supply chain means that suppliers always know precisely when they will be
paid and can plan their finances accordingly. Predictability is often more important than speed when it
comes to payments.
Crowdfunding
Crowdfunding refers to raising capital through large numbers of small contributions for a specific
project. Crowdfunding platforms are websites that enable interaction between fundraisers and the
crowd. The crowdfunding sector in Europe has continued to grow over the last years. Based on one of
the largest datasets currently available, with figures from 367 European platforms which are stated to
represent 90% of the visible market, the European alternative finance market grew by 92% to reach the
value of EUR 5.43 billion in the year 2015 (University of Cambridge Centre for Alternative Finance
2016). In 2015 the United Kingdom remained market leader in terms of size with a total market
30

volume of EUR 4.41 billion, followed by France (EUR 319 million), Germany (EUR 249 million), the
Netherlands (EUR 111 million), Finland (EUR 64 million), Spain (EUR 50 million), Belgium (EUR
37 million) and Italy (EUR 32 million). When looking at market volume per capita, the United
Kingdom was first with EUR 65.88, followed by Estonia (EUR 24.02) and Finland (EUR 11.65).
In terms of crowdfunding type, peer-to-peer consumer lending and peer-to-peer business lending
accounted for the largest activity in 2015, with approximately one third (EUR 366 million) and one
fifth (EUR 212 million) of total market activity respectively. Equity-based models, such as equitybased crowdfunding and real estate crowdfunding across Europe account for around a fifth, while nonfinancial return based models accounted for another 16% in 2015.
Figure2 5. Alternative Finance Volume by Model in Europe (excl. UK) 2013–2015 (EUR million)
400
350
300
250
200
150
100
50
0
2013

2014

2015

Peer-to-Peer Consumer
lending

2013

2014

2015

Peer-to-Peer Business
lending

2013

2014

2015

Equity-based
Crowdfunding

2013

2014

2015

Reward-based
Crowdfunding

Source: European alternative finance report 2016

Equity-based crowdfunding is particularly significant for funding business start-ups. The average deal
size in equity-based crowdfunding is now approximately EUR 459 000, in contrast to just over EUR
190 000 for debt-based securities, just under EUR 100 000 for peer-to-peer business loans and just
under EUR 10 000 for peer-to-peer consumer loans.
A third form of crowdfunding used for business is ‘loan’ crowdfunding (also known as ‘crowdlending’
or ‘marketplace lending’). As the name suggests, this involves (retail) funders advancing credit to
businesses, usually with the aid of credit scores produced by the platform. It too has grown very
rapidly as a form of small business finance. As mentioned above, debt financing is unsuitable for firms
without fixed assets, which is borne out by the fact that loan crowdfunding tends to be sought by
established small businesses, as opposed to start-ups (Mach et al 2014).
Asset class shares within P2P have remained very consistent. For the last 2 years SME lending has
represented around 45% of the volume while consumer and invoice lending have 38% and 12%
respectively.
Furthermore, there is a rising institutionalisation of crowdfunding – 26% of peer-to-peer consumer
lending, 24% of peer-to-peer business lending and 8% of equity investment. This is combined with a
high degree of automation in lending (selection or bidding processes) – 82% of consumer loans, 78%
of traded invoices and 38% of business loans. Invoice trading is gaining momentum – growing from
EUR 7 million in 2014 to EUR 81 million in 2015. Finally, the formation of new platforms has peaked
and a phase of consolidation has started.

31

Figure 2.5 Top Three Countries by Model - Alternative Finance Volume (excl. UK) 2015 (EUR million)
140
120
100
80
60
40
20
0
DE

FR

FI

NL

DE

FR

Peer-to-Peer Consumer Peer-to-Peer Business
lending
lending

FR

DE
Equidy-based
crowdfunding

NL

FR

DE

NL

Reward-based
crowdfunding

Source: European alternative finance report 2016

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. Market activity in the crowdfunding sector remains mostly domestic.
Almost half of platforms indicated that not even a part of the funds they helped raise were supplied by
foreign investors. A third of platforms indicated that they had raised less than 10% from foreign
investors. Different consumer or investor protection rules, among other factors, seem to lead many
platforms to refuse to provide their services to non-residents and make extension to new markets
possible only through new establishments. With regards to foreign outflows, 76% of platforms
reported that 0% of the funds raised went to projects outside the national border.
Private placement
A private placement is generally understood as a medium or a long-term financing transaction of debt
securities (in a loan or a bond format) between a listed or unlisted company and a small number of
institutional investors, without a public offer. Investors involved in private placements are usually
banks, mutual funds, insurance companies and pension funds.
Private placement markets broaden the availability of finance for unlisted medium-sized companies. A
key benefit of taking the private placement route for mid-sized companies is the diversification of their
funding away from bank lending. In the current low rate environment, the development of private
placements is also beneficial for institutional investors as it allows for higher yields, asset risk
diversification and long-term asset matching.
With more than EUR 26 billion at the end of 2016, the German Schuldschein is by far the largest
private placement market in Europe (Scope Ratings 2017). More than 80% of Schuldschein loans are
bought by banks, particularly German savings and cooperative banks. Schuldschein have also created a
growing interest among international investors since they represent a third of the total number of
investors. The demand for issuing by foreign firms reached 45% in 2015 in the
German Schuldschein market (Scope Ratings 2017).

32

Figure 2.6. Shuldscheindarlehen volume of German and non-German issuers (EUR billion)
30
25
20
15
10
5
0

50%
40%
30%
20%
10%
0%
2011

2012
German

2013

2014

Non-German

2015

2016

Share of non-German SSD issuers

Source: Scope Ratings

The European private placement markets beyond Germany are smaller, but growing, with EUR 8.4
billion raised and 103 deals in 2015, compared to 4.7 billion and 85 deals in 2014 (Dealogic 2016).
Outside Germany, the French Euro-PP market remains the private placement largest market with EUR
4.8 billion in 2015. Insurance companies are the largest investors in French Euro-PPs.
Figure 2.7. 2015 European Private Placement Volume (EUR 8.4 bilion) By Country
France
Italy
Belgium
Germany
Spain
Luxembourg
Israel
Finland
Netherlands
0%

10%

20%

30%

40%

50%

Source: Dealogic

The credit quality of issuers accessing the French Euro-PP market is wider than in the German market
as it is open to non-investment grade credit quality as well. HSBC estimate that around 40% of the
issuers have an implied BBB- (investment grade) rating, 15% of them have a better rating, and around
28% are an implied BB+/BB grade.
Despite its recent success, the development of private placement markets is very uneven and the PP
market was sluggish in 2016. Although private placement activity is now well-established in France
(Euro-PP) and Germany (Schuldschein) and is taking off in few other Member States; it remains
largely underdeveloped in many EU jurisdictions.
Due to a lack of a mature private placement market in the EU, companies in the EU have historically
been actively tapping the US private placement. In 2015, Europe-based groups raised EUR 8.1 billion
of private placement funding in the US, representing 20% of the EUR 40 billion total paper issued in
the US in 2014.

2.3 General policy implications
Successful entrepreneurs, start-ups, scale-ups and other small and medium-sized firms need access to
different types of financing to fund innovation and their expansion. The work focuses in particular on
strengthening market-based finance in a number of key areas, notably the following:
33

1.

Venture capital: EU venture capital markets remain fragmented, lacking scale and
geographical reach. Good progress has been made on the implementation of the venture capital
package that the Commission brought forward in the CMU Action Plan. It is expected that the
European VC Funds-of-Funds will be able to commence capital raising and investing in Q3
2017. It will have firepower of around EUR 1.6 billion, with cornerstone investments of up to
EUR 400 million from public finances. Agreement on the European Venture Capital Funds
(EuVECA) proposal could pave the way to extend the range of managers eligible to market and
manage these funds, increase the range of companies that can be invested in by EuVECA funds,
and make the registration and cross-border marketing of these funds easier and cheaper. The
comprehensive study is being published on tax incentives for venture capital and business angel
investments offered by the Member States. It identifies good practices for the design and
implementation of key features (e.g. targeting) of such tax incentives which could help improve
their effectiveness and foster the development of local capital markets

2.

Markets for the private placement of corporate debt have made big strides in recent years,
but their development is very uneven in Europe. Building on the experience of well-functioning
national regimes (such as Schuldscheine in Germany and the Euro-PP market in France), the
dissemination of best practices could enhance the take-up of private placement across a wider
selection of EU Member States which are big enough to host a local private debt market.
Moreover, insurance undertakings could be incentivised to invest to a greater extent into
markets for privately placed corporate debt and for private equity through a reduction of the
prudential treatment of these instruments in Solvency II.

3.

Supply chain finance: Many entrepreneurs, start-ups and small businesses fail due to cash flow
problems although having a viable business model. Market practices on supply chain finance to
help companies overcome temporary cash flow problems, such as factoring and invoice trading,
are already well established and should be further boosted by the increasing up-take of
electronic invoicing (notably in light of the implementation of Directive 2014/55/EU on
electronic invoicing in public procurement). FinTech firms are opening up new supply-chain
financing opportunities for SMEs that were previously unavailable. Banks are also partnering up
with FinTech firms to improve the existing models. The identification of best practices would
provide support for the development of supply chain finance.

4.

Better connecting SMEs with alternative finance possibilities: Member States have taken
local initiatives or support initiatives to better connect SMEs with alternative finance providers
and disseminate SME information to support creditworthiness assessment, in particular by
harnessing the potential of FinTech solutions. In April 2017, the Commission services also
published a Call for Proposal under the Horizon 2020 programme to improve access to
alternative forms of finance by innovative SMEs. The aim would be to allow funding capacity
building projects to address information barriers for SME funding and increase the range of
financing opportunities by drawing on these successful local initiatives.

2.4 Key indicators 18
EU SMEs' funding structure

Indicator
Issuance of equity by euro-area SMEs over the last
six months, % of total SMEs surveyed (SAFE
survey)

18

Last 5-year
average

Latest
observation

Value

4.3%

Jun 2015

1.4%

EU, unless indicated otherwise.

34

Funding with risk concentration

Indicator

Last 5-year
average

Angel investments outstanding investment (visible
part), EUR million
Venture capital, investment, EUR billion
Private equity, investment, EUR billion

EUR 58019
million
EUR 3.8 billion
EUR 46.9
billion

Latest
observation
2015
2016
2016

Value
EUR 607
million
EUR 4.4 billion
EUR 53.7
billion

Funding with risk dispersion

Indicator
Alternative Finance (Crowdfunding) Volume by
Model in Europe, EUR billion
European Private Placement Volume (EURO PP
plus Schuldschein), EUR billion

19

Last 5-year
average

Latest
observation

Value

NA

2014

EUR 1.2 billion

EUR 19.7
billion

2015

EUR 27.8
billion

Last 3-year average

35

3

Making it Easier for Companies to Enter and Raise Capital on Public
Markets
20

Raising capital on public markets broadens the financing alternatives available to firms. Access to
public markets benefits firms by diversifying their investment base and by facilitating subsequent
access to financing and M&A activities. For SMEs, ready access to equity markets also offers an 'exit
strategy' for investors who invested in the earlier stages of the firm's life cycle. Given that SMEs might
face additional structural barriers compared to large firms,21 they are discussed separately.
Investors benefit from public markets also thanks to additional diversification opportunities and
increased transparency. In effect, mandatory disclosure of listed firms mitigate information
asymmetries, reducing investors' search costs and allowing them to take better informed investment
22
decisions. In a broader perspective, it stimulates the use of market-based financing which, in turn,
supports economic growth (Cornède et al. 2015).

3.1 Access to public markets: long-term trends
EU capital markets, relative to the size of the economy, remain underdeveloped and fragmented
compared to other developed countries like the US or Japan. For instance, stock market capitalisation
to GDP in Europe was about one third of the ratio for the US in 2015. Significant differences in the
depth of equity and bond markets also exists within Europe, with Member States that joined more
recently often having less developed markets.
3.1.1

Financial structure of EU firms

EU firms are typically known for their overreliance on bank lending, especially for SMEs. In the
period from 2002-2008, banking lending accounted for 70% of total financing in the euro area,
compared to only 40% in the US (See Figure 3.1).
Figure 3.1 Share of bank to non-bank financing of NFCs in the euro area and the US (cumulated transactions)
100%
80%
60%
40%
20%
0%
2002-2008

2002 - Q1 2016

euro area

2002-2008

2002 - Q1 2016

United States
bank

non-bank

Source: ECB, Federal Reserve System.

Furthermore, loans grew in the run up to the crisis at the expense of market-based financing. The
financial crisis revealed the rigidity of this undiversified funding model, as the capacity of banks to
lend, especially to high-risk sectors and SMEs, became seriously impaired due to deteriorations in the
20

Access to public markets is more relevant for firms that are in the later stages of their life cycle. See Chapter 2 for details
on the funding accelerator model and financing options during the prelisting phase. In view of the well-developed European
bank lending system, bank-based and market-based financing largely complement each other. (See Chapter 2 as well).
21
The financing mix of SMEs also differs from the one observed for large firms.
22
See Chapter 6 for details.

36

quality of banks’ balance sheet assets and capital constraints. Corroborating this finding, Campolongo
et al (2016) show that the role of cash is more important during the banking and sovereign debt crises.
Following the financial crisis, the dependence on bank financing in the euro area has decreased,
accounting for 50% of total financing in the period from 2002-2016. This statistics is mainly driven by
big corporates' access to non-banking funding, such as corporate bonds.
Figure 3.2 Sources of funding of NFCs in the EU (% of total liabilities)
100%
Other liabilities

90%
80%

Trade credit

70%
60%
50%

Unlisted shares & other
equity

40%

Listed shares

30%
Debt securities

20%
10%

Loans

0%
2005

2008

Source: ECB and Eurostat. Note: Consolidated data.

2015
23

Dependency on traditional credit (bank loans and other loans) has remained stable over the past 10
years at around 30% (see Figure 3.2 and Figure 3.3). Bank loans are particularly important in countries
like Greece and Cyprus, while they have a low importance for firms in Belgium, Luxembourg and
Ireland. Although evidence on equity is mixed across euro-area Member States, there are only a
handful of countries where companies rely on listed shares on a solid basis. Other equity & unlisted
shares, which is not public market-based funding appears to be the dominant source of equity and
overall funding. Listed shares represent 20.9% of overall funding of NFC in the EU in 2015. NFCs'
outstanding debt securities in the EU have also increased in recent years, but are rather small
compared to total NFC funding.

23

The Loans category is comprised of domestic loans by MFIs and other loans which includes cross-border loans by MFIs.
Listed equity refers to equity securities listed on a recognized exchange or any other form of secondary market. Unlisted &
other equity comprises all forms of equity other than those classified as listed equity. Unlisted shares are equity securities not
listed on an exchange and include shares issued by unlisted limited liability companies as follows: (a) capital shares; (b)
redeemed shares whose capital has been repaid but which are retained by holders; (c) dividend shares, also called founders’
shares, profits shares, and dividend shares, which are not part of the registered capital. (d) Participating preference shares or
stocks. Other equity includes: (a) all forms of equity in corporations which are not shares; (b) investment by general
government in the capital of public corporations whose capital is not divided into shares and which by virtue of special
legislation are recognised as independent legal entities; (c) investment by general government in the capital of the central
bank; (d) government investments in the capital of international and supranational organisations, with the exception of the
IMF, even if these are legally constituted as corporations with share capital (e.g. the European Investment Bank); (e) the
financial resources of the ECB contributed by the national central banks; (f) capital invested in financial and non-financial
quasi-corporations. (g) the financial claims that non-resident units have against notional resident units and vice versa. See
Eurostat (2013) for further details.

37

Figure 3.3 Sources of funding of NFCs in the EU (2010-2015, % of total)
100%
80%
60%
40%
20%
0%
EL CY ES IT SI AT MT PT DK LV NL LT HR DE FR BG RO CZ FI EE SE SK PL HU UK IE BE LU
Loans

Debt securities

Listed shares

Unlisted shares and other equity

Trade credit

Other liabilities

Source: ECB and Eurostat. Note: Consolidated data.

Focus on SMEs
A firm's financial structure and its financing mix are dependent on a firm's size. 24 For SMEs, bankrelated products are perceived to be the most relevant financing source for SMEs, while the use of
market-based financing is marginal at best (see Table 2.1). Based on the 2016 ECB SAFE survey,
market-based sources of finance such as equity (12%) and debt securities (3%) are relatively less
important for SMEs. In most countries included in the 2016 survey (except Greece and France), SMEs
indicate that they have sufficient access to external funds compared to their needs for external
financing (external funding gap), marking a significant improvement compared to 2013-levels were
the financial gap for countries was still predominantly negative. Nevertheless, SMEs are very
heterogeneous: some low-growth, very young or SMEs with strong family ties might not have the
need to attract external funding, while other SMEs might have a strong need for external funding but
might still be faced with a negative funding gap. SMEs in Europe are indeed very diverse in their
financing mix and the extent to which they experience access to finance problems (Masiak et al.
2017).25 Debt-financed and internally-financed SMEs report comparatively the most problems with
access-to-finance with respectively 23.4% and 27.6% of all SMEs that report high occurrence of
access-to-finance problems belonging to these two groups. At the same time, about 50% of the SMEs
that report low access-to-finance problems are internally-financed SMEs, illustrating that there is also
a large group of internally-financed SMEs that do not experience supply-side restrictions and
consciously choose not to finance externally.
3.1.2

Developments in public equity and debt markets

The relative size of European public equity and debt markets is low and shows significant dispersion
across Member States. The value of corporate bond and stock markets as % of GDP equals 12% and
56% for the EU (10% and 51% for EU27, respectively), compared to 31% and 112% for the US.
United Kingdom figures hold the middle between US and EU27 figures with corporate bond and
equity markets equal to 18% and 78% of GDP (Wright & Bax 2016). Capital market development also
24

See also Chapter 2 for further details.
Based on hierarchical cluster analysis they identify 7 groups of SMEs: debt-financed SMEs; internally-financed SMEs
mixed-financed SMEs with focus on other loans; mixed-financed SMEs focus retained earnings or sale of assets; statesubsidised SMEs; trade-financed SMEs; and asset-based financed SMEs.
25

38

varies considerably across European countries. Countries that joined the EU more recently often have
lower ratios than the EU27 average. As a general indicator of access to public markets, 3,796
prospectuses were approved in the EEA in 2015, coming from 3 931 in 2014.
Equity Issuance
IPO activity in Europe has been moderate and rather volatile over time (see Figure 3.4). The number
of IPOs decreased dramatically during the financial crisis. The activity, measured by volume,
rebounded strongly after the crisis but has lost momentum since. In 2016, European IPO activity
declined significantly with a drop of 27% in the number of IPOs compared to 2015. This represents a
51% decrease in value to EUR 27.9 billion (Figure 3.4). The number of IPOs is also much lower than
before the crisis. Taken together, the figures suggest that the deal size per IPO has increased. The
breakdown of IPO activity based on the market capitalisation of the issuing firms clearly illustrates
that large firms account for the majority of the total deal value (see Figure 3.5; see note for definition
of cap segments). In 2016, they account for 66% of total deal value compared to 24% and 6% for midcap and small-cap firms. In addition, the number of IPOs is also much more volatile for smaller firms
compared to large firms, illustrating that the IPO market for smaller firms is less stable and more
vulnerable to shocks.
Figure 3.4 European IPO activity
504
500

434
80

400
60
244

228
185

178

40

269

300
193

159

200

110
69

20

5,2

Number of IPOs

Value of IPOs (EUR billion)

100

100

57,2

54,4

8,4

19,7

14,3

2006

2007

2008 2009 2010
Value of IPOs (lhs)

2011

6,8

23,0

47,8

55,7

27,9

2012 2013 2014 2015
Number of IPO deals (rhs)

2016

0

0

Source: Dealogic

The average value per IPO has increased from EUR 113 million in 2006 and even EUR 75 million in
2009 to EUR 144 million in 2016. IPO activity in Europe is also strongly concentrated: the United
Kingdom plays a prominent role with 28% of the total EU28 market measured by IPO value in 20142016, representing approximately one fifth of all IPO deals (See Figure 3.6, box). The EU market is
also concentrated measured by IPO to GDP (see Figure 3.6) or measured by IPO concentration per
stock exchange. The London Stock Exchange account for 24% of IPOs measured by value, while CR3 (London, Frankfurt, Madrid and CR-5 (CR-3 plus Amsterdam and Milan) account for 44% and 57%,
respectively.

39

Figure 3.5 Breakdown of IPO activity according to firm market capitalisation, % of total value
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2006

2007

2008

2009
Large cap

2010

2011

Mid cap

2012

Small cap

2013

2014

2015

2016

Micro cap

Source: Dealogic.
Note: Break-down is based on market capitalisation. Following the World Federation of Exchanges, large market cap segment
comprises companies with a market cap > USD 1.3 billion; mid-market cap segment comprises companies between USD 1.3
billion > market cap > USD 200 million; the small market cap segment comprises companies of between USD 200 million >
market cap > USD 65 million; the micro market cap segment consists of companies with a market cap < USD 65 million.

Looking at long-term trends worldwide, IPO activity (for firms in general and growth firms) has
decreased in advanced economies. Over the period 1995-2014, IPO activity in advanced economies
decreased significantly with the number of IPOs and amount raised in 2014 shrinking by 63% and
57%, respectively compared to the average in the period 1995-2000 (OECD 2015a). The opposite
trend is noticeable for emerging markets spurred by IPO activities of Chinese companies, accounting
for 62% of all capital raised on emerging markets since 2008.
Figure 3.6 IPO activity in the EU (value as %GDP; EU = 100; average 2014-2016)
Market share (% total IPO value; average 2014-2016; selected countries)
Denmark; 3%
Poland; 4%
Sweden; 4%
Netherlands; 7%
United Kingdom;
30%

France; 8%

Italy; 8%
Germany; 13%
Spain; 11%

Sources: Dealogic, AMECO

Corporate Bond Issuance
Corporate bond issues increased and have mitigated the effect of bank lending constraints at least for
large firms. Compared to 2006, the number of corporate bond issuances in Europe has nearly doubled
40

in 2016 to 788, representing a volume of EUR 240 billion in 2016 (Figure 3.8). This trend mirrors the
evolution witnessed in advanced economies were non-financial corporate bond amounts nearly
doubled from 2000 to 2014.
The strong increase in issuing activity following the 2008 financial crisis suggests that in this period
debt securities had some degree of substitution effect for shrinking bank lending (see Figure 3.8). This
finding is confirmed by world-wide data that demonstrate that the number of first time bond issuers
increased significantly in the 2008-2010 period (OECD 2015a). In addition, the risk profile of bonds
changed, with riskier bonds being issued after the 2008 financial crisis.
The relative importance of the high-yield bond issuance fell dramatically during the crisis,
representing only 3% of the total issuances (21% in 2006). High-yield bond issuances grew very
rapidly in the post-crisis period, peaking at EUR 57 billion in 2014 (representing 26% of total
issuances), to decrease to EUR 41 billion in 2016.
Figure 3.7. High-yield bond markets 2006-2016 (gross issuance value, % total)
30%
25%
20%
15%
10%
5%
0%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Source: Dealogic

Contrary to large firms, SMEs reacted to the shrinking availability of bank financing by relying
increasingly on internally generated funds and alternative financing like trade credit (Masiak et al.
2017, Casey & O’Toole 2014, Ferrando & Mulier 2015).
Figure 3.8 Corporate bond issuance by NFCs in Europe
300

1000
900

250

800
700

200

600
150

500
400

100

300
200

50

100
0

0
2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Number of tranches EU-27 (rhs)

Number of tranches in EU-28 (rhs)

Volume in EU-27 (bn EUR, lhs)

Volume in EU-28 (bn EUR, lhs)

Source: Dealogic

41

3.2 Drivers of going public
3.2.1

Equity

The decision to issue equity to the public is determined by general economic conditions, the
institutional framework and firm-specific factors. In considering an IPO, a firm has to evaluate the
advantages of an IPO with costs associated with the IPO process and the costs of being listed.
IPOs occur in waves. This might occur (i) if managers try to time the IPO to profit from relative
overvaluation, (ii) because they are tempted by previous successful IPOs, or (iii) because they may
want to go public when they face low adverse selection costs which would lead to clustering of IPOs
over the business cycle. Although many studies conclude that firms appear to time their IPO to profit
from (relative) overvaluation, Ditmar and Ditmar (2008) challenge this conclusion: they conclude that
IPOs waves are related to the fact that equity issues occur more frequently in the early stages of the
business cycle when cash flow is likely to be too low compared to the many interesting investment
26
opportunities. As a result, broad regulatory initiatives that are put in place to support economic
growth will positively affect the probability that firms will go public.
The IPO market is also influenced by the institutional framework, both directly and indirectly. A
country's lending infrastructure or its financial development for instance impact a firm's capital
structure decision, which in turn will impact its need to raise capital on public markets. Financial
regulation may also affect the IPO market. It is often introduced to reduce information asymmetries
between investors and issuers. Firms that are characterized by high information asymmetries will be
reluctant to raise equity because they may face large costs (Myers 1984, Myers & Majluf 1984). From
an investor's perspective, financial regulation in general, and regulation on disclosure requirements in
particular, can reduce information asymmetries and boost investors' confidence in the functioning of
public markets. Increased compliance costs introduced by tighter regulations for publicly traded firms
could however reduce the attractiveness of going public, especially for small firms in case of one-sizefits-all regulation. Financial regulators should thus strike a balance between stimulating access to
finance and consumer protection. Proportionate financial regulation could help in achieving this
balance, while at the same time avoid regulatory overreach.
Various firm-specific motives could support a firm's intention to conduct an IPO. Firm could offer
public equity to reduce their cost of capital and optimize their financing mix. Going public also allows
a firm to diversify its financing structure and ownership which results in more external monitoring and
enhances corporate governance due to increased market scrutiny, although - as suggested by the
pecking order theory (Myers & Majluf 1984, Myers 1984) - firms that face high asymmetric
information costs might prefer to exhaust internal financing first. Firms might also attempt to obtain an
optimal debt ratio, which according to the static trade-off theory is reached when the corporate tax
advantage of debt is balanced against the (discounted) value of the costs of financial distress (see also
Modigliani & Miller 1958, 1963). This theory indicates that equity financing suffer from a tax
disadvantage – given the widely applied interest deductibility of debt financing – and that policy
actions to reduce this unequal tax treatment between debt and equity finance could influence a firm's
reliance on equity. Additionally, a firm's capital structure will also be affected by IPOs if it increases a
firm's financial flexibility and bargaining power with banks. This will reduce the cost of credit, lower
the overall cost of capital and allow firms to diversify its funding. Going public also allows insiders to
cash out, which might be particular relevant for venture capitalists for which the IPO provides an
elegant opportunity to exit. Going public might also be initiated with a view to future M&A activities.
Companies could become a takeover target or shareholders may want to establish a market price when
they intend to cash out or sell the company. Alternatively, the firm may want to acquire other

26

Contrary to previous studies, they did not study IPOs alone but analysed IPOs and share repurchases (i.e. opposing
transaction to IPO) together. Based on this analysis, Ditmar & Ditmar (2008) show that both are correlated and that the
increased volume for both transactions is not driven by overvaluation.

42

companies in the post-IPO period. Finally, an IPO may be undertaken to increase reputation,
credibility, and investors' recognition.
Empirical evidence suggests that the motives depend on firm characteristics such as age, size, etc. In a
survey of Chief Financial Officers (CFOs) from 12 European countries, CFOs view enhanced
visibility, financial flexibility and funding for growth are important universal factors (Bancel & Mittoo
2009). Other studies conclude that going public to facilitate subsequent acquisitions is a key driver
(Celikyurt et al. 2010, Brau & Fawcett 2006). Newly listed firms are very active acquirers. Although
this partly reflects the fact that they are often active in industries with intense M&A-activities, they are
more active than firms already listed in these industries. Moreover, newly listed firms are
predominantly acquiring firms (instead of being take-over targets). IPO activity also affects
subsequent market activities and funding practices. A firm's M&A appetite is supported not only by
the initial capital injection but also by subsequent access to capital markets. Hence, well-functioning
and liquid capital markets are important in order to ensure the further development and growth of
firms (Helwege, Pirinsky, & Stulz 2007). M&A activities by IPO firms are supported by the fact that
the IPO largely resolves the uncertainty regarding the value of the firm (Zingales 1995). This
uncertainty resolution, together with improved public information after the listing, also positively
affects the firms bargaining power when securing additional financial means. Empirical evidence
27
shows that in the post-IPO period firms reduce the cost of bank credit and increase their debt
capacity (Pagano et al. 1998, Celikyurt et al. 2010). This evidence suggests that mandatory
information and disclosure requirements of firms positively affect a firm's visibility and access to
finance. It helps the firm to diversifying its funding needs by increasing its bargaining power vis-à-vis
its lenders.
In considering an IPO, a firm needs to balance the economic advantages of an IPO with the costs
associated with the IPO process and the costs of being listed. The costs of going public depend on the
market choice and the size of the issue. Direct costs related to the IPO include underwriting fees,
professional fees (legal advisers, audit and accounting fees, etc.), compliance costs and initial listing
fees. In addition, IPOs tend to be offered at a discount which is an indirect cost to firms. After the IPO,
the firm also has to deal with recurrent regulatory costs related to disclosure and corporate governance
28
obligations and has to pay additional professional and annual listing fees.
Costs of listing vary depending on the market choice and the size of the issue. The Federation of
European Securities Exchanges estimates the cost of an IPO to be between 3 and 15% of the amount
raised (FESE 2015). This is in line with estimates of other market players in Europe: Deutsche Börse
and Euronext estimate the average cost at 8.7% and 7.5%, respectively.
The choice of the actual listing market, is an important element in the IPO decision. Going public will
not only alter a firm's funding structure, it will also affect a firms ownership structure, corporate
governance structure and information stream. Disclosure requirements and corporate governance
obligations will increase the accountability of a firm compared to an unlisted firm. These elements are
determined by the prevailing legal system and are therefore factors to be considered when a firm
29
chooses its issuing market. The market choice is considered to be important in terms of managing
visibility and investors' expectations, as well as the ability to raise capital in the future. Institutional
settings and market functioning are also key factors for institutional investors when considering an
IPO investment. In a survey of 321 institutional investors, 53% of respondents indicated that the
exchange is an important determinant of their investment decision. Liquidity, regulatory environment
and high corporate governance standards are reported as key decision criteria.

27

IPO firms experience not only lower interest rates but also less credit concentration after the IPO.
Increased compliance costs following the introduction of the Sarbanes–Oxley Act (SOX) is one of the main determinants
of delisting in the US (Marosi & Massoud 2007, Leuz et al. 2008). See Martinez & Serve (2016) for an overview of delisting
motives.
29
The legal system will also affect overall IPO activity. La Porta (1997) shows that firms' reliance on external capital
increases with the level of investor protection. Hence, lack of harmonization of legal requirements will explain to some extent
cross-country differences in external funding and IPO activity.
28

43

Besides firm-specific factors such as size and internal governance systems, the choice of the IPO
market is also influenced by the prevailing ecosystem (e.g. analytics and research, underwriting and
brokerage functions). A firm's broker has an important influence on its market choice decision. In
addition, the presence of prestigious underwriters and degree of venture capitalist syndication may
impact the market choice.
Finally, market choice is influenced by firm size, with smaller firms considering growth markets as an
alternative for listings on traditional markets. Compared to large firms, the market choice of smaller
firms is also more influenced by the costs of listing.

Box 3.

M&A activity in Europe

M&A activities are volatile, with pronounced boom and bust phases, spurred by the availability of
credit, changes in government policy (e.g. deregulation), innovation, and high stock valuations
facilitating stock financed take-overs. Economic conditions are the key factor influencing the M&A
market.
Figure 3.9 European M&A activity (EUR billion)

Domestic inbound
Extra-EU inbound
Share of extra-EU in IM&As

2016

2015

2014

2013

2012

0%

2011

0

2010

10%
2009

200
2008

20%

2007

400

2006

30%

2005

600

2004

40%

2003

800

2002

50%

2001

1.000

2000

60%

1999

1.200

1998

70%

1997

1.400

1996

80%

1995

1.600

Intra-EU inbound
Share of cross-border

Source: Dealogic

The 2008 financial crisis marked the end of the last M&A wave and stalled the M&A market for an
extended period. Although confidence has gradually returned to capital markets supported by
accommodating monetary policy, firms initially held back from M&A actions, and preferred to pay
out dividends or start-up stock repurchasing programs. The M&A market reached a tipping point in
2013 and has started to pick up significantly since 2014 supported with an increase in very large
transactions. Interestingly, cross-border M&A activity has become relatively more important since
2009.
Focus on SMEs
In general, access to equity markets by smaller companies is limited and mostly young, fast growing
SMEs use public equity markets to raise capital (OECD 2015). Based on evidence from the US market
and (to a lesser extent) the European market, Ritter et al. (2013) argue that SMEs might follow a
strategy to get big fast by becoming part of a larger organisation that has a relative advantage in terms
of realising economies of scope and scale, which could explain why some SMEs are not considering to
access public markets.
There is a clear IPO gap for SMEs. It is estimated that the IPO market in Europe is only half the size
of the one in the US, and for smaller deals it is only about one third (Wright 2014, Didier et al. 2015).
44

Masiak et al. (2017) also demonstrate that a significant number of internally financed SMEs appear to
deliberately opt to shy away from external financing.
SME dynamics are also distinct in the post-IPO phase. Rose & Solomon (2016) found that the
probability of staying listed within the first five years following an IPO is lower for small firms
compared to mid-cap and large-cap firms, suggesting that small firms may experience structural
30
disadvantages that accentuated their unsuitability to raise capital in the public equity market.
Taken together, these results suggest that equity markets have significant potential for SMEs to attract
funding, but are likely not to be relevant for all SMEs. Hence, it is important to clearly identify those
SMEs that could benefit from a better access to equity markets, identify the barriers they face and to
ensure that financial regulation is sufficiently targeted to these firms.
Compared to large firms, smaller firms face a number of structural disadvantages owing to their size
and the heterogeneity of SMEs. Firstly, information asymmetries are more pronounced for small firms
compared to larger ones. SMEs lack track record and are less visible. Adverse selection costs should
therefore be more serious for the listing of young and small companies (Pagano et al. 1998). In
addition, the lack of standardization and harmonization of performance and other financial data adds to
the information gap between insiders and investors. According to the pecking order theory, firms that
are characterized by high information asymmetries will rely more heavily on internally-generated
means. Secondly, SMEs are confronted with high fixed costs of becoming listed compared to the deal
size. The Federation of European Securities Exchanges (FESE) estimated that in 2015 the costs varies
from 10 to 15% of the amount raised from an initial offering of less than EUR 6 million to 3 to 7.5%
from more than EUR 100 million (FESE 2015). On top, recurrent compliance costs after listing (e.g.
information disclosure) have to be taken into consideration as well.
Table 3.1 Listing costs (as a % of the amount raised)

Amount raised from the IPO

Cost of raising capital
(as a % of the amount raised)

less than EUR 6 million

10 to 15

between EUR 6 million and EUR 50 million

6 to 10

between EUR 50 million and EUR 100 million

5 to 8

more than EUR 100 million

3 to 7.5

Source: Federation of the European Securities Exchanges (FESE) (2015).

Growth markets could alleviate some of the cost concerns given their lower admission costs, more
31
flexible listing criteria and less stringent disclosure requirements. A proportionate approach aimed at
SMEs could therefore be helpful. Such an approach should be balanced and should not undermine
consumer protection. Thirdly, market funding for SMEs might be hindered by a lack of demand.32 The
participation by institutional investors is hampered by a lack of market liquidity and available research
coverage (OECD 2015b). Market infrastructure (market makers, etc.) and equity research coverage are
important to increase liquidity and visibility of SMEs, but they are underdeveloped in Europe (ECSIP
2013). Aggregation of SMEs investments by pooling listed SME securities could increase the liquidity
of SME investments and, in turn, could broaden the base of institutional investors. In this regard,
Bartlett & Solomon (2016) show that the decline in small IPOs in the US market since 1998 can be
partly attributed to a decrease in the demand by large equity mutual funds. The growth in asset under
30

Within five years of an IPO, only 55% of small capitalization companies remain listed on a public exchange, compared to
61% and 67% for middle and large capitalization companies, respectively.
31
Less stringent measures should still assure high quality information. This can for example be achieved by requiring the
same disclosure content as on the main exchange but reduce the number of disclosure moments WFE (2016).
32
Rose & Solomon (2016) also stress the importance to foster investor demand for small IPOs to revive the SME IPO
market.

45

management for these funds leads to larger investment positions and an increased attention to liquidity
exposure.
Besides institutional investors, retail investor participation is also underdeveloped. Appropriate
investor education33 and investor protection appear to be key factors to promote retail investments in
listed SMEs. Retail investors should clearly understand the higher risks associated with investments in
SMEs and the quality of IPOs by SMEs needs also to be monitored closely. Retail investors'
participation in the market, for instance through the allocation of part of their pension fund
investments, would deepen the market and provide a strong impetus for its development.
Fourthly, the existence of a well-functioning listing ecosystem is essential for SMEs. The ecosystem
consists of investment banks, SME-specialised banks, sales, brokers, research analysts, advisers,
market makers, and other parties that support the SME IPO process and subsequent listing process (see
Figure 3.10). The ecosystem is especially relevant for SMEs given that they are often locally oriented
(thus relying on a well-developed local ecosystem) and often are less knowledgeable about the listing
process. Nevertheless, the ecosystem for SMEs appears to be too narrow owing to a large extent to a
lack of economic incentives for market players to provide such services.
Figure 3.10 Ecosystem for SME listings

Source: OECD (2015b)

Equity research is of particular importance for SMEs given that they have lower visibility than large
cap firms and information is more opaque and scarce. A market failure however exists provided that,
despite the clear need for SME equity coverage, analysts tend to orient their coverage to large caps
33

Note that financial education of SMEs might also be important to raise their awareness of market-based financing
opportunities.

46

(Weild & Kim 2009), as research on large caps is more profitable. Providing good quality research on
SMEs is relatively harder in view of the characteristics of SMEs (e.g. higher information
asymmetries). It is argued by market participants that SME coverage is hardly profitable in view of the
low trading activity in SME stocks (ECSIP 2013). Hence, some exchanges opt to subsidize research
by paying for research reports or analyst fees (Harwood & Konidaris 2015, World Federation of
Exchanges 2016).
Advisers can reduce the information asymmetries between investors and issuing SMEs. Advisers are
typically corporate finance firms approved by the stock exchange that offer SMEs assistance in the
IPO and listing process by assessing the appropriateness of a SME seeking admission and supporting
the firm in fulfilling the ongoing listing obligations. NewConnect and AIM are two European stock
exchanges that use the system of authorised or nominated advisers extensively (Harwood & Konidaris
2015).
Liquidity of SME stocks should also be supported. Liquidity is a vital element in order to attract
institutional investors. Changes in the market structure (due to, among other things, the rise of highfrequency trading and ETFs) have however increased the focus on liquid large-cap stocks (OECD
2016). Market makers could reinforce the ecosystem by providing additional liquidity to the market
and many stock exchanges encourage market making for SME listings.34 Economic incentives could
be put in place by policy makers and stock exchanges to develop more mature ecosystem that can
support SME listings (OECD 2015b).
Investments in equity markets are also subject to home bias, i.e. the tendency to overweight domestic
stocks. Although this is a common feature of equity investments, the lack of cross-border investments
may be more pronounced for SME IPO markets. Empirical research shows that foreign investors
prefer large stocks. Hence, market fragmentation further curtails SMEs access to equity markets.

Box 4.

Post-trading market infrastructure

Well-developed and efficient and post-trading systems are vital to ensure a smooth, stable and resilient
operation of trading markets. CCPs and CSDs are essential in this context as they ensure that securities
can move safely from sellers to buyers.
Regulatory intervention has already made significant progress in this area by increasing transparency,
accessibility and standardisation of systems and operations. A key aspect throughout all regulatory
initiatives enacted has been to promote competition and reduce or, where possible, eliminate barriers
to cross-border transactions. Nonetheless, the systems and environment supporting European posttrade operations often remain fragmented and many of the barriers to cross-border clearing and
settlement identified in the Giovannini reports are still present. Moreover, the European Post-Trade
Forum (EPTF), an expert group set up by the European Commission in 2016, found 13 structural,
operational, legal and tax related barriers to an efficient functioning of the single market in post-trade
services.
There are however signs that the European market is progressively moving towards more centralised
infrastructures and is developing solutions to cross-border post-trade workflows (cf. MiFIR, T2S).
At the same time, the financial industry is investing heavily in the automation of post-trade processes
(e.g. FinTech solutions), thereby increasing efficiency, and stimulating competition. While the
ongoing transformation and innovation are expected to reduce fragmentation, they may potentially
also give rise to new harmonization needs.
3.2.2

Corporate bonds

Corporate bond issuance is determined by firm-specific characteristics, general macro-economic
factors, and by the bond market structure.
34

See OECD (2015) for the importance of market makers, and Harwood & Konidaris (2015) for examples of market-maker
models.

47

As regards firm characteristics, firms might first use internally generated means and network financing
(family & friends) in the early stages of their life cycle and subsequently borrow from banks. Only in
later stages, firms might consider to access public bond markets. Firm characteristics will affect a
firm's choice between bank and market-based financing. Firms that are larger, more profitable, and
more creditworthy, or have more investment opportunities will access public debt market quicker (see
amongst others Denis & Mihov (2003), Hale & Santos (2008) and Mizen et al. (2009)). In addition, a
firm's reputation,35 and the extent to which it has already received funding from private bond markets
or syndicated loans affects its reliance on the public bond market, indicating that a firm's track record
provide a signal for subsequent public debt financing (Hale 2008). Moreover, the provision of
collateral and the presence of tangible assets will facilitate public debt finance provided that these
elements act as a buffer in case of default.
Bond issuances are related to macro-economic conditions although, unlike for IPOs, market timing
appears not to be a major influence in bond issuance activities. In times of recessions, there is an
increased demand for low-risk products. As a result bond issues are countercyclical, at least for
investment-grade issuers.36
The cost of corporate bonds is also affected by the market structure. Bond market liquidity is an
important feature for issuers as well as for potential (institutional) investors. Secondary markets for
corporate bond have experienced significant (structural) changes, stemming from monetary policy,
technological developments, the growth of the asset management industry and the changing role
played by banks as market-makers, changing risk appetites of investors in response to the crisis, and
financial regulation and a rise in corporate issuance.37
In addition, bond markets are not integrated. Debt issues in domestic and international bond markets
have different characteristics, even when issues are made by the same firm (Gozzi, et al. 2015). Issues
in international markets tend to be larger, have lower yields, include more fixed rate contracts, have
shorter maturities and denominated in foreign currency. Hence, bond markets appear to be segmented.
Frictions like tax, regulation and information asymmetries could hamper the integration of debt
markets. International bond markets are also not accessible for all firms, with firms that issue debt
abroad being much larger and also more leveraged than those that stick to domestic issues.
Focus on SMEs
SMEs make little use of public bond issues because they face a number of barriers. According to
OECD (2015a), public bond issues by firms with an asset size of USD 250 million or less decreased
from 7% in 2000 to only 2% in 2014. In addition, the median value of bond issues has increased as
well.
SMEs have a number of structural disadvantages when considering a bond issuance, similar to those
for equity issuances (higher information asymmetries; more uncertainty surrounding their
creditworthiness; limited track record; lower visibility; high issue costs). From an investor's point of
view, SME financing might require more frequent monitoring, diversification and economies of scope
which are easier achieved by banks and bank lending.
Overall, the analysis and literature review shows that European equity and bond markets remain
underdeveloped compared to other developed economies, reflecting in part capital market
fragmentation. Access to public markets occurs in waves due to its dependence on macro-economic
35

In line with the reputational model (Diamond 1991), both firms with high and low reputation enter the public bond market
quicker than firms with an intermediate reputation. Hale (2008) finds corroborating evidence for this theory.
36
A similar pattern is documented for other types of external finance, with public equity issuances and private loans do not
significantly decline during downturns for investment-grade borrowers while they do for noninvestment-grade borrowers
(Erel et al. 2011).
37
In response to the crisis, policy measures - such as stricter bank prudential rules, tighter limits on hedging requirements,
and a push for greater transparency - were put in place to make the financial system more resilient which, in turn, might
potentially negatively affect liquidity. Given that different liquidity metrics point to different directions, existing studies are
inconclusive.

48

activity and is further influence by firm-specific and institutional factors. It affects a firm's current
financing mix, facilitates subsequent funding opportunities (via better access to equity and bond
markets and improved bank lending conditions) and impacts a firm's subsequent involvement in M&A
activities. Access to public markets is lower for SMEs because they face additional challenges due to
higher information asymmetries, high fixed costs, underdeveloped ecosystems and relatively low
demand from investors.

3.3 General policy implications
European equity and bond markets remain underdeveloped compared to other developed economies,
reflecting in part capital market fragmentation. Access to public markets is lower for SMEs because
they face additional challenges due to higher information asymmetries, high fixed costs,
underdeveloped ecosystems and relatively low demand from investors.
Further work is needed in the following directions:
1.

Adapting the regulatory environment to support SMEs' access to public markets. The
regulatory regime for SME Growth Markets introduced by MiFID II needs to strike the right
balance between avoiding unnecessary administrative burden and providing sufficient investor
protection. A sustained focus on 'proportionality' is needed to take account of the specific
challenges confronting smaller issuers (compliance costs including for financial reporting,
governance and culture changes contingent on becoming a 'public company'), small exchange
operators (limited listings and low trading volumes, illiquid stocks ) and the specific constraints
of the surrounding ecosystem (brokers, underwriters and research analysts).

2.

A disappearance of local ecosystems surrounding stock exchanges, i.e. a network of brokers,
equity analysts, credit rating agencies, lawyers, accountants focusing on local SMEs, reduces
capacity to support companies at the IPO stage. The decline is particularly acute for equity
brokers specialising in SMEs. Due to regulatory and technological changes, equity trading is
focusing on large caps, thus leading to a decline in the liquidity of SME shares. This low
liquidity can deter institutional investors from investing in SME shares. As liquidity is weak,
brokers specialised in SMEs also experience a decline in their brokerage fees. Therefore, those
brokers may not be incentivised anymore to provide equity research on SMEs, which in turn
may have a downward impact on liquidity. If there is a decline in local ecosystems, the costs of
SME IPOs could potentially rise, as SMEs are compelled to rely on large banks' services when
going public (according to OECD, 55% of the global IPO volume was conducted by the top 20
banks in 2016).

3.

Tailoring disclosure requirements for SMEs. The above analysis highlights the deterrent
effect of regulatory disclosures for small or initial issuances. The rapid agreement on revised
EU Prospectus rules has been a significant achievement. It paves the ways for calibrating
prospectus requirements for listings on growth markets. This reflection should also extend to
financial reporting where care must be taken to create a cliff-edge effect in financial reporting
obligations for small issuers coming to public markets in terms of their financial reporting
obligations. This must be balanced against the desire to promote comparability and readability
of financial reports to maximise engagement by a wider pool of international investors. A
voluntary, tailor-made accounting solution, which could be used by companies admitted to
trading on SME Growth Markets, could be another way to reduce structural informational
barriers. The International Accounting Standards Board (IASB) is currently working on its
disclosure and materiality projects, including the usability and accessibility of International
Financial Reporting Standards (IFRS). This can be an important reference point for this work.

4.

There is a weak pipeline of SMEs seeking a listing, as IPO costs (such as auditors', corporate
advisors', lawyers' fees and listing fees) are high and can deter SMEs from seeking an admission
of shares to trading. According to FESE (2015), the costs of an IPO can account for up to 1215% of the capital raised by an SME, compared to 2.5 - 3.5% for the costs of listing for large
corporates and only 2% for corporate bond issuances. After the IPO, the listed SMEs also face
high compliance costs from EUR 150 000 to 500 000 a year for companies with less than EUR
49

150 million of capitalisation. Best practices could be developed on the use by Member States of
EU funds to partially finance costs borne by SMEs when seeking admission of their shares on
the future SME Growth Markets.
5.

The lack of institutional investor appetite for SME shares creates a mismatch between
capital demand and capital supply for SME shares. European households and institutional
investors have a lot of savings that could be invested, but a very low flow of investment is
effectively channelled into SME shares. As a consequence, there is little incentive for small
companies to list their stocks on a stock exchange. It should be assessed whether investment
could be unlocked, for example, through support from a public-private investment fund, in close
cooperation with the European Investment Bank that invests in SME listed shares.

6.

Improving corporate bond market liquidity. Corporate bond markets are an increasingly
important funding channel for larger companies, and the size of viable issuances has been
declining, allowing more companies to tap this market. This has been facilitated by the
development of private placement markets in some Member States. The Commission's Expert
Group on Corporate Bond Market Liquidity due in September 2017 will work on how to sustain
these positive developments, and to improve liquidity in secondary markets for these
instruments.

3.4 Key indicators 38
NFCs financial structure
Last 5-year
average
13.9

Latest
observation
Q2 2016

4.3

Q2 2016

4.7

Listed shares, % of total liabilities
Bonds, EUR billion, outstanding volumes

16.5
1 640

Q2 2016
Q2 2016

17.9
1 984

Listed shares, EUR billion, outstanding value

6 242

Q2 2016

7 561

Last 5-year
average

Latest
observation

Value

32.2

2016

27.9

223.7

2016

240.0

4 049

2015

3 796

Indicator
Bank loans, % of total liabilities(i)
Bonds, % of total liabilities

(i)
(i)

(i)

Value
11.8

unconsolidated data.

Developments in public equity and debt markets
Indicator
European IPOs, EUR billion, total value of deals
Corporate bond issuance by NFCs, EUR billion,
total value
Approved prospectus, total number, EAA

38

EU, unless indicated otherwise.

50

4

Strengthening banking capacity to support the wider economy

Efficient capital markets solutions can help banks to strengthen their lending business through (i) risk
transfer, balance sheet management and the pricing of illiquid assets (e.g. securitisation, secondary
market for NPLs), and (ii) wholesale funding (e.g. covered bonds, ESNs). This chapter reviews
developments in asset securitisation which helps banks to transfer risks. It reviews funding techniques
that banks can use, notably covered bonds to finance mortgage and public sector loans as well as a
similar new instrument, European Securitized Notes, which banks could use to finance SMEs and
infrastructure loans. The final section focuses on secondary markets for non-performing loans (NPLs).

4.1 Asset securitisation
Securitisation is a financing mechanism in which credit institutions package loans which they have
granted into securities and sell them to investors.39 Through this process, illiquid financial assets (such
as mortgages, loans, leases) are bundled together and converted into liquid securities, funded by and
tradable in the capital markets. Securitisation is a useful tool for banks to transfer risk to other
institutions or/and investors and thus to reduce funding costs and increase their funding capacity.
Securitisation benefits investors by giving them access to assets which they could not otherwise
access.
Securitisation entails risks when done in a complex, opaque or atypical way. Such risks materialised
during the last financial crisis, when misaligned incentives (with overreliance on mathematical models
and third party opaque risk assessment and guarantees) created a volume-based securitisation process
that amplified the crisis imposing huge losses on banks that were later bailed out.
4.1.1

Trends in securitisation markets in Europe

Amid global distrust, securitisation activity remains subdued. In Europe, following constant growth
for almost a decade prior to the financial crisis, securitization activity plunged markedly and has not
yet fully recovered. Since 2008, when EUR 105.5 billion of securitised products were issued, the
European securitisation market has nearly halved. At the end of the fourth quarter of 2016, the
securitisation market amounted to EUR 1 274 billion of outstanding value.
The weak demand for securitisation products in Europe reflects a global problem of distrust due to the
role that securitisation played during the crisis. Underscoring the high credit quality of European
securitisation issuance, credit rating upgrades keep outpacing downgrades among European securitised
products over the last quarters. Also during the crisis, EU securitisations performed far better than
their US counterparts.40

39

A typical example of securitization is a mortgage-backed security but other loans, such as SME loans, could also get
securitised.
40
European securitised products have proven remarkably safe during the crisis, generating near-zero losses. Illustrating this,
default rates of AAA EU RMBS products never really exceeded 0.1% while the rate was 16% in the US. For riskier (BBBrated) products, EU securitisation also performed very well, with worst-performing classes defaulting in 0.2% of the cases at
the height of the crisis as compared to the default rate of 62% in the US.

51

Figure 4.1 Issuance/outstanding amounts of securitised products in Europe, in EUR billion
900

2500

800
2000

700
600

1500

500
400

1000

300
200

500

100
0

0
2008

2009

2010

2011

2012

2013

outstanding

issuance

2014

2015

2016

Source: AFME

Securitisation market remains unqually developed in the EU. The United Kingdom and the
Netherlands constitute the biggest markets, holding a combined 40% share in the total outstanding
amount. Italy and Spain have, each, market shares exceeding 10%. In total, those four mentioned
countries are over 60% of the European securitisation market. The share of France, Germany and
Belgium in the EU securitisation market exceeds 5% each while shares of other EU countries are
lower. The described breakdown stays rather constant over time and is similar when based on
securitisation issuance, a better proxy for market dynamics. The latest securitisation issuance data for
the EU shows that combined slightly smaller market shares of the United Kingdom and of the
Netherlands while slightly bigger market shares for both Italy and Spain, reflecting positive trends in
the development of these two markets.
Figure 4.2 Outstanding/issuance amounts of EU securitised products in 2016, by country of collateral (% of
total)
Outstanding

Issuance

Source: AFME

Residential Mortgage Backed Securities (RMBS) systematically make up the majority of the EU
securitisation market. The UK and Dutch RMBS led placed totals in Europe in 2016. Explaining the
popularity of securitised transactions involving residential mortgages is the fact that the latter are
standardised, have long maturities, and generate regular payment streams. Another important segment
is securitisation on a short term basis, usually through ABCP programmes.
In contrast, SME loan securitisation remains weak in the EU, representing merely 7% of outstanding
securitisation. SME securitisation has exhibited a changing trend over the last years. It peaked in 2007
at EUR 77.3 billion and it failed to revert to such levels ever since. Most of the transactions executed
prior to the crisis where placed with investors and a significant amount of transactions was synthetic.
52

Germany and Spain constituted the most active markets. From 2008 onwards, the volume, type of
placement and geography of SME securitisation changed significantly. Only a minority of transactions
was placed with investors (with the majority of deals being retained, mainly for repo funding with the
Central Bank). Synthetic securitisation dropped sharply and markets in Italy, Greece and Portugal
became more active.
The particularity of SME securitisation is that they usually have smaller portfolios than other
securitisations. In addition, the small size of SME loans implies a higher number of pooled assets.
Consequently, SME securitisation is generally more expensive than securitising other, more standard
types of loans such as mortgages. SME securitisation also usually requires substantial resources on the
investor side to assess the credit quality of the underlying assets and of the resulting securities. The
cost of SME securitisation is further exacerbated by limited standardisation or an outright lack of data
on SME loans, which makes it hard for prospective investors to compare the risk-return characteristics
between products. Data problems and gaps sometimes make credit rating agencies refrain from rating
41
SME securitisations . Next to high set-up and operational costs, SME securitisations have generally
lower returns on the underlying assets, which makes structuring a profitable SME securitisation
difficult. In jurisdictions where the sovereign rating cap binds securitised product into lower credit
ratings, the disadvantage in investing in SME securitisation becomes even larger. The described
factors restrict the investor base for SME securitisation, making it a niche market.
Figure 4.3 Total securitisation issuance in the EU (in 2016) placed by type42
WBS/PFI; 1%
SME; 8%

Auto ABS;
12%
Consumer
ABS; 12%
Credit Card
ABS; 1%
Lease ABS;
4%

RMBS; 50%

Other; 1%
CDO; 9%
CMBS; 2%

Source: AFME

4.1.2

Levers to revive securitisation in the EU

In an effort to revive the securitisation market in the EU, the Commission presented the Simple,
Transparent and Standardised (STS) securitisation proposal in September 2015. By differentiating
‘high-quality’ securitisation products from other securitisation transactions, the intention is to identify
securitisations that are standardised, that use consistent and well understood structures, where the
issuer retains some of the assets that are being securitised, and where the obligations for all the parties
involved are clear. Considering the lower risk profile, the intention is that STS securitisation is
supported by preferential treatment in the capital requirements and in the Liquidity Coverage Ratio
(LCR) for banks. In addition, insurance companies will face lower capital requirements for
securitisation positions that meet the "high quality" requirements.

41

Credit rating agencies typically require 3-5 years of financial performance and credit history when rating a securitised
product
42
RMBS stands for residential mortgage backed securities; WBS/PFI stands for whole business securities/project finance
initiatives; ABS stands for asset-backed securities; CDO stands for collateralised debt obligations; CMBS stands for
commercial mortgage backed securities.

53

European SMEs, which currently fund themselves mainly using bank credit, are expected to draw
important benefits from a revived securitisation market. Direct benefits can be expected in several
ways: (i) inclusion of ABCP in the STS framework will foster the growth of this important source of
short-term SME financing; (ii) granting a prudential treatment equivalent to STS for certain simple
types of synthetic securitisations, i.e. those used by public development banks to fund SME loans,
benefits for SMEs coming from the STS initiative will be ; (iii) introducing a single and consistent EU
securitisation framework and encouraging market participants to develop further standardisation, the
STS initiative should reduce operational costs for securitisations, with important benefits for the cost
of credit to SMEs, and (iv) thanks to promoting the securitisation market as a whole, investors and
issuers will build expertise around assessing, pricing and trading securitisations. This in turn should
reduce due diligence and credit analysis costs, helping SME loans to become a more viable asset for
yield-seeking investors. Moreover, indirect benefits to SMEs can be expected increased bank credit
reflecting that banks can obtain capital relief by securitising other loan portfolios.
The revival of the securitisation market in the EU is expected to benefit all Member States and not
only those with deep capital markets and developed financial infrastructures. Countries where the
funding of banks and the credit provision in general tends to be more problematic will benefit from a
revived funding channel. Also, a single and harmonised framework for EU securitisation could lay the
foundations for developing securitisation markets where these are currently not developed, like for
instance in Member States in CESEE.
Still, the described action constitutes only a first step towards a full recovery of the securitisation
market in Europe. Legislative efforts should be combined with adequate market practices, supporting
the growth of the securitisation market, such as greater standardisation and transparency of deals.
Moreover, information problems surrounding the SME sector and hindering the securitisation of SME
loans need to be resolved. Finally, the success of the STS initiative will also depend on the general
economic and monetary conditions, the demand for investment and credit, and developments in
alternative funding channels.

4.2 Covered bond markets
Covered bonds are a very important source of bank funding in many Member States and are used to
refinance mortgage loans and, to a lesser extent, other asset classes.
4.2.1

Market trends

The covered bonds market has a long and successful history in Europe, witness the increasing trend in
issuance and buildup of outstanding amounts (see charts below). The outstanding volumes of covered
bonds in the EU reached EUR 2.2 trillion at the end of 2015. About 80% of outstanding amounts
stems from 6 EU Member States: Denmark is by far the country with the largest new issuance
volumes (EUR 164 billion). Other major issuers are Sweden (EUR 61 billion), Germany (EUR 58
billion), France (EUR 45 billion), Spain (EUR 42 billion) and Italy (EUR 29 billion). Poland and
Romania are developing their markets. There has also been an expansion of the covered bond market
outside the EU, with the highest growth rates observed in non EU countries, primarily in Australia
(+97%), and Canada (+75%), and with first issuances by Asian countries in 2015.
Covered bonds have performed well in crisis periods, notably due to their low-risk structure (dual
recourse). Covered bonds were also attractive because they could be used as collateral to access the
several funding initiatives made available by the ECB and by other central banks.

54

Figure 4.4 Issuance of covered bonds (EUR
billion)

Figure 4.5 Volume of outstanding covered bonds (EUR
billion)

Source: EBA, ECBC.

Figure 4.6 Covered bonds outstanding versus growth rates in selected world countries

Source: Own calculations based on ECBC statistics.

The trend of an increasing use of mortgages as cover pool collateral continues (residential and
commercial real estate mortgages), and a parallel decline in the share in volume of public sector loans
and other asset classes in the cover pools; shipping loans, SME loans, infrastructure loans and aircraft
loans43. One of the reasons is that most national laws do not allow for the use of SME and
infrastructure loans as a cover pool asset class. Another reason is that SME loans are not eligible as
covered bond collateral under the Capital Requirements Regulation (which, in turn means that they are
not accompanied by preferential risk-weighting). The regulatory treatment in CRR reflects that the
credit quality of a cover pool backed by SME and infrastructure loans and the related refinancing risk
are potentially higher than in the case of mortgages or public sector loans. Moreover, the credit
assessment of such a cover pool is more difficult than for traditional asset classes due to diversity of
SME loans, the long-term and complex nature of infrastructure loans, and the lack of clear and
standardised credit information on SMEs, and on the types and features of infrastructure loans.
43

In most Member States, eligible assets for inclusion in the cover pool are prescribed by legislation and are usually
mortgages and private sector obligations.

55

There has also been a tendency towards longer maturities44, justified by the search for higher yields.
Issuance of soft-bullet maturities, where redemption dates can be extended under certain
circumstances, has seen growing popularity as it helps issuers to their over-collateralisation
requirements. As extendable maturities give the pool manager more time to sell assets after an issuer's
insolvency, soft-bullet structures might assure a higher recovery value and greater ratings stability.
In terms of the covered bond investor base, banks are still the largest covered bond investors (with
35% of investor base in 2015), amid favourable regulatory treatment in the EU: (i) in the Capital
Requirement Regulation (CRR, art. 129) giving a preferential treatment to covered bonds; (ii) in the
EU liquidity coverage ratio (LCR) framework, which allows the inclusion of covered bonds in the
liquidity buffer and is a crucial driver for banks’ investments in covered bonds; and (iii) in the EU
banking recovery and resolution framework, which exempts covered bonds from the scope of the bailin instrument. Central banks have substantially expanded their share. The ESCB, in the framework of
its quantitative easing asset purchases has bought so far about EUR 200 billion. By contrast, asset
managers, insurance and pension funds have shown a tendency to reduce their investments (their share
decreased from 50% in 2009 to 32% in 2015). Favourable treatment under Solvency II, which grants
low-spread risk factors to covered bond, might be expected to reverse this trend for investments by
insurance undertakings.
Figure 4.7 Allocation of euro area covered bond issuance by investor type (2009 and 2015)

2009

2015

5%

6%

2%
Banks

14%
35%

35%

Central banks

26%
Asset managers

37%

Pension
funds/insurance

9%
31%

Hedge funds, retail,
corporates and others

Source: EBA, BAML.

4.2.2

Market barriers and challenges

The EU covered bond markets remain fragmented along jurisdictional lines and between stronger and
weaker Member States, reflected in covered bond pricing particularly in stressed economic conditions.
In the period up to the financial crisis of 2008, yields and spreads contracted between the various
European covered bond markets indicating that investors viewed those as fundamentally homogeneous
assets. The financial crisis changed this pattern abruptly, with yield dispersion between the financial
instruments of various Member States rising strongly.
Furthermore, the covered bond investor base remains relatively home-biased and concentrated in a few
large Member States, partly due to insufficient homogeneity in legal, regulatory and supervisory
frameworks amongst Member States, forcing investors to incur in higher costs to undertake separate
analysis for the covered bonds of each MS.
The lack of a truly integrated EU covered bond model also hampers investment from third countries,
as investors there do not have a comprehensive basis for comparison with the covered bond
framework of their home jurisdiction.
44

Covered bonds are in general medium-term financial products, with an average maturity of around 5-7 years for the new
issues, and 70% maturing within 7 years. In a search for higher yields, maturity has risen somewhat in the past few years.

56

Box 5.

Commerzbank SME structured covered bond programme

The structured covered bond programme of Commerzbank is backed by SME loan collateral which is
not based on a specific legal framework for covered bonds. In Germany, unsecured SME loans are not
eligible as collateral for Pfandbriefe, the German covered bond product. Hence, the Commerzbank
covered bonds are contractually based and issued directly by the bank; they are also ECB-eligible.
Currently, the amount outstanding is EUR 500 million. The collateral pool consists of 1,680 loans of
which 1,344 were granted to German SME borrowers.
The bonds benefit from an unconditional and irrevocable guarantee by SME Commerz, an SPV
holding SME loans. The cash flows from a pool of SME loans are transferred to the SPV to back the
guarantee given to covered bond investors. The SPV is consolidated on the balance sheet of
Commerzbank and buys SME loans from covered bonds funded by a subordinated loan. In case
Commerzbank issues new bonds, the SPV will buy further loans to fulfil over-collateralisation
requirements stipulated by the covered bond documentation. The SME loans in the SPV are registered
in a refinancing register. Once registered there, they are deemed insolvency remote.
As long as Commerzbank pays all its dues on the SME covered bonds and fulfils its overcollateralisation requirements, cash flows generated by the SME loans are released to Commerzbank.
In case the bank stops paying, the guarantee provided by the SPV gets triggered and the cash flows
generated by the SME loans in the cover pool are used to pay the interest and principal of the bonds.

4.3 European Secured Notes
The creation of European Secured Notes (ESN) has been proposed by the covered bond industry as an
alternative to covered bonds. Like covered bonds, ESNs are dual recourse financial instruments, but
their cover pool would focus exclusively on SME loans and infrastructure loans, including for local
infrastructure (like schools, hospitals, etc) and sustainable investment.
A dual recourse ESN could be set-up as a direct on-balance instrument or as a structured product. The
direct ESN would be similar in structure to a classic covered bond. The ESNs would be issued by a
bank without transferring the assets to an external entity. The ESN would remain on the issuer's
balance sheet together with the underlying pool of assets. The issuer would ensure that the value of the
cover pool dynamically backs the financial obligations it generates. The investor has recourse to both
the cover pool and the issuer in the event of default (''dual recourse''). The direct ESN is similar to
covered bonds issued in Germany, Spain, Denmark, Cyprus and Belgium. Its main advantages are its
simplicity (no need to transfer assets to a different entity) and dual recourse. It could however require
changes to legislation in some jurisdictions (e.g., bankruptcy and security law, segregation of assets
requirements).
A structured ESN would also be issued by the bank, but assets would be transferred to a separate legal
entity, an SPV, that guarantees the ESNs issued. The guarantee provided by the SPV implies a dual
recourse, because in the event of default, the investor has access to the cover pool and to the issuer. A
structured ESN requires that the legal framework allows the transfer of assets to an SPV. The
structured ESN is similar to covered bond structures in Italy, the Netherlands, the United Kingdom,
Canada, New Zealand and Australia. Based on it, Italy was the first EU Member State to introduce an
ESN legal framework (see Box 6) and Commerzbank made a SME structured covered bond
programme (see Box 5).
One advantage of ESN is that it could help overcome moral hazard problems linked to the lack of
credit data on SME loans in capital markets which is one important reason why securitisation of SME
loans is not picking up. The lack of data gives rise to a substantial cost for the investor. When issuing
ESNs, rather than securitising the asset, banks remain liable for their SME loans, thereby signalling to
the investor that they have screened the loans in terms of credit quality. Small banks in particular rely
on relationship banking and they would benefit from such a new instrument.

Box 6.

The Italian ESN legal framework

Italy was the first Member State to adopt a regulation on an ESN-like instrument in April 2016. The
primary legislation allows the issue of bonds by banks (called Obbligazioni Bancarie Collateralizzate
57

– OBC) collateralised by SME loans, leasing, factoring, ship loans and other types of commercial
assets. OBCs is a dual recourse instruments. The structure is similar to the existing covered bonds
(Obbligazioni Bancarie Garantite – OBG) though the law clearly differentiates between the two
products as the new instrument is expected to be different in terms of underlying asset class and
regulatory features. Secondary legislation will specify some features of the new instrument such as the
exact definition of eligible assets and identification of licensable issuers.
OBCs will be under public supervision. This is a key element as public supervision is a pre-requisite
for the ESN to be UCITS-compliant and therefore exempt from bail-in, and eligible for a number of
prudential and regulatory requirements. Other characteristic features will be the bankruptcy
remoteness of the segregated assets, which will be assigned to an SPV (the so-called true sale
mechanism). Two major rating agencies have already expressed their support to this instrument. There
has been no issuance of OBCs so far as the secondary legislation is not yet in place.

4.4 Improving the functioning of a secondary market for NPLs
The large stock of non-performing loans (NPLs) on EU banks' balance sheets continues to weigh on
45
the EU financial sector . Moreover, it hampers the proper functioning of the intermediation role
banks play within the economy. Resolution of banks' NPLs is therefore key, as it will release
46
considerable capacity for new bank lending, notably to SMEs, and spur economic growth .
Addressing the high volumes of NPLs has gained momentum in the last couple of years in the banking
sector of most Member States and has increasingly become the focus of attention by supervisors. A
whole range of options are available, going from internal workout by the bank originally holding the
impaired asset, over asset protection schemes, securitisation, transfer to an Asset Management
Company, to an outright sale to investors. Meanwhile, it has become clear that a comprehensive
approach is needed in order to reduce the duration and the cost of NPL resolution problem. Such a
comprehensive approach may inter alia include: (1) the need for supervisors (SSM, EBA, national
regulators) to incentivise banks to restructure, write-off or provision bad loans; (2) the need for
enhanced debt legal framework; and (3) a better functioning secondary market for impaired assets.
This chapter focuses on this last aspect.
4.4.1

The stock of non-performing loans

At the end of the third quarter of 2016, the 130 largest EU banks held a stock of about EUR 1.1 trillion
of gross NPLs (EUR 0.6 trillion in net terms).47 Compared to the total gross loan book, the gross
weighted average NPL ratio stood at 5.4% (7.4% of EU GDP), coming down from a peak of 8% in
2013. The current NPL levels are still much higher than in other major developed countries, e.g. US
(1.7%) and Japan (1.6%). Whereas the US has been fairly quick in resolving NPLs stemming from the
financial crisis (through swift provisioning and writing-offs by banks, as well as by state supported
solutions), the EU banks continued piling up bad debts until 2013 and have been protracted in
provisioning and writing off NPLs. The decline over the last years is also partly on account of the
economic recovery getting traction and unemployment levels falling back.
The NPL ratios are very unevenly distributed across Member States and type of assets/counterparties,
as shown in Table 4.1.

45

NPLs weigh significantly on banks profitability as NPLs force banks to raise provisioning, lowering net income, while
these NPLs at the same time usually do not generate income streams or at least less than performing assets. They further tie
up more capital, due to higher risk weights on impaired assets; capital which could be used to finance new projects. NPLs
thus raise the risk profile of the banks involved, translating into higher funding costs for banks, and forcing banks to propose
higher lending rates and reduce lending volumes.
46
Several studies demonstrated that NPLs hamper the economic recovery prospects for the European economy.
47
EBA Report on NPLs.

58

Table 4.1 NPLs across the EU, mid 2016
NPL ratio by counterparty (%)

Member State

NPLs, EUR
billion

NPLs, % of
gross loans

SME

Large Corp.

Households

IT

276.0

16.4

30.4

20.6

12.9

FR

148.4

3.9

9.1

5.0

4.2

ES

141.2

6.0

17.4

7.8

4.5

EL

115.1

46.9

66.2

37.4

46.4

UK

90.6

2.2

5.2

4.2

2.7

DE

67.7

2.6

8.6

5.1

2.0

NL

44.6

2.7

5.4

5.1

1.5

PT

40.8

19.7

29.0

35.6

9.3

IE

32.8

14.6

30.2

13.2

14.9

AT

25.2

6.0

9.8

7.9

5.4

BE

21.4

3.6

6.8

5.1

3.9

CY

21.4

47.4

64.7

61.1

55.9

DK

19.8

3.4

12.4

4.9

5.5

SE

10.9

1.0

2.1

1.4

0.8

PL

6.7

6.8

13.5

9.7

5.2

5.6
5.4

16.7

7.6

4.9

Other MSs
33.9
EU
1096.5
Source: EBA and own calculations.

As regards country variation, Cyprus and Greece bear relatively the highest legacy cost, with almost
one-half of total loans not performing, accounting for about one-third of total bank assets. Portugal,
Italy and Ireland report NPL ratios of almost 20%. On the other end of the spectrum, many countries
report NPL ratios of less than 3%.
Equally strong is the dispersion at the level of type of assets/counterparties. Over 60% of NPLs are
related to corporate lending, of which about one-third is related to lending backed by commercial real
estate (CRE). Within the asset class of banks loans to SMEs, 16.7% is non-performing on average in
the EU; the impairment is particularly pronounced in Greece and Cyprus (ratios above 60%), and Italy
and Ireland (ratio around 30%). Amongst the bank loans to large non-financial corporates, 7.6% are
non-performing in the EU. Besides Greece (37.4%) and Cyprus (61.1%), Portugal (35.6%) ranks high,
together with Italy (20.6%). Finally, 4.9% of loans to households are non-performing in the EU, in
particular in Cyprus (55.9%), Greece (46.4%), Ireland (14.9%) and Italy (12.9%).
Provisions for NPLs amount to about 46% of the book value of euro area bank's balance sheet.
Including the collateral (covering 36% of total exposure), the coverage ratios are on average about
82%. Again, these coverage ratios differ significantly from one Member State to another, with
differences reflecting various levels of collateralisation (depending on lending practices as well as to
segments most impacted by NPLs) as well as heterogeneous accounting practices. While these levels
of the coverage ratios are not threatening the capital position of the banks involved, they will eat-in on
profits for many more years to come.
4.4.2

Developments in loan sales markets

The secondary market of distressed loan sales is quite opaque. Analysis of non-performing loan sales
is complicated because published transactions data most often aggregate data of NPLs with that of
non-core loan sales. In this regard, the stock of performing non-core assets, i.e. loans banks are willing

59

48

49

to shed off their balance sheet , amounts to EUR 1.2 trillion . Together with the stock of NPLs, EUR
2.3 trillion loan assets are available for sale in the EU.
The secondary market of distressed loan sales is quite opaque. Analysis of non-performing loan sales
is complicated because published transactions data most often aggregate data of NPLs with that of
non-core loan sales. In this regard, the stock of performing non-core assets, i.e. loans banks are willing
50
51
to shed off their balance sheet , amounts to EUR 1.2 trillion . Together with the stock of NPLs, EUR
2.3 trillion loan assets are available for sale in the EU.
Although the NPL stock has been building up gradually in the aftermath of the financial crisis, it is
only since the second half of 2013 that the sale of distressed and non-core loans has been picking-up,
with transaction volumes rising to EUR 71 billion in 2014, EUR 118 billion in 2015 and about EUR
200 billion in 2016 (compared to a size of USD 469 billion in the US at end-2013). At the current pace
of loan sales, and not taking account of new incoming NPLs, it would still take 10 more years to solve
the NPL issue. Last year, the improving investor sentiment towards the banking sector, still very
favourable financing conditions (amid exceptional accommodative monetary policy) and a general
improvement in the EU real estate markets (implying an increase in collateral value, and downward
revision of collateral value haircuts), presented attractive opportunities for banks to sell NPLs and
non-core assets. For the current year, the trend is expected to hold, with transaction volumes further
boosted by regulatory pressure and modest insolvency regime reforms.
Transactions were initially concentrated in a few Member States (mostly Ireland, Spain, United
Kingdom). In 2016 there was an increasing trend towards sales of performing non-core portfolios in
Member States where NPLs have been significantly unloaded (e.g. United Kingdom). Meanwhile,
more investors have been actively looking at the Italian market, as competition for distressed assets is
intensifying across EU, and initiatives like the shortening of legislative proceedings, and the
establishment of the Atlante fund. The market in Italy is further moving towards more complex deal
structures, including more SME loans. Also in Spain have the sales transactions become more
complex with secured SME and corporate exposures taking a larger part of the sales, even if the bulk
of sales are still related to residential mortgages,.
Market data on the pricing of NPLs is very much anecdotal. Market intelligence suggests that bid-ask
spreads are very significant, with strong differences amongst asset classes. The weighted average price
for concluded sales of NPLs is 34%, while average net book value is 56% (all EU banks). The average
price is highest (60%) for secured retail loans (including mortgages), followed by commercial real
estate loans (45%), SME/corporate loans (35%) and merely 10% on average for unsecured retail loans
(mostly consumer credit, credit card loans). However, trading in this last category is quite active. Also
sales of residential real estate NPLs have been buoyant (EUR 58.5 billion in 2015). Commercial real
estate loans are expected to have been plateauing in 2016 (EUR 49.5 billion in 2015).
The top 10 investors active on the secondary market of NPL take more than half of the volume of NPL
sale transactions on their account. Amongst the most active buyers are private investment firms (e.g.
Cerberus, Lone Star, Blackstone), hedge funds (e.g. Fortress Investment Group, Oak Tree) and
investment banks (e.g. Deutsche Bank, Goldman Sachs). The purpose of most of these large buyers is
cash-flow driven. A minority of portfolios is repackaged and resold. The scale of the big players
enable them to build up a data advantage of how loan portfolios perform which helps them in their
subsequent biding, build up a reputational advantage, and a track record with the main vendors. These
element give the big players a vital edge and explain why the current market for NPLs is assessed a
buyers' market with a small number of large buyers. The lack of an efficient third party loan-servicing

re businesses (in terms of asset class or geography) and to shed performing assets which consume too much risk-weighted
regulatory capital.
50

Increased banks regulation (SSM) and capital requirements (Basel III, IFRS9) continue to stimulate divesture. Besides,
also financial markets spur banks to place stricter focus on core businesses (in terms of asset class or geography) and to shed
performing assets which consume too much risk-weighted regulatory capital.
51
According to PWC, 7th annual European Bank Restructuring Conference, March 2016.

60

company across the EU forces investors to having to create their own servicing capacity and creates an
extra barrier to entry to buy NPLs.
The functioning of secondary markets for NPLs is also hampered by a number of structural
impediments. For example, there are legal requirements in some Member States on rules for the
transfer of credit contracts or restrictions on purchasers of NPLs. Investors are also deterred by high
uncertainty around debt recoveries and their timing, and collateral enforcement success. These
impediments explain the wide gap between net book value of NPLs and the proposed bid-price by
buyers. Data on the size of that gap is scant but it is thought to be very large. For instance, estimates
suggest that, for a fully collateralised non-performing loan, the discount required by a private investor
may exceed 40% solely due to the cost, time and uncertainty of the recoveries. The impediments also
explain why the direct sales of NPLs are more successful in relation to one type of assets than to other
types, and why the NPL market is presently a buyers' market, with a sub-optimal level of competition
at buyers' side.

4.5 General policy implications
Banks are important financial institutions in capital markets. Efficient capital markets solutions can
help banks to manage their balance sheets better and strengthen their lending capacity through risk
transfer and wholesale funding in particular.
The following considerations are relevant in informing future work:
1.

A rapid agreement on the Commission's proposal of September 2015 to create Simple,
Transparent and Standardised (STS) securitisation would provide the necessary impetus to the
revival of asset securitisation markets in the EU. Regulatory reform needs to be accompanied by
incentives for insurers' to invest in the STS securitisation market through a specific prudential
treatment in Solvency II and standardisation of market practices.

2.

Covered bonds have proven to be a reliable source of wholesale funding for banks, including
during periods of financial market stress. Tackling market inefficiencies and fragmentation to
achieve a more integrated EU covered bond markets could help improve funding conditions for
mortgage loans and public sector loans.

3.

The development of a new dual recourse ESN could potentially be an additional channel for
funding bank loans to SME, thereby complementing covered bonds and STS securitisation.
ESNs might contribute to overcoming moral hazard problems linked to the scarcity of
information about SME credit quality. Nonetheless, ESNs warrant further investigation about its
added value as a new type of bank financing instrument. Further work may be undertaken to
explore how ESNs complement covered bonds and securitisation and what are the conditions
for this market solution to develop.

4.

Despite some increased momentum in recent years, the market of direct sales of NPL remains
less developed in the EU compared to some major advanced economies. The functioning of
secondary market for NPLs should be supported with various types of measures targeting the
removal of impediments on both the buy and sell-sides. Measures could encompass a wide
range of policy options aimed at, for example, improving the transparency and quality of data
on NPLs. The management of NPLs would also benefit from more efficient and more
predictable loan enforcement and insolvency frameworks designed to enable swift value
recovery by secured creditors. In this context, it should be assessed how to strengthen the ability
of secured creditors to recover value from secured loans to corporates and entrepreneurs, while
remaining consistent with the Commission's proposal of November 2016 on the effective
functioning of the pre-insolvency/insolvency systems.

61

4.6 Key indicators52
Indicator

Last 5-year
average

Latest
observation

Value

Securitisation, outstanding volume, EUR billion

EUR 1 459
billion

2016

EUR 1 274
billion

Securitisation, gross annual issuance, EUR
EUR 222 billion
billion

2016

EUR 238
billion

Covered bonds, outstanding volume, EUR
billion

EUR 2 617
billion

2015

EUR 2 498
billion

Covered bonds (euro area only), outstanding
volume, EUR billion

EUR 1 222
billion

2017 Q1

EUR 1 224
billion

Non-performing loans, in % of outstanding gross
volume of loans

5.77%

2016

5.4%

52

EU, unless indicated otherwise.

62

5

Institutional investment: Investing for Long-term, Infrastructure and
Sustainable Investment

Institutional investors that have long-term liabilities are an important source of finance for long-term
sustainable investments, such as those in infrastructure and green bonds. Given their long-term
liability structure, the focus is primarily on insurance companies and pension funds' contribution to
more long-term sustainable investments.

5.1 Long-term institutional investments at the forefront
The strategic asset allocation of institutional investors with long-term liabilities relies on the ability to
act with limited constraints about liquidity of investments to implement such strategies. They can act
as shock absorbers in the economy by providing liquidity and not being forced to sell assets when
asset prices drop. Therefore, they express a counter-cyclical view. Their importance in national
economies can be gauged by the size of their asset holdings relative to GDP. Pension funds and
insurers are major investors in a large number of developed economies, with assets representing over
60% of GDP in Europe and other countries, such as Canada and the US (OECD 2015). In 2015, the
European insurance market was the largest in the world having combined total assets of EUR 9.89
trillion. France, the United Kingdom and Germany represent each about a fifth of the total amount,
with Italy representing 7%. The European pension market was the second largest in the world in 2015.
Combined assets under management totalled EUR 6.16 trillion for the top 1000 pension funds. It
should be noted that the United Kingdom and the Netherlands account for some 39% of those assets
(PwC 2016). In 2014, the combined GDP of the EU Member States was EUR 13.96 trillion.
5.1.1

Trends

Pension funds
In 2015, pension funds invested around 30% of the total portfolio in equity (Pensions Europe 2016).
Irish pension funds hold more than 50% of their investments in equity. Data from the Dutch Central
Bank indicate that the share of equity holdings by Dutch pension funds has decreased over the past
years to 13% at the end of Q3 2016. This reflects however a shift towards indirect holdings of equity
via mutual funds (50% in Q3 2016). As much as 80% of direct equity holdings are invested outside the
euro area.
There is quite some heterogeneity in the asset allocation between EU Member States. In 2015, pension
funds in continental Europe had a more conservative asset allocation than their counterparts in the US
with the exception of Poland (see Figure 5.1). A large share of investment has gone into government
bonds and less than 30% of assets were in (listed and unlisted) equity.

63

Figure 5.1 Asset allocation of autonomous pension funds (% of total investment, 2015)
Denmark
Sweden
Italy
Portugal
United Kingdom
Latvia
Luxembourg
Switzerland
Austria
Estonia
Netherlands
Finland
Belgium
United States
Ireland (1)
Poland
0%

10%

Equities

20%

30%

Bills and bonds

40%

50%

60%

Cash and Deposits

70%

80%

90%

100%

Other (2)

Source: OECD (1)Figures for Ireland are from 2013 (2) The "Other" category includes loans, land and buildings,
unallocated insurance contracts, hedge funds, private equity funds, structured products, other mutual funds (i.e. not invested
in cash, bills and bonds, or equities) and other investments.

Insurance companies
Compared to pension funds, equity investment by insurance undertakings are rather lower. Direct
equity investment represents only around 6% of insurers' total investment portfolio, which is mainly
invested in bonds (60%) and in other non-equity products (loans, deposits, structured notes, etc) for
around 10%. Data from the industry suggest that the share of equity decreased compared to 10 years
ago.53 Drivers behind this change are multiple, including accounting and prudential treatment of equity
exposure.
Insurance companies have been rebalancing some of their direct investments in listed shares (currently
at 6%) to indirect investment in equity shares via investment funds. in aggregate insurers’ allocations
to debt-like products are generally significantly higher than to equity. A key shift in asset allocation
can nevertheless be noted in the area of infrastructure, where insurers have significantly increased their
exposures over recent years. This came against the background of low interest rates and low returns on
traditional assets, but also as a consequence of a strong political push in this area, focused on both the
creation of infrastructure pipelines throughout the EU and the review of excessive prudential barriers
about which the insurance industry had expressed concerns. While the average EU allocation remains
in the area of 1% of insurers’ total portfolios, a range of European companies have publicly expressed
their intention to increase the average weight to as much as 5-10% (Insurance Europe 2016).

53

Solvency II harmonised reporting will soon provide clarity on actual investments, e.g. through funds and taking into
account unit-linked products.

64

Figure 5.2 Breakdown of insurers' investment portfolio – 2014 (%)

Assets held for indexlinked and unit-linked
funds; 7%

Participations; 6%
Investments (other
than assets for indexlinked or unit-linked
funds), 85%

Equities; 6%

Bonds; 48%

Property, other than
for own use; 3%
Other investment; 3%
Deposits other than
cash equivalents, 3%

Investment funds; 32%

Derivatives, 0.1%
Loans and mortgages,
8%
Source: Insurance Europe

5.1.2

Drivers

The investment strategies of institutional investors differ significantly across countries. Asset
allocation is influenced by a variety of factors, such as market trends, investment beliefs, regulation,
risk appetite, liability considerations, cultural factors, governance structures, tax issues and ultimately
domestically available assets (OECD 2015).
Traditionally, institutional investors have been a source of long-term investments via two main asset
classes (bonds and equities) and an investment horizon tied to the often long-term nature of their
liabilities. However, over the last decade there have been major shifts in investment strategies. Very
low rates have created a demand for a kind of “barbell” portfolio in institutional investment: large
asset allocations to both i) private equity and low cost exchange-traded funds (ETF) at one end; and ii)
capital market risk assets, based on leverage, that pay higher short-term cash yields (e.g. hedge and
absolute return funds, etc.) at the other end. In between is an allocation to equities, cash and bonds
within which further herding of investors into concentrated positions is found: into high-yield noninvestment grade bonds; and into equities that focus on providing strong dividends and buybacks
(OECD 2016). Significant adjustments to strategic asset allocation have been rare, with the exception
of a long-term trend among many institutions to shift more of their portfolios to illiquid assets.
Until recently, strategic asset allocation has been rather nonstrategic. Most institutions used historical
estimates of returns, correlation, and volatility, plugged in relevant constraints, and generated a
frontier of portfolio options that theoretically matched their risk and return objectives. Instead of
working on strategic asset allocation, many institutions have focused the bulk of their time on
searching for alpha through a number of means, including active management (both internal and
external) and direct investing in illiquid asset classes. The work on beta has been mainly to reduce
costs, often through internalizing management, with some exploration of enhanced-beta portfolios.
Institutions generally spent 20 percent of their time on beta, including strategic asset allocation, and 80
percent on the search for alpha. By far the most important change, however, is coming to the 80/20
alpha/beta management approach. Institutions plan to change those proportions by focusing on
building portfolio-construction capabilities, given that these drive the vast majority of long-term
returns (McKinsey 2015).
The financial crisis showed big investors that they didn't fully know their own portfolios. Moreover,
they felt they were overpaying middlemen – fees of 2% of the sum invested and 20% of profits were
65

once common – and were working to different time horizons (pension funds invest for generations;
private-equity funds for five years). A long investment horizon is the institutional investor’s greatest
competitive advantage, yet asset-managers’ cycles have become ever shorter.
Pension funds and insurers are significantly increasing their direct investments —a response in part to
high fees and disappointing returns of many asset managers. The trend is a logical extension of the
practice of co-investing platforms, in which institutions put money directly into specific deals
alongside funds in which they have also invested. Institutions have demanded such opportunities both
to cut the overall cost of investing via private-equity funds and to gain experience that might help
them initiate deals of their own in future (Monk and Sharma 2015).

5.2 Infrastructure
Infrastructure is usually divided into economic and social sectors. Using a broad definition economic
infrastructure typically includes transport; utilities54; communication; and renewable energy. Social
infrastructure - also called public real estate – includes schools, hospitals and stadiums. An investor
classifies infrastructure along its risk/return profile. The investor perspective is important when
defining infrastructure, as these differences will ultimately attract or deter different sources of private
finance (Della Croce 2011).
Ageing infrastructure facilities are deteriorating. This combined with urbanisation trends and albeit
slower but continuing growth of the population and shifting demographics makes for massive and
growing infrastructure needs (European Commission 2017). The European Investment Bank (EIB)
estimated that the total cumulative infrastructure investment needs in the EU could reach up to EUR 2
trillion for the period up to 2020.
Over the last decades, public capital investment in infrastructure has on average declined in OECD
countries. The OECD average ratio of capital spent in fixed investment (mainly infrastructure) to GDP
fell from above 4% in 1980 to approximately 3% in 2005. This reflected a decline in public investment
in countries with both traditionally high and low public investment rates between the early 1980s and
late 1990s, though it has subsequently stabilized (Della Croce and Yermo 2013).
Portfolio allocations of pension funds to infrastructure debt and equity are small, at around 0.5%
(Della Croce 2012). A major reason for the apparent mismatch between infrastructure investment
demand and the supply of infrastructure finance is the lack of a pipeline of properly structured
projects. Infrastructure investments entail complex legal and financial arrangements, requiring a lot of
expertise. Building up the necessary expertise is costly, and investors will only be willing to incur
these fixed costs if there is a sufficient and predictable pipeline of infrastructure investment
opportunities. Otherwise, the costs can easily outweigh the potential benefits of investing into
infrastructure over other, less complex, asset classes.
The lion’s share of the growth in infrastructure financing is shouldered by banks (Ehlers 2014). Banks
will remain important financiers, in particular in the early stages of new projects (see Box 7). But
banks, which have mostly short-term liabilities, are not well-placed to hold long-term assets on their
balance sheets for an extended period of time. Bonds would be suitable instruments for large pension
funds and insurance companies with their long-term liabilities. In addition, other new forms of
finance, such as infrastructure investment funds, can help to tap some of the vast resources of
international capital markets. The project bond and loan market has been gradually increasing over the
last four years; reaching EUR 70 billion at end-2015 (see Figure 5.3).

54

energy distribution networks, storage, power generation, water, sewage, waste

66

Figure 5.3 Historical European project financing issuance (EUR million)
Project loans

Offschore wind project bonds

Project bonds

Offshore wind project loans

100.000
80.000
60.000
40.000
20.000
0

Source: Thomson Reuters Project Finance International and Scope.

Facing constraints on public resources and fiscal space, while recognizing the importance of
investment in infrastructure to help their economies grow, governments are increasingly turning to the
private sector as an alternative additional source of funding to meet the funding gap (World Bank
2016). PPPs enable cooperation between a government and one or more private sector companies to
finance and operate long term infrastructure projects in sectors such as transport, healthcare and
environment. In 2016, the aggregate value of PPP transactions that reached financial close in the
European market totalled EUR 12 billion, a considerable decrease from 2007. Education was the most
active sector in terms of number of deals with 27 projects closed and an aggregate value of EUR 1.6
billion, thus achieving its best performance since 2010. In the healthcare sector, whilst the number of
projects that reached financial close increased to 15, the aggregate value contracted significantly to
EUR 2.3 billion. Four projects in France closed in the telecommunications sector for an aggregate
value of EUR 1.2 billion.
Figure 5.4 The European PPP Market by Value and Number of Projects since 2007
Value (EUR billion)

Number of projects

30

140

25

120
100

20

80

15

60

10

40

5

20

0

0
2007

2008

2009

2010

Value in H1

2011

2012

Value in H2

2013

2014

2015

2016

Number of projects

Source: European PPP Expertise Centre (EPEC)

Box 7.

Different financing instruments for different phases

A typical project has several distinct phases (planning, construction and operational). Each phase
exhibits different risk and return characteristics, and each faces different incentive problems and calls
for a different role for governments, banks and capital markets. Bank loans usually supply the largest
share of financing in the two initial phases of an infrastructure project (planning and construction).
67

Bank loans have some key advantages over bonds or other structured financing solutions: (i) debt
holders serve an important monitoring role in the project and banks tend to have the necessary
expertise. The risks banks take ensure they perform a crucial monitoring role in the process of setting
up an infrastructure project that is valued by other potential debt investors; (ii) infrastructure projects
need a gradual disbursement of funds and bank loans are sufficiently flexible; and (iii) infrastructure
projects are relatively more likely to require debt restructurings in unforeseen events and banks can
quickly negotiate restructurings among each other, whereas the restructuring of bonds, for instance, is
complex and time consuming. Bank loans for infrastructure projects are in many cases extended by a
syndicate of banks rather than a single bank.
The operational phase is distinctively different from the initial phases. As the infrastructure project is
starting to generate positive cash flows, default risks subside rapidly over time, on average even below
those of other highly rated debt securities. With stable underlying cash flows in the operational phase,
infrastructure projects are akin to fixed income securities and therefore bond financing is a natural and
economically appropriate financing instrument. Bonds often come into play when initial bank loans
are being refinanced, as they represent a low-cost financing alternative. Nevertheless, the volume of
issued infrastructure project bonds is surprisingly small; though it is increasing rapidly. Still,
compared to syndicated loans, bonds constitute only 10–20% of infrastructure debt financing.

5.3 Sustainable finance
Hard data on sustainable investments are scarce. This is because definitions of green investments or
ESG investment processes can vary from one fund to another. Renewable energy and social
infrastructure are relatively new sectors in the portfolio of certain investors although increasing. Some
funds reported sector allocations for unlisted infrastructure, listed shares, and debt, or in a combination
of these three categories. Further work is needed to make use of the data on investments available
under the European System of Accounts framework (Gross Fixed Capital Formation), its satellite
system the European Environmental Economic Accounts and in the Structural Business Statistics to
monitor the shift towards sustainability in investment patterns in the economy.
Pension funds and insurance companies have a long-term investment horizon. Issues related to climate
change and its impact on portfolio values is inherently important for risk management. Long-range
forecasts of climate change scenarios shed light on the potential risk to portfolio investments,
particularly those that are carbon intensive. Holistic risk management processes capture such scenarios
and begin to quantify potential risks, and search for ways to hedge such risks at low cost. Investments
in green technologies and businesses or infrastructures that are less sensitive to climate change
scenarios are one way that funds are taking action.
Green bonds are in the vanguard. The market for green bonds has been expanding rapidly over recent
years, with the amount of green bonds outstanding more than doubling between end-2014 and end2015. However, this market still remains marginal, representing less than 0.1% of the global
outstanding debt securities market.
According to estimates by EUROSIF, "systematic integration" of ESG issues, including, on the one
hand, investment strategies where investors systematically consider or include ESG analysis when
rating or valuing investment and, on the other hand, investment strategies involving mandatory
constraints based on findings from ESG research stood at around EUR 1.9 trillion at end 2013, a 65%
increase since end-2011, covering 11% of all European professionally managed assets. This trend
shows growing awareness and interest among investors. In terms of asset allocation, equities
represented about half of European Sustainable and Responsible Investment (SRI) assets at end-2013,
up from 33% at end-2011. Bonds represented 40% of SRI assets – 21% in corporate bonds, 17% in
sovereign bonds.
A strategy has emerged to recycle capital from the balance sheets of traditional funding institutions.
By buying into projects and/or refinancing existing projects, institutional investors free up debt and
equity capital in construction and operating-stage renewable electricity projects. Banks, private equity
funds, project developers and utilities can then redeploy the proceeds into the development and

68

construction of new projects. Closed-end funds and real-estate investment trusts (REIT) have played
an important role in this respect for some time.
As of April 2017, 3% of the total investment of EUR 183.5 billion expected to be mobilised by the
EFSI supports projects in the environment and resource efficiency sector. In addition, 24% of the total
investment expected to be mobilised by the EFSI supports projects in the energy sector, a number of
which cover the renewable energy and energy efficiency sectors.
The review of the EFSI framework is putting greater focus on meeting the EU's social objectives.
Private capital can support the EFSI objectives when financial returns are associated with positive
social externalities. Investments into social housing could for example provide accommodation to lowincome households. Investments into vocational training can widen the supply of a skilled workforce,
with positive effects on the competitiveness of EU businesses. Investment into long-term care
increases labour market participation rates, benefitting labour productivity. Social impact bonds are
also proving to become successful in several Member States.
The positive development of the markets for sustainable investment can be supported, for example, by
improving confidence in disclosures and labels, and providing appropriate regulatory recognition of
any observed improvement of risk-return performance of these assets. Environmentally harmful
subsidies, such as those for fossil fuels, are also potential distortion of pricing on energy markets and
potentially inhibit investments in the clean energy transition and innovation.55
Moreover, while funding abounds and technology costs for renewable electricity are falling fast, there
is a shortage of bankable projects. Both policy and market factors have an impact on the risk-return
profile of renewable electricity projects. Investor uncertainty as to what extent revenues can be
recuperated through energy markets, together with the uncertainty related to the support schemes for
Renewable Energy Sources (RES) and past retroactive changes is an impediment to capital markets
investments. At the European level, the EU ETS puts a price on emissions reduction on the industry
which in principle can help companies to profit from low carbon investments, including in RES.
However, while overall emissions from the power sector have been reduced in line with EU climate
objectives, there is currently a significant oversupply of allowances driven by uncertainty. A revision
of the EU ETS, with a functioning Market Stability Reserve (as proposed by the European
Commission)56, will help to reduce this uncertainty. Where support for RES investments is still
needed, support schemes should be cost effective and market-based without retroactive changes.
.

5.4 General policy implications
Institutional investors are important financial institutions in capital markets. They have a capacity to
channel private capital to investments that support the long-term growth potential of the economy and
the necessary infrastructure, as well as to contribute to a sustainable allocation of resources that takes
into account the environmental and social needs of people living in the EU.
The following considerations are relevant in informing future work:
1.

As regards long-term investment, there is a need to identify the economic drivers of equity
investments by insurance companies and pension funds, including intra-EU investments and the
potential impact of regulatory constraints at the EU and national level and other factors. As part
of this, it would be appropriate to assess whether the accounting treatment of equity instruments
in international accounting standards, in particular IFRS 9, endorsed by the EU in November
2016, is sufficiently conducive to long term financing. Moreover, the implementation of the

55

The Commission put forward next steps to this end in the Communication on "Clean Energy for All" (November 2016).
The Market Stability Reserve implemented as of 2019 will reduce the auction automatically and in a gradual manner. As
part of the ongoing co-decision on the ETS, proposals such as those included in the position adopted recently by the
European Parliament and the […] Council to temporarily double the feeding rate of this reserve would further strengthen the
ETS and the ability of the Market Stability Reserve to reduce the oversupply on the market and make it more robust against
future changes in demand, regardless of whether these reflect economic factors or policy developments.
56

69

Shareholding Rights Directive will seek to facilitate the cross-border exercise of shareholder
rights, including on-line voting.
2.

To support infrastructure investments by insurance undertakings, the reduced risk calibrations
in Solvency 2 for qualifying infrastructure projects have been extended to investments into
infrastructure corporates.

3.

EU single market freedoms provide a comprehensive set of rules for investment protection.
National courts and authorities might, however, not always be fully aware of such rules or may
find them difficult to apply. Greater clarity on substantive EU standards for the treatment of
cross-border EU investments is particularly important for EU investors, national
administrations, stakeholders, as well as for national court judges, and should ensure more
transparency with regards to the effective protection of EU investor rights in the single market.
Moreover, options should be assessed to establish a framework for the amicable resolution of
investment disputes.

4.

Regulation should include the appropriate signals, incentives and obligations that lead actors on
financial markets to internalise the wider risks and returns on their investments, including those
linked to environmental issues as well as other social and ethical considerations. The
forthcoming analysis and recommendations of the Commission's High Level Expert Group
(HLEG) on Sustainable Finance will represent an important input in developing a
comprehensive EU approach to rewiring financial regulation to better integrate sustainable
finance. Moreover, best practices in the Member States that associate financial returns with
positive environmental and social externalities could be investigated.

5.5 Key indicators57
Long-term investment
Indicator
Asset allocation of autonomous pension funds
– equity, percentage of portfolio
Asset allocation of insurance companies –
equity, percentage of portfolio
ELTIFs, number

Last 5-year
average
NA

Latest
observation

Value

2015

30%

2014

6%

NA

2016

7

Last 5-year
average

Latest
observation
2016
2016
2016
2015
Q1 2017
Q1 2017
Q1 2017

NA

Infrastructure investments
Indicator

Infrastructure deals completed, value, Europe
European project bond issuance, value
EUR 8.5 billion58
European project loan issuance, value
EUR 43.6 billion62
PPP transactions, Europe
EUR 15.8 billion62
Number of projects supported by EFSI
NA
EIB financing for EFSI-supported projects
NA
Expected total investment in EFSI-supported
NA
57
58

Value
EUR 232 billion
EUR 15.0 billion
EUR 55.6 billion
EUR 12 billion
477
EUR 33.9 billion
EUR 183.5

EU, unless indicated otherwise.
Last 6-year average

70

projects

billion
Sustainable investments

Green bonds issuance, global, value

EUR 19 billion

2016

EUR 100 billion

71

6

Fostering retail investments

Retail investors are the main providers of funding for the economy, with total holdings of financial
assets close to EUR 34 trillion in 2016 (Eurostat). Understanding how they invest retained savings and
allocate funds to different financial assets is hence crucial for devising policies to foster investments
into capital markets, as well as to enhance investor protection. While significant progress towards
establishing a more competitive internal market for retail financial services has been made, there still
remain a number of problems, which hinder a more efficient flow of financial investments into the
economy. These are related to both market structure and the regulatory framework, especially in crossborder transactions and provision of services. Behavioural biases and free-riding problems (from
information asymmetry) on the side of retail customers reinforce supply side issues.

6.1 Key trends in retail investments
6.1.1

Saving Rates

The financial situation of European households has significantly improved since the financial crisis.
Real adjusted gross disposable income of households per capita has been increasing since 2009, both
in the Eurozone as well as in the EU, leaving consumers with more money to spend on consumption or
to provision for future consumption in the form of savings.
Savings represent a crucial factor in the analysis of the retail investment market as it reflects the
amount of money that households have freely at their disposal for investments. It forms the main
domestic source of funds for capital investment and high saving rates can translate into funds being
available for economic growth. The propensity to save has been relatively stable since 2012 for the
Euro area and slightly declining below pre-crisis level. The saving rate stood at 10.2% of total
disposable income in the third quarter of 2016 for the EU (Figure 6.1). While there has been a
historical close alignment in saving rate trends of the EU and the Euro area, there is an initial
divergence over the period from 2012 to 2016. This indicates a higher inclination to spend income on
consumption and an increase in household borrowing outside of the Euro area, where risk aversion
remains high.
Figure 6.1 Household saving rate (2005-2016)
15%
14%
13%
12%
11%
10%
9%

EU 28

Euro area

Source: Eurostat.

A considerable proportion of retail savings are invested in financial assets, which form an important
part of overall wealth. The contribution of households to overall financial assets is especially strong in
certain peripheral countries such as Greece (66.3%) and the Slovak Republic (62.3%). Beyond
representing potential funding sources for companies, households' financial assets are also an
72

important source of revenue, either through capital gains or interests and dividends. Enhancing the
efficiency of retail financial markets and optimising the returns on retail products thus holds a dual
advantage: increased financing for the economy and higher income for households, both of which
would add to economic growth. Active retail investor participation in financial markets also improves
the information flow and ultimately price discovery.
6.1.2

Household Financial Assets: a balance sheet analysis

Retail investments can only provide direct sources of alternative funding for the real economy when
channelled through capital markets in the form of financial investments. Figure 6.2 provides an
overview of households' financial assets in the EU over time. Households’ financial wealth has grown
consistently since 2012, mainly driven by deposits and investments in insurance and pension products.
Equity holdings have marginally increased on the long-term, but gone down in 2016. The other three
components, including investments in units of funds, are flat and of limited size. Currently, most of the
investment of households in investment funds goes through insurance and pension products, compared
to the US, where there are more direct holdings of equity and investment funds units (e.g. ETFs, etc).
Figure 6.2 Household financial assets in the EU (EUR billion)
35.000

35.000

30.000

30.000

25.000

25.000

20.000

20.000

15.000

15.000

10.000

10.000

5.000

5.000

0

0
2012Q4 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 2014Q4 2015Q1 2015Q2 2015Q3 2015Q4 2016Q1 2016Q2 2016Q3
Insurance, pensions and standardised guarantees
Equity
Debt securities
Loans
Net financial wealth (rhs)

Currency and deposits
Investment fund shares/ units
Other accounts receivable / payable
Financial derivatives and employee stock options

Source: Eurostat. Note: For UK and Ireland, non-profit institutions serving households are included as well.

The composition of households' financial assets however varies considerably across EU Member
States (see Figure 6.3). Some countries, such as Greece, Cyprus and Slovakia, exhibit a considerably
larger proportion of financial assets held in the form of currency and deposits than the EU average
(over 60% of financial assets).A total of 20 out of 28 countries are above average. Other countries, in
particular the United Kingdom and the Netherlands, have much higher proportions invested in
insurance and pension funds. Estonia, Bulgaria and Lithuania exhibit the largest proportional holdings
of equity instruments while Luxembourg, Belgium and Spain show the highest percentage values of
financial assets held in investment funds. These differences occur due to different reasons. Countries
with a higher GDP per capita, for example, tend to show smaller holdings of cash deposits as higher
earnings will allow households to save and invest more long-term. National regulatory and tax regimes
which favour may also introduce additional bias.

73

Figure 6.3 Composition of households' investments in financial assets across Member States (% of total
financial assets)
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
SE DK NL UK HU FR BE EE EU FI IT LT LV RO IE BG DE AT ES MT PT PL LU SI CZ HR SK CY EL
avg.
Currency and deposits
Equity
Debt securities
Loans
Investment fund shares/ units
Insurance, pensions and standardised guarantees
Financial derivatives and employee stock options
Other accounts receivable / payable

As suggested by Figure 6 (as a percentage of gross disposable income), there has been a considerable
outflow of retail investments from debt securities starting in Q4 2012. While the pace is relatively
slow, households were still selling EUR 300 per capita of debt securities in Q3 2016. This may be due
to loosen monetary policies, such as the ECB’s asset purchase programme, which has significantly
reduced yields on debt securities.
Allocations to investment funds and equity have developed more positively over the same period,
growing considerably between 2013 and 2015. Inflows have, however, slowed for three consecutive
quarters with figures for Q2 2016 showing an inﬂow of EUR 370 per capita, compared to an average
of EUR 590 in 2015. Monetary easing is not necessarily a driver, as a low interest rate environment
should facilitate increased equity investments. Equity underweight in retail investors’ portfolio is a
structural issue in Europe. In recent years, moreover, there has been a rather marked shift from equity
to investment in life insurance and more importantly currency and deposits because of uncertainty and
instability.
Figure 6.4 Household investments in financial assets and contributions by component (% of gross disposable
income)
14%
12%
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
2012Q4 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 2014Q4 2015Q1 2015Q2 2015Q3 2015Q4 2016Q1 2016Q2 2016Q3
Insurance, pensions and standardised guarantees
Currency and deposits
Investment fund shares/ units
Financial derivatives and employee stock options
Equity
Other accounts receivable / payable
Loans
Debt securities

Source: ECB Household Sector Report Q2 2016

74

The recent growth in households’ financial assets is currently driven by cash and deposits. In the third
quarter of 2016, household holdings of these assets reached a six-year high with net inflows of EUR
730 per capita. In normal circumstances, these increased deposits may in theory facilitate banks’
ability to lend more and thus provide increased financing to the economy. Banks today, however, face
negative interest rates in holding cash and are trying to reduce overreliance on deposits. Given the
current situation of the lending market, increased deposits are extremely unlikely to provide increased
funding to the economy.59 A lack of demand for loans, combined with a high proportion of bad loans
or low capital levels of banks in some countries, results in a limited increase in bank lending.
Uncertainty about global trade and economic growth add more to the picture. Finally, heightened risks
for bank profitability, led by negative interest rates, and refinancing, as bank bond issuance continues
to drop, is another element of uncertainty. As a result, many companies have resorted to bond
issuance, while investors are increasingly looking outside the EU while slowly decreasing holdings of
government bonds.
Some of the retail financial investments flowing into currency and deposits could be put to alternative
uses through capital markets instruments. While deposits are a stable and prudent way to store value,
the current level of interest rates paid on them is not sufficient in real terms. In effect, households are
forgoing future consumption and hindering economic growth by holding a large proportion of
financial wealth in cash or deposits. Allocating an increasing amount to equity and debt securities
would benefit the European economy by freeing additional sources of financing, against the
background of a European banking sector undergoing restructuring.
6.1.3

Europe's retail market structure

In spite of considerable progress toward European capital market integration and the introduction of
the euro, national borders still constitute a barrier for retail financial markets. The level of direct crossborder transactions in retail financial services remains low compared to fully integrated national
markets, like the US. Consumers still largely purchase retail financial products from suppliers based in
their own domestic market and firms generally only serve markets in which they are physically
established.
A 2015 study of the European Consumers Association showed that there are still substantial price and
nominal interest differentials among Member States (BEUC 2015), suggesting insufficient crossborder competition. This is corroborated by a study carried out by the Dutch central bank (DNB 2015),
which found that the willingness to switch banking product differs but is the strongest for main
savings accounts. Retail clients should therefore normally be expected to change their savings account
to providers across borders if better offers are available. The same study, however, also concluded that
it is especially difficult to stimulate consumers to switch to foreign banks (DNB 2015). For basic
products, like current accounts, this is often linked to factors such as language or physical proximity of
branches.60 Even though information technologies, such as the internet, and innovation in the sector
could erode those barriers (e.g. multi-lingual offerings by banks), national regulatory fragmentation
and consumer trust issues are still hampering the cross-border provision of services.
The European insurance sector displays a very similar picture, since also there cross-border sales
without physical presence in the target market play only a marginal role. A 2014 study (EVZ 2014)
showed that 47% of a select group of insurance companies provided the possibility to conclude a
contract via the internet. However, when trying to conclude insurance contracts from an address in a
country that deviated from the country of origin of the insurance company, only 14 out of 144 tested
companies actually offer such contracts. This means that only 9.7% of the selected group of insurers
offered cross-border insurance contracts via the Internet. A related written survey (EVZ 2014) showed
59

At the end of October 2016, excess reserves and deposit facilities subject to negative interest rates in the Eurozone
amounted to 1047 billion euros, representing an annual gross cost of 4.2 billion euros for commercial banks. This cost may,
however, be offset to some extent by the capital gains realised by selling securities to the ECB.
60
See for example: BCG customer centricity study 2011 showing that proximity still drives about 30% of new customer
acquisition in retail banking (France - 28%, Germany – 39%, United Kingdom – 26%)

75

similar results. Only 3 out of 32 companies (9.4%) that replied to the survey offered cross-border
insurance contracts that could be concluded by consumers with a primary residence abroad.
Insufficient cross-border competition is also evident when one compares the price of products. Premia
for a comparable non-investment 25-year term life insurance product, for example, can range from
EUR 10 per month in Slovakia and EUR 12.40 per month in Spain to GBP 65 per month in the United
Kingdom (FSUG 2015). A similar situation exists in the motor insurance market where quotes vary
significantly across countries, even for the same car model (Insurance Europe 2015). Likewise annual
fees charged for a credit card can vary from EUR 9.10 in Romania to almost EUR 114 in Slovakia and
offline credit transfers, while free in some Member States, can cost an average of EUR 3.58 in
France (FSUG 2015).
A market that is characterised by a particularly high degree of fragmentation across national borders
and low cross-border sales is that for personal pension products. There is already a low level of
investment and participation by households in pension products at national level 61, which endangers
Europe’s future prosperity in view of demographic change. Strongly fragmented national markets add
to this issue as it prevents efficiency gains via economies of scale, risk diversification and innovation
on the side of providers while the lower levels of competition implies higher costs for consumers.
Given that personal pension products operate on a long-term basis, trust and understanding are
particularly important in this market. Nonetheless, personal pension products exhibit some of the
lowest consumer trust rankings across retail financial products in the EU. In many Member States
third pillar savings products remain strongly underdeveloped while they are not offered at all in
Greece and Cyprus. Given the long-term liabilities of pension providers, they are ideally suited to
invest in higher yielding illiquid long-term assets and even infrastructure or real-estate projects.
Creating a more integrated European market would thus reduce deadweight loss while at the same
time increasing the funding available to the economy
The European market for investment funds is likely to be the most integrated market tapped by retail
investors. The passport regimes established under UCITS and AIFMD have facilitated significant
improvements to cross-border activity and competition. Together, UCITS funds and AIFs have EUR
13.38 trillion Assets under Management (AuM), with 57% of the funds having the right to passport.
This initially indicates a significant level of integration of markets. However, much of the market
actually remains along national lines. While 57% of funds have the right to passport, the funds
marketed cross-border represent only 40% of total AuM. It should also be noted that many of these
funds are only sold in one additional Member State to their home country ('round-trip funds'). They are
generally sold back to the Member State where the asset management company is domiciled
(indicating that these funds are domiciled in a different Member State to take advantage of beneficial
tax treatment or other factors). For UCITS funds it is estimated that this applies to one third of funds
captured as being marketed cross-border, while another third is not sold in more than four other
Member States. Data collected at the end of 2015 indicates that only 30% of funds are sold by
distributors outside their home market (EFAMA 2016). This marks a significant increase from 18%
recorded at end of 2005 but still lags behind figures that would be expected in a fully integrated
market. The total number of European funds is a further indication of a lack of cross border
competition and integration. While the United States only counts around 7 000 mutual funds there are
more than 30 000 UCITS funds available for sale in Europe. Likewise, the United States' mutual funds
are close to seven times as big on average as European funds, thus reaping larger benefits of
economies of scale and facilitating lower costs. Larger sized funds would also be expected to compete
more readily across borders as they are able to stem costs of expanding distribution channels and
overcoming regulatory barriers more easily.
To sum up, regulatory barriers affect distribution and market entry and include fragmented registration
procedures, costly and diverse marketing requirements, inconsistent administrative arrangements and
tax obstacles. This affects how both large and specialised niche funds compete and manage the quality
of product supply. The elimination of regulatory barriers would be also an important aspect for the
insurance and banking markets. Here, equally, administrative burdens arising due to non61

Current market size estimated at around EUR 0.7 trillion based on Commission figures

76

harmonisation, differences in supervisory treatment and lack of standardisation create costs that
prevent more efficient cross-border competition. While behavioural biases may still lead to a certain
favouritism of domestic products, this effect tends to dissipate as the number and visibility of crossborder offers increases. Other barriers such as language or culture can be overcome with relative ease
today, given technological innovation and increased labour mobility across borders.

6.2 Characteristics of retail investment services markets
There are several market structure issues in retail financial markets, both on the supply and on the
demand side of capital. While regulatory actions have already been undertaken to address these issues
they still form important drivers of markets and costs. The market for retail financial services in
Europe, like other segments of the financial services industry, has suffered considerably during the
financial crisis and continues to be impacted by its aftershocks still today. At the same time, revenues
in this sector have been more stable than many other segments and it has thus increased in importance
for the global financial services industry. In addition to the market distortions experienced during the
crisis, the sector has been undergoing rapid change in recent years. Technological innovation, often
driven by “maverick” market entrants, has forced market players to adapt to a new competitive
situation. The sector has also faced a range of regulatory actions, both at the European and national
level, which have required providers to adjust their behaviour and to disclose an increasing amount of
information. This has in turn led to increased overall compliance costs. Both of these developments
have resulted in a decrease in overall margins and triggered national consolidation in many markets as
well as cross-border M&As.
Figure 6.5 Retail investment market failures

1. Structural
information
asymmetry

2.
Transaction
costs

3.
Behavioural
biases

Source: Commission services

While this indicates that there is an increasing competitive pressure in this market segment, many
indicators and studies still point to a lack of competition overall, especially in a cross-border context.
Whereas the sector appears to be highly competitive at first sight, given a vast choice of products, a
multitude of providers and relatively low barriers to entry, there are significant discrepancies in terms
of costs both within national markets and even more so across the EU. The reasons for this lie in the
structure of the market and regulatory fragmentation across national markets as well as the behaviour
of consumers. Together, they create an environment that hampers efficient competition.

77

6.2.1

Structural information asymmetry

The market for retail financial services displays several differences with other segments of the
financial services industry. Most notably, customers purchasing retail financial services often possess
little or no knowledge of the market itself. This leaves the demand side at a considerable disadvantage.
The inability to measure quality for a lack of knowledge (on top of the asymmetry generated by the
nature of the service provided) means that consumers can have structural difficulties to price products.
While sophisticated customers may be more able to determine which products are of high quality and
offered at a reasonable price, as they professional knowledge, a large majority of retail clients will be
unable to do so.
Other markets exhibit similar information asymmetries, as the ones in retail financial services.
Common examples include the provision of healthcare or legal services or the market for second hand
cars62. The commonalities shared by each of these markets is that the supply side holds a significant
informational advantage, either in terms of technical knowledge necessary to provide the service or
good and/or knowledge of the market itself. At the same time, the incentives of the supply side are
naturally not aligned with those on the demand side. A second-hand car retailer, for example, will not
necessarily aim to sell the best-priced car to a customer but rather to sell a car at the highest price
irrespective of its quality. This behaviour is particularly prevalent in markets where switching costs
are high and where the quality of products is difficult to evaluate.63
Markets characterised by asymmetric information generally face efficiency problems, as the usual
laws of competition only apply to a lesser extent. In more transparent markets, the demand side may
have higher chances to purchase the product or service that offers the highest quality at the lowest
price.64 This forces less competitive market participants to either improve their price and/or quality or
leave the market altogether. In opaque markets, however, these actors can often remain in the market
by successfully masking the actual cost of the service. The information asymmetry gives rise to
problems that go beyond price-based competition alone. As retail consumers cannot readily discern the
quality of financial products, it makes them vulnerable to conflicts of interest and misconduct on the
part of the provider and creates risks of adverse selection. Increased complexity of products further
aggravates this issue. Providers can deliberately exacerbate the information asymmetry by obscuring
key product characteristics through marketing strategies or product differentiation.
Although the supply side can aggravate information asymmetries, they are not the initial source of this
asymmetry. Providers and distributors today are increasingly transparent, given new regulatory
disclosure and reporting requirements imposed in the aftermath of the financial crisis. Examples
include the UCITS KIID or the upcoming changes under MiFID II and the Prospectus Regulation.
While these requirements should be further enhanced and harmonised, both across products and
national European markets, the consumer also carries significant responsibility to alleviate information
asymmetries. There is a general tendency of retail customers to under invest in information. A
common misconception is that other consumers will have already investigated the safety and integrity
of suppliers of financial services, so there is little need to do it themselves. Consumers feel that they
can 'free-ride' on previous customers' research, which clearly leads to “under-information” problems,
if this is the approach taken by a majority of them (Benink, Llewellyn 1995). Conversely, there are
high search costs involved in comparing the multitude of products and providers in the market which
render a complete market comparison uneconomical65. While increased market research may improve
62

See for example Akerlof 1970.
Many financial products and services (if not all of them) are typically called 'credence goods', because their quality cannot
be fully assessed even after using them. This is the case of products that have a strong idiosyncratic nature. For instance, the
quality of financial advice is difficult to evaluate, as there is no benchmark to compare with (only with proxies). Advice is
individual and relies on current and expected circumstances, which can in the future evolve in an infinite set of scenarios. As
future scenarios are infinite, then, it is difficult to build a benchmark, but only provide general indications.
64
There will be other factors affecting the decision of consumers (e.g. taste and preference, customer loyalty) but price and
quality usually remain the most important factors, especially in the long-run
65
As demonstrated in the following sub-section, even a full analysis of all offers may not improve the quality of services
received given market opacity and conflicts of interest on the side of suppliers.
63

78

the quality of products or services and/or reduce the fees paid, this benefit can be offset by the search
costs. In some cases the increased search efforts could potentially even lead to an overall decrease in
value.
The likely outcome of information asymmetries coupled with high search costs is a pooling
equilibrium in which the commissions that suppliers receive reflect the reputation of the industry for
quality and long-term value for money (Spencer 2000). This point links to the conflicts of interests and
principal-agent problems assessed in the following section.
Conflicts of interest and principal-agent problems
Misaligned incentives and information asymmetry give rise to principal-agent problems in retail
financial services markets. Agency problems occur in situations where one person (in this case the
provider or distributor referred to as the 'agent') is able to make decisions on behalf or that have an
impact on another person (the consumer, referred to as the 'principal'). This gives rise to issues of
moral hazard, i.e. the agent is incentivised to act in their own best interests, which stand contrary to
those of their principal and the principal cannot monitor effectively (as monitoring costs are too high).
Retail financial services are particularly prone to this issue given the structure of the market, including
the distribution channels through which products are offered to retail customers. Currently, it is still
common practice that distributors of retail financial products (e.g. banks) receive inducements from
product providers, while still promoting themselves as 'independent'. The commissions paid by the
providers can give rise to a degree of bias in the advice provided and products recommended by the
distributor. Similarly, in-house products may be favoured over third-party products, especially if the
third party does not pay any inducements. As the retail investor generally lacks the information
necessary to make an informed decision they may be unable to spot ill-advice.
The problems arising from the principal-agent relationship between customers and providers or
intermediaries is already being addressed by a range of new regulatory measures that aim to align the
incentives of customers with the supply side. A problem is that regulation of various segments of the
retail financial services market still varies, meaning that customers cannot rely on the same level of
customer protection. For example, while MiFID II prohibits portfolio managers and independent
advisers from accepting payments or benefits from a third party in relation to the services provided,
unless they can prove that acceptance of these inducements improves the quality of the service
provided, insurance distributors will only need to demonstrate that such inducements do not lower the
quality of their services. Retail customers will generally not be aware or be unable to prove these
differences, which may considerably impact the quality of the services that they pay for. Increased
harmonisation of consumer protection measures across all retail financial services may alleviate this
issue. National regimes still exhibit considerable differences as well, thus lowering the trust of
customers when dealing with providers offering services on a cross-border basis.
6.2.2

Transaction costs in cross-border provision of retail financial services

The market structure of retail financial services is not the only factor that impedes a higher efficiency
and lower costs for end consumers. While certain national markets may already exhibit reasonable
levels of competition, there is a clear lack of cross-border competition throughout the EU. Since
increasing amounts of retail services and products are offered and marketed online, the physical
location of providers and distributors should play an ever deceasing role. Nevertheless, the European
retail financial services market remains clearly fragmented by national borders. This fragmentation
arises from a variety of different factors ranging from concentration of national distribution channels
and cultural preferences to regulatory costs arising from less harmonised supervisory approaches and
taxation constraints. While there are some indications that providers are gradually engaging in crossborder operations, operations are generally limited to the largest market participants, who are able to
invest considerable amounts in setting up new distribution channels in other Member States and
shoulder the legal and economic costs of market entry.

79

There is also a lack of demand for the provision of services on a cross-border basis. Reasons for this
include barriers that are difficult to overcome by regulatory change, such as language. There are,
however, also trust issues that stem from the consumers' belief that they are less protected when
engaging with foreign providers. While this is at times purely due to cognitive and behavioural biases
there are also aspects where there are in fact differences in consumer protection rules and related legal
fields such as contract law.
Distribution Channels and Market Structure
Analyses of retail distribution channels traditionally distinguish between direct and indirect channels.
Direct distribution channels are channels where the provider engages with its customers without
intermediaries. The provider owns the channel, acquires the customers and initiates a direct sales
relationship with them. Indirect distribution channels, on the other hand, involve intermediaries or
agents (sometimes referred to as distributors) who establish the sales relationship with the customer.
Third party distributors are categorised into independent and tied intermediaries the former being able
to sell products from a number of providers while tied the latter are restricted to selling products from
one particular company.
Each of these channels holds certain advantages and disadvantages and different segments of the retail
financial services market display greater use of one as compared to the other. Retail banking, for
instance still shows a big reliance on direct distribution while the insurance and investment sectors
extensively use third parties such as insurance brokers and financial advisers in their distribution
strategy (Gough 2005). While indirect channels allow providers to extend their market coverage
without increasing fixed costs, it will often require investments in control mechanisms and training.
Conversely, direct channels hold the advantage that they allow for a greater and better control of client
interactions but these benefits are offset by potentially large set-up, channel management costs and
more limited coverage. Direct and indirect distribution channels are obviously not exclusive and many
market participants today employ multi-channel strategies where a product is made available through
two or more channels of distribution (Webb, Hogan 2002). While potentially increasing costs, a multichannel approach can be very effective as different channels may be more appealing to specific
customers groups or hold other advantages such as decreased costs or geographical scope.
Furthermore, the retail financial services market has seen a significant blurring of lines between
different institutional types (Chakrabarty, Ennew 2007). Retail banks, for example, now frequently
offer insurance products (bancassurance) and insurance companies may offer bank accounts.
Intermediaries today can also include other non-financial institutions such supermarkets and postoffices which launch their own credit cards or act as insurance distributors.
In addition, new technologies are increasingly changing the structure of retail financial services
markets and the way that users are accessing financial services. Innovative market entrants, such as
FinTech companies, are gradually contesting incumbents' market shares and traditional distribution
channels by offering more specifically tailored products and services, thus providing direct channel
access and a richer customer experience. New data storage abilities such as cloud computing and
distributed ledger technologies in conjunction with artificial intelligence, machine learning and big
data analytics are enabling these providers to increasingly automate highly time-consuming functions,
thus lowering costs, while still providing highly bespoke services. Through the use of internet and
mobile communications technologies they are able to directly engage with consumer where previously
they would have been dependent on accessing them via traditional retail service providers.
How these new technologies will ultimately impact the market will depend on various factors such as
customer preferences, reactive innovation and M&A activities on the side of incumbents as well as
potential regulatory measures aiming to address new risks arising from these technologies. While there
is certainly a trend towards an increasing use of online distribution channels, especially for transaction
activities, branches and other forms of face-to-face and voice-to-voice channels are likely to maintain
a crucial role for sales-and-advice interactions (Boston Consulting Group 2013). Customer surveys
have also shown that factors such as branch proximity still play a key role in customers' decision of
bank providers (Boston Consulting Group 2011).
80

Ultimately, new innovations are expected to increase interactions across multiple channels and
facilitate increased specialisation of providers and intermediaries, as they maximise each channels'
value depending on product and customer group. Direct and indirect channels may also cooperate
more closely, although this will depend on the respective market participants. The increased
competitive pressures will work to the benefit of the consumer but there are also risks of information
and choice overload, especially for less informed retail customers.
National fragmentation of rules and gold-plating
While the large majority of consumer protection requirements are set at the European level, there is
still a significant degree of fragmentation arising from Member States' practice to 'gold-plate' existing
rules. Often implemented under the pretext of needing enhanced consumer protection this practice
significantly undermines the internal market and cross-border competition. Providers of retail financial
services and products will need to invest significant amounts in legal advice and analysis when
entering a new Member State, if they cannot rely on the same rules that apply in their home Member
State. Respondents to the consultation on the cross-border provision of funds, for example, highlighted
a lack of transparency of national standards and deviating definitions and provisions in key areas. This
includes notification, marketing and distribution, which often vary across Member States, all well as
differing requirements for administrative arrangements such as paying agents. Similar comments were
received under the Call for Evidence whereby the definition of an activity as marketing was noted
particularly frequently in this context as being inconsistent.
Stakeholders also stressed potential dangers of gold plating and additional national requirements in
offering documentation, the pre-approval of marketing material or the repurchase or redemption of
investment fund units. Discretion on non-implementation of provisions related to National Private
Placement Regimes is an additional example. The fragmentation of provisions and deviating
supervisory practices will work to the detriment of legal certainty. These increased business risks may
significantly obstruct cross-border business activities.
Fragmentation of distribution channels
While direct channel distribution is likely to increase in importance given online sales opportunities,
mobile technologies and other forms of innovation, traditional distribution channels via banks and
other intermediaries remain important, especially for sales-and-advice interactions. Distribution
networks, while technically open to cross border access, often remain concentrated along national
borders.
In the context of the distribution of investment funds, requirements to have a local agent in certain host
Member States were pinpointed as creating unnecessary barriers to entry. These mandatory agents will
increase the time efforts of achieving market entry while posing an additional cost factor, which affect
smaller funds in particular. Their respective roles and costs furthermore vary considerably across
Member States thereby leading to additional transparency and fragmentation issues.
Other factors limiting cross-border competition
Non-harmonised legal frameworks in other areas, such as tax law, securities law, contract law and
insolvency law, add to the costs and legal uncertainty of passporting providers. The tax treatment of
products forms a significant driver of demand for retail investment products. Considerably different
taxation regimes therefore not only lead to a concentration of providers in certain Member States but
also to strong divergences in demand for products. Products may thus need to be adapted to the
respective taxation regime in order to be competitive, creating administrative burdens for providers.
Similarly, access to data and information on consumers and national trends, alongside standards for
property valuation and procedures for collecting debts can vary greatly thus undermining cross-border
lending and provision of insurance products.

81

6.2.3

Behavioural Aspects: biases in retail investment decision-making

Risk and return are the two most important attributes of any investment. Any risk-averse investor will,
as a general rule,66 try to maximise his returns while minimising the exposure to risk. The risk is the
uncertainty of an expected return actually being realised. It follows from this that there is a trade-off
between risk and returns.67 Modern portfolio theory can help to develop insights into investing. It is a
normative theory, describing how people could make optimal investment decisions. In practice, retail
investors often (if not always) deviate from the optimal choice. To broaden our insights regarding
actual investment behaviour, we need to account for behavioural biases, non-rational behaviour and
other influences. Retail investment decisions are often biased, leading to suboptimal investment
behaviour such as under diversification, excessive trading, herding, and the tendency to sell winners
and hold on to losing stocks (so-called disposition effect). This suboptimal behaviour has been
associated with behavioural biases. The following section shortly discusses the main biases related to
belief and preference formation, and also looks at the effect of cognitive limitations with respect to
information processing.
Limited information processing capabilities
In making investment decisions, retail investors are confronted with complex information and a wide
range of investment alternatives. Investors are not able to evaluate all relevant information because of
cognitive limitations to process information (information overload). As a result Benartzi and Thaler
(1999) argue that they are inclined to rely on heuristics that are cognitive shortcuts or rules of thumb
that simplify the original decision but can also lead to cognitive biases (systematic errors). Besides
limited capacities to process financial information, decisions are also influenced by framing effects.
Framing refers to the fact that the manner in which choices are presented changes their relative
attractiveness. Hence, the framing itself influences the decision. Overall, the evidence on heuristics
and framing underlines the importance of providing high quality and easily understandable financial
information to investors.
1) Biases in beliefs
Biases in beliefs are largely related to the fact that investors rely heavily on readily available or
familiar information. In essence, investors are not optimally weighing all pieces of information -as
assumed in standard portfolio theory- because they rely too heavily on historical information relative
to new information (conservatism bias), a single piece of information (anchoring bias), readily
available information (availability bias), familiar information (familiarity bias), or because they
believe that stereotypes and recent information are representative for the whole sample
(representativeness bias and extrapolation bias). These biases explain why investors react suboptimally to financial news, leading to patterns of over- and under-reaction. In addition, they also
provide an explanation for the fact that investors react stronger to more salient information and, for
instance, rely too much on past performance as an investment selection criterion.
In addition, investment beliefs are also to a large extent influenced by overconfidence, indicating that
investors overestimate their own knowledge or ability. Overconfidence explains why retail investors
are under-diversified, trade excessively (compared to the benefits generated by their trades) or have
biased risk perceptions.

66

There may be situations where the investor is pursing goals other than maximising returns. Examples include investments
in social or ecological projects, which may carry higher risks and/or lower expected returns than other available investments.
67
Some researchers doubt the existence of this trade-off, pointing out that the statistical evidence in support of the hypothesis
is weak. Most studies supporting this motion stem from tests applying the Fama-McBeth methodology, or variations thereof.
There is little evidence, however, for the statistical power of this methodology, especially in the analysis of short time periods
– See Bradfield 1993

82

Box 8.

Passive long-term investments and ETFs

The Efficient Market Hypothesis (EMH) developed by Eugene Fama (Fama 1970) states that modern
financial markets are 'efficient', i.e. markets will quickly react to new information and the price of an
asset reflects all available information. While the EMH faces a number of deficiencies, especially as
concerns some of its underlying assumptions68, it nonetheless holds a range of valuable insights. This
is particularly true for retail investors as they do not generally follow markets in real-time, nor have
access to inside information which markets have yet to process.
One of the major consequences of the EMH is that an investor can never exploit the market to make
abnormal profits by using information that the market already knows. While abnormal profits are
certainly possible, this is down to plain luck and these profits can never be maintained in a systematic
fashion in the long-run. What follows from this is that assets cannot be categorised as
"over/undervalued" in the absence of private information. A further implication is that the total
market is always perfectly diversified and that any portfolio which deviates from the total-market
cannot achieve a higher degree of diversification. In effect, no other portfolio can have both a higher
expected return and lower risk than the total-market portfolio. This investment approach of retail
investors may be partially misguided in cases where they attempt to outperform markets via actively
managed funds. Although a limited number of professional investors manage to outperform their
respective benchmarks, this is a rare occurrence when assessing investment periods of longer than 5
years. Moreover, any positive alpha that fund managers may generate is usually eroded by fees
imposed on the investors. The S&P Spiva Scoreboard (S&P Dow Jones Indices 2016), as an example
of numerous analyses in this area, shows that less than 50% of EU equity funds outperformed their
respective benchmark over a 5-year time horizon when taking fees into account. This figure drops to
less than 30% over a 10 year period and reaches as low as 1.1% for certain other markets.
Even more worrying in terms of retail investor protection is that a significant proportion of funds that
are marketed as active are actually passively managed to a large extent. These so-called closet
indexers nonetheless charge fees comparable to true actively managed funds without explicitly
disclosing their passive investment strategy to investors. The Danish FSA, for example, found that 3
in 10 actively managed funds are charging active fees even though they are effectively behaving as
passively managed funds (Finanstilsynet 2014). This compares to research carried out by
Morningstar, which revealed that the average active share for European large-cap funds was only
69.6% and that 20.2% of European funds had a three-year average active share of below 60%
(classified as closet indexing) (Morningstar 2016). ESMA, taking a slightly more cautious approach,
still found that 15% of funds had an active share below 60% (European Securities Markets Authority
2016). In view of these figures, it appears that total-market investing via passively managed funds,
such as ETFs69, can be a better option for retail investors than actively managed funds in many
circumstances. While professional investors may have reasons to divert from total market investing
and are in a position to evaluate the strategies of respective active funds, this does not normally apply
to retail investors. Not only are ETFs cheaper in terms of management fees, given the absence of
entry and exit fees, but they also allow for greater diversification across markets and geographical
regions when investing small sums. There is even the possibility to match investors' risk preference
and adjust the stock/bond ratio via ETFs70.
Moreover, passive investments, whether through ETFs or otherwise, have shown to outperform
active strategies in the long-run. The key behavioural aspect that undermines the realisation of these
superior returns is usually that retail investors nervously sell investments in market downturns and
believe that they can time market entry and exit. Experience has shown that even professional
investors are unable to carry this out effectively, at least over a longer period of time. Passive wait
68

Examples include (i) complete information (ii) perfect ability to process information (iii) aligned incentives
Note that certain new ETFs are not truly passive anymore and do not necessarily reflect a respective benchmark (e.g. 'smart
beta' ETFs)
70
It should be noted that there are potential regulatory concerns regarding ETFs with illiquid underlying assets, such as bond
ETFs, given issues such as a liquidity mismatch which go beyond the scope of this document
69

83

and hold strategies are thus the logical answer to maximise returns.
Table 6.1 Percentage of European Equity Funds Outperformed by Benchmarks

Source: S&P Dow Jones Indices (see S&P Dow Jones Indices 2016).

2) Behavioural preferences
A central feature is the attitude of investors towards losses and regret.71 The prospect theory stipulates
that investors are loss averse. Investors appear to weight losses twice as much as gains of similar
magnitude. Loss aversion and prospect theory could explain the disposition effect. Investors hold on to
'paper' losses, hoping that the stock will recover so they can avoid the realization of the loss, while
they are quick to lock in gains by selling winners. Besides loss aversion, investors also deviate from
standard portfolio theory because they are subject to mental accounting. This is used to describe the
fact that people treat money differently depending on the money's origin and intended use.
Consequently, investors hold different risk perception for different 'accounts' (low risk for retirement
investments, medium to high risk for general investments), without proper risk aggregation at the
portfolio level.
Financial decisions will also be influenced by other factors such as personal traits and emotions. Selfcontrol, for instance, is an important personal trait that influences one's ability to control his/her
impulses and delay gratification. Impulse control will lead investors to be less prone to trade
excessively or follow the herd, while delaying gratification stimulates long term investments in the
stock market. Hence, in reality individual and aggregate investment behaviour will also be influenced often through unconscious patterns - by emotions (Taffler 2014).

Box 9.
FinTech and behavioural biases
The financial services sector has been continuously transformed and improved by an increasing use of
technology over time. Big legacy banks and brokers however focused predominantly on enhancing
wholesale services, given strong competitive pressure, while paying little attention to retail markets.
Innovation in retail markets traditionally aimed at increasing the rents extracted rather than improving
the quality of services provided to clients. This has been changing considerably over the past few
years given the advent of new 'FinTech' companies, which take advantage of new technological
advancements and greater market accessibility.
FinTech can work as an important driver to expand access to financial services for consumers and
investors, bringing greater choice and more user-friendly services, including at lower prices. Current
limitations in traditional financial service markets (e.g. opacity, lack of use of big data, insufficient
competition), such as financial advice, consumer credit or insurance, may foreclose access to some
categories of individuals. New financial technologies can thus help individuals to access alternative
funding sources and other specialised services that support their saving and consumption behaviours.
FinTech has the potential of bringing benefits, including cost reductions as well as faster and seamless

71

Investors exhibit regret avoidance if they fear that their decision will be wrong in hindsight and try to avoid such negative
consequences.

84

provision of different financial services.
Several recent consultations and actions launched in the context of the CMU or the Green Paper on
retail financial services have covered questions how to best accompany the digital transformation of
finance. In parallel, the Call for Evidence has highlighted elements of EU regulation that may not yet
be conducive to technological development. This has led to a new consultation and workstream
specifically focused on FinTech which aims to address potential barriers for new technologies while
addressing risks that may potentially arise in their adoption.
Lack of financial literacy
Financial literacy has a positive effect on many aspects of an individual's economic life, including the
way he/she participates in financial markets, deals with financial information and relates to financial
intermediaries. For instance, financial literacy results in higher levels of wealth accumulation (Van
Rooij, Lusardi, & Alessie, 2012), greater preparedness for retirement (Lusardi & Mitchell, 2009, 2011;
Van Rooij et al., 2012), better debt management (i.e. lower levels of debt and better loan conditions)
(Campbell, 2006; Huston, 2012; Lusardi & Scheresberg, 2013; Lusardi & Tufano, 2009; Stango &
Zinman, 2009), and more appropriate risk diversification in case of investment (Abreu & Mendes,
2010). More financially literate consumers are also beneficial for the society at large, but drivers of
financial literacy are still largely unexplored.72
Competition and innovation in markets stimulates and is stimulated by the presence of financially
literate consumers that can take well-informed decisions. In addition, the more rational and predictable
financial behavior of financially literate people may lead to a more efficient financial sector and less
costly financial regulation (OECD 2012). Faced with a financial crisis, financially literate people are
also better equipped to deal with income shocks thereby contributing to financial stability (Klapper,
Lusardi & Panos 2013; OECD 2012).
In spite of these benefits, there is overwhelming evidence that financial illiteracy is widespread
(Bernheim 1998; Lusardi & Mitchell 2011; OECD 2013). A recent global survey taken in 144
countries indicates that only 33 percent of the population above the age of 15 can be considered to be
financially literate. In Europe, 48 percent of adults are financially illiterate.73 This lack of financial
literacy directly impacts investor participation in the stock market (Van Rooij, Lusardi & Alessie
2011; Abreu & Mendes 2010) via reducing risk aversion to capital market investments, increasing
savings rate and portfolio selection. Financially literate people are disproportionately more likely to
participate in the stock market and to be better prepared for retirement. For instance, they hold more
diversified investment portfolios (Gaudecker 2015). In addition, financial literacy may help investors
to process financial information. The latter is often complex and investors are often confronted with a
significant amount of investment alternatives. As a result, their choice might be subject to framing and
to problems related to information overload. Financial literacy reduces these effects. Figure 6.6 shows
the relationship between financial literacy and stock/debt market capitalisation across EU Member
States.

72

For Europe, a recent OECD report on Financial Education in Europe identifies the following key elements that provide a
rationale for financial education in Europe (OECD): population ageing and accompanying pension reforms; high leverage of
households; growing complexity of financial marketplace; financial exclusion in a number of European countries and
generally low level of financial literacy.
73
The survey measures the following four concepts of financial decision-making: basic numeracy, interest compounding,
inflation, and risk diversification. A person is defined as financially literate when he or she correctly answers at least three
out of the four financial concepts.

85

Figure 6.6 Financial literacy vs. stock and debt market capitalisation across Member States (excl. LU & IE)

Source – 2016 ECMI Statistical Package, S&P Global Financial Literacy Survey

The graphs broadly confirm the positive relationship between market capitalisation and financial
literacy. A more sophisticated (and perhaps competitive) financial system tends to have a higher share
of financially literate investors. Great care should be taken though when analysing the impact of
financial literacy to avoid any direction in the causal relationship. Causality probably goes in both
directions, as more developed and competitive capital markets foster transparency and so interest in
improving financial literacy. In addition, market capitalisation does not take into account the
participations rates of domestic versus foreign investors. It is thus uncertain to what extent the
financial literacy in a country is responsible for a higher market capitalisation, as a certain share of
investment inflows will be due to cross-border investments. For this reason, Luxembourg and Ireland
are not included in the analysis, as their market capitalisation is strongly driven by cross-border
investments and listings. Furthermore, measurement of financial literacy are very sensitive to the
wording of survey questions (Van Rooij, Lusardi, Alessie 2007) and will be also impacted by the
population of the survey.
In sum, financial literacy may positively affect the long term participation rate of investors in financial
markets, while, for individual investors, financial literacy will contribute to more sound investment
decisions and adequate processing of financial information.
Trust and financial advice
As mentioned above, retail investors are faced with complex investment decisions and they often lack
the financial knowledge or do not possess all relevant information to make sensible decisions.
Investors could try to improve their financial decision-making by increasing their financial literacy or
by seeking financial advice. Regulation and the provision of default options could simplify the
decision framework as well. Most empirical studies support the notion that financial literacy and
financial advice complement each other. In any case, the participation of retail investors in financial
markets will also depends on their trust in the financial system and on their personalised trust in
financial advisers74. Regarding aggregate trust, empirical evidence suggests that trust in the financial
system has a positive effect on stock market participation (Guiso, Sapienza & Zingales 2008; Pasini &
Georgiakis 2009). Global trust in banks and the financial system, however, declined significantly in
the aftermath of the financial crisis, although it has been slowly recovering in the recent past (Edelman
Trust Barometer 2016).

74

Note that most empirical studies support the notion that financial literacy and financial advice are complementary.

86

In contrast with the low levels of global trust, most investors trust their financial adviser, although the
extent to which financial advice improves retail investment decisions has been vigorously questioned
(Calcagno, Monticone 2015; Hoechle et al. 2014; Bhattacharya et al. 2012). On the one hand,
investment advice and the delegation of portfolio decisions is economically sensible given that it may
lead to economies of scale in information acquisition and portfolio management. Given the low levels
of financial literacy, financial advisers are also likely to be more knowledgeable about investments.
On the other hand, investment advice is costly and financial advice is sometimes perceived as being
too expensive (Burke & Hung 2015). Retail investors are also confronted with information
asymmetries: the quality of the advice cannot be ascertained in advance and the relation between
adviser and advisee may be troubled by possible conflicts of interest. Advice might, for instance, be
biased where financial advisers also act as sellers of financial products or where remuneration policies
provide an incentive for selling high commission products, independently of the quality of the
investment product.
Overall, the market of financial advice seems to be imperfect. Most empirical evidence confirms that
financial advice might be skewed, does not attenuate investors' biases and hurts retail investors'
investment performance. In addition, there are also demand side factors that contribute to the
inefficiency of the market for retail advice. Investors with low levels of financial literacy are less
likely to consult a financial adviser (Calcagno and Monticone 2015). Hence, those who could profit
the most from financial advice rarely rely on it. This phenomenon is reinforced by the fact that
advisers give more information to knowledgeable investors, providing an incentive for financially
literate investors to consult them. Furthermore, investors are reluctant to take free and unbiased advice,
which seems to indicate that measures taken to increase the good functioning of the market for
financial advice should not only look at market failures on the supply side but should also analyse
demand side factors.

Box 10.

Options to foster a more 'equity-oriented' investment culture
Investment Savings Account

An Investment Savings Account is a new form of account offered to retail investors in an increasing
number of Member States which aims to facilitate trading in financial instruments. Unlike an ordinary
securities account, you pay no capital gains tax on your transactions. Capital gains tax has been
replaced by an annual standardised tax and, as with an endowment, you do not report your purchases
or sales in your tax return.
Unlike an endowment, you own the assets in an Investment Savings Account, which means that you
have the right to attend and vote at shareholder meetings. Furthermore, you can offset capital losses in
your tax return against standardised income in the account.
Assets that are stored and/or deposited in an investment savings account are subject to the provisions
of the corresponding deposit guarantee scheme. The guarantee takes effect if an institution goes
bankrupt or when the Financial Supervisory Authority so decides. The deposit guarantee reimburses
capital and accrued interest up to a maximum amount equivalent to EUR 100 000 per person and per
institution.
There are normally limitations as to the securities that can be purchased via an Investment Savings
Account. These accounts usually limit investment to financial instruments that are admitted to trading
on a regulated market (or an equivalent market outside the EEA), instruments traded on a trading
platform and units in investment funds.
Nonetheless, these accounts appear to be an attractive new option for retail investors seeking to gain
greater exposure to capital markets. An annual standardised tax and deposit guarantees facilitate both
increased investor convenience as well as consumer trust. These accounts may thus prove to be an
effective means to encourage households to shift financial assets away from deposits towards capital
market investments which should ultimately generate higher returns for them while providing
increased funding to the economy.
87

Employee share Ownership
Research shows that companies partly or entirely owned by their employees are more profitable, create
more jobs and pay more taxes than their competitors without employee ownership. At the
macroeconomic level, employee financial participation (EFP) leads to higher productivity and,
therefore, higher competitiveness and growth as well as strategic stabilisation of ownership. At the
company level, it can contribute to solving problems such as absenteeism, labour turnover and the
retention of key employees, as well as business succession and funding, especially in SMEs and
micro-enterprises.
Currently, about 65% of firms in the EU do not provide any form of financial participation to their
employees. At the same time, the latest analysis of the ECS estimates that around 300 000 firms across
the entire EU8 could be potential candidates for the introduction of EFP. Employee share ownership
schemes are much less frequently used in Europe than, in the U.S for example. The underdeveloped
use of such schemes is partly due to cultural differences and company mentality but also arises from
other factors. In particular, there are barriers for cross-border plans, which arise from (i) differences in
regulatory density, application and legislative requirements of national legal frameworks and (ii)
differences in the fiscal treatment of existing schemes.

6.3 General policy implications
Households' participation in capital markets has been increasing in recent years, but participation is far
from optimal. While the EU has one of the highest savings rates in the world, which generally
facilitates availability of funding for the economy, these savings are excessively held in cash or
deposits. Retail capital markets services are also barely developed on a cross-border basis, reducing
opportunities and incentives to hold assets cross-border (with beneficial effects for private risk
sharing, discussed in Chapter 1).
The following considerations may be relevant in order to facilitate retail investors' engagement in
capital markets:
1) Addressing transparency issues via actions, such as improved reporting of market-wide cost
and performance indicators for the principal categories and subcategories of packaged longterm retail and pension products. This transparency may need to be underpinned by market
infrastructure or systems to ensure that mandated disclosures can be used by intermediaries
and investors to inform product selection and direct investment flows to lowest-cost/highest
net return solutions.
2) Tackling the need for increased competition across EU Member States by reducing, and
where possible eliminating, the remaining barriers to cross border provision of retail financial
services and products. This will require increased harmonisation to avoid competition
impeding gold-plating as well as improved coordination of national supervisory approaches.
Together with measures to enhance transparency, including on national regulatory
requirements, this will lower market entry costs and increase competitive pressures in the
market.
3) Addressing behavioural biases and financial illiteracy amongst retail investors. Taking into
account the complexity of financial education, some policies can stimulate investors to
increase their financial literacy. For example, the experience in some Member States has
shown that investment savings accounts (ISA) can contribute to a high level of retail investor
engagement with capital market products, via easier access to investment products such as
equities, corporate bonds and investment funds. Employee share ownership (ESO) schemes
provide an opportunity for beneficiaries to get familiar with capital markets, giving a first
insight into equity investment. National retail investment schemes foster investments into
SME growth markets and contribute to increase financial literacy in a pragmatic manner.
Moreover, a more competitive financial industry can promote best practices that may attract
investors' curiosity to learn more about capital markets and financial investments more
broadly.
88

6.4 Key indicators75
Retail investors' financial structure and propensity to save

Indicator
Saving rates (% of GDP)
Households financial assets (EUR billion and
% of GDP)
Equity (% of total financial assets)

Last 5-year
average
10.69%
EUR 30 990
billion
(217%)
16.6%

Latest
observation
2016
2016

Value
10.3%
EUR 33 344
billion (225%)

Q3 2016

16.1%

Q3 2016

6.8%

Q3 2016

2.8%

Q3 2016

EUR 23 106
billion (69.2%)

(2013-2016)
Investment fund shares/ units (% of total
financial assets)
Debt securities (% of total financial assets)

6.6%
(2013-2016)
3.7%
(2013-2016)

Share of financial assets other than currency
and deposits (EUR billion and % total financial
assets)

EUR 21 539
billion
(69.5%)
(2013-2016)

75

EU, unless otherwise indicated.

89

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