What is the EU Capital Markets Union?
The Capital Markets Union (CMU) refers to the integration and deepening of national capital markets within the European Union (EU). This is not precisely defined, but rather an integration process and the question of the form and speed in which this should and can be driven forward. The debate covers a broad spectrum - between continuing to have relatively independent national capital markets and a fully integrated EU capital market without barriers or regulatory differences. Key cornerstones of integration include the harmonization of national regulations, the removal of barriers for investors and the centralization of capital market supervision, whereby some key integration steps have already been implemented.
At present, the capital markets in the EU member states are highly fragmented - i.e. nationally oriented and regulated - and less developed than in the USA, for example. This is particularly evident in the equity markets: although the EU accounts for 17.5% of global gross domestic product (GDP), its share of the global equity markets is only 11.4%. Despite a similar number of listed companies, the US capital market is around four times as large as the European market.
The freedom of capital is one of the four fundamental freedoms of the European single market and is enshrined in Art. 63 TFEU. Although this article does not explicitly define the term capital flows, according to the case law of the European Court of Justice (ECJ), it includes cross-border investments in securities (such as shares, bonds or funds), foreign direct investment, the acquisition of real estate and loans. In the political debate, the term usually refers to European investments in securities.
The Capital Markets Union complements the European Banking Union, which - despite remaining gaps - is already further advanced and was also created as a result of the euro crisis. Together, the Capital Markets Union and the Banking Union are regarded as central building blocks for the completion of the European Economic and Monetary Union (EMU). The capital markets union pursues a number of strategic objectives. At present, the focus is particularly on strengthening European competitiveness through increased (venture capital) investment - promoted by the Letta Report and the Draghi Report. Figure 1 shows where the Capital Markets Union fits into the structure of EU economic policy and institutions.
Two central developments are always associated with the Capital Markets Union: the deepening of the capital markets and their integration within the EU. While deepening is primarily aimed at expanding capital market-based financing in the EU - measured in terms of GDP or in relation to bank financing, for example - integration is intended to ensure that a larger proportion of this financing takes place across borders. Only the interaction of both processes will create genuine European added value.
Economists at the European Central Bank (ECB) associate the following objectives with the Capital Markets Union:
- To strengthen investment by private and institutional investors in order to promote growth and competitiveness in the EU,
- Financing investments for the twin transformation (green and digital),
- Expansion and higher returns on private pension provision,
- Promoting private risk sharing within the EU.
The first two objectives, which are closely linked, are examined below. The political measures for implementing the Capital Markets Union - as formulated in the European Commission's “Capital Markets Union 2020” action plan, for example - are diverse, but currently focus primarily on stimulating the European securitization market, increasing the participation of private investors and centralizing financial market supervision at the European Securities and Markets Authority (ESMA). However, the economic literature emphasizes further prerequisites for sustainable and stable capital market integration. These include, in particular, the creation of a pan-European “safe asset” (as an alternative to German government bonds, which are currently often used as safe assets), a uniformly implemented set of rules for all financial companies and the harmonization of national insolvency and tax regulations on the capital markets. Only when these structural requirements are met can an EU single capital market be created that functions across borders without legal and financial barriers.
How can the Capital Markets Union contribute to transformation financing?
Many European economists hope that the Capital Markets Union will contribute to transformation financing both indirectly through a general increase in the level of investment and directly through more targeted investments in start-ups and the spread of green financial products. For North Rhine-Westphalia, a deeper European integration would be particularly promising due to the high need for investment in industrial transformation and the close economic ties with neighbouring countries - both for mobilizing private capital and for strengthening regional competitiveness.
Increasing the level of EU investment
Even if the exact estimates vary, one thing is undisputed: Building a climate-neutral European economy requires huge investments. The European Commission, for example, assumes an annual investment requirement of EUR 1,241 billion to achieve the climate targets by 2030 - EUR 477 billion per year in addition to the current investment level. In addition to climate protection, the Draghi report also takes into account other strategic goals such as digitalization, defence capability and competitiveness and estimates an additional investment requirement of 750 to 800 billion euros per year, around 4.5% of EU GDP.
Although public investment plays a key role - particularly as a driver - it is expected that around 80% of the necessary funds will have to come from the private sector. For example, the EU Recovery and Resilience Facility, the centerpiece of the Corona recovery program, with its total of EUR 660 billion for climate action, will only cover around 15-20% of the investment needs by 2030. The fragmentation of the EU capital markets is seen as a key obstacle to private investment: Different national rules, smaller market volumes and higher transaction costs inhibit cross-border investments. As a result, the financing of European companies remains heavily bank-based, while private investors often do not invest capital efficiently - or at all. The main reasons for this are as follows:
(1) Bank-oriented financial system: An international comparison shows that Europe has a strongly bank-based financial system. Companies and households in the EU finance themselves to a large extent via bank loans: banks in the European Union hold around 90 % of all private debt and 70 % of corporate debt. In the USA, on the other hand, this figure is only 40% and 20% respectively. This dependency has structural disadvantages: Compared to capital market players, banks allocate less financial resources with their total capital, are often more risk-averse and frequently invest less efficiently (more on this in the section on venture capital). In addition, banks in the EU are subject to strict capital and supervisory regulations as a result of the financial and euro crisis, which limits their room for maneuver. One of the consequences of this is that a disproportionate amount of capital flows into the real estate sector. Our article Fin.Connect.Kompakt No. 2 provides an in-depth analysis of whether the limited equity of banks represents a bottleneck for transformation financing.
(2) Low level of private investment: Although households in the EU have one of the highest savings rates in the world, a large proportion of these assets are barely used: Funds remain predominantly in cash, bank deposits, savings accounts, life insurance policies or government bonds- forms of investment that usually generate low or no returns and hardly contribute to financing green innovation (see also above and the following section). Private funds, which are used more for capital market-based and sustainable investments, could represent a significant lever for transformation financing: In 2023, European households held around EUR 34.5 trillion in financial assets. In 2023, European households held around EUR 34.5 trillion in financial assets, a third of which were cash or bank deposits - i.e. assets that do not generate a return. At the same time, annual savings in the EU amounted to around EUR 1.4 trillion. This was significantly higher than that of US households at 840 billion euros.
Despite the large volume of savings, the efficient use of private investments in the EU continues to be restricted by structural hurdles. For example, the small and fragmented capital markets are associated with higher costs and a pronounced “home bias” - i.e. a preference for domestic shares, etc. The fundamental risk aversion of many private investors also makes it difficult to channel capital into higher-growth but more volatile investments.
This is particularly evident on the European venture capital markets, which are crucial for financing start-ups and future technologies: While the annual fund costs for venture capital in the US are only around 0.4%, they average 1.4% in the EU. In addition, private investors in Europe pay around 40% higher fees than institutional investors. In contrast to the USA, there has so far been a lack of strong competitive pressure in the EU to reduce these costs and attract private investors to invest in the venture capital market.
Harmonization of regulations and the adoption of European best practice examples could significantly increase the attractiveness of the capital markets for private investors, both directly and indirectly - for example via institutional investors such as pension funds, banks and insurance companies. At present, existing dissonances in tax law (e.g. capital gains tax, holding period regulations), in the promotion of pension provision, in the design of financial product information and fee structures, in the transferability of securities and in company law (e.g. insolvency or dividend law) make cross-border access difficult. These regulatory differences are often too complex for private individuals and cause additional costs for institutional intermediaries. The latter lead either to higher product prices or to a stronger focus on national, low-risk - but usually low-return - financial products.
It should be noted that not all private savings should or must be invested in venture capital in the future. It is also clear that uniform standards and more competition on the European capital markets alone will not be enough to completely close the existing private investment gap. In addition to increased costs and regulatory barriers, cultural factors - such as a pronounced risk aversion, trust in the supposed security of national shares and insufficient financial education - also play a decisive role. Nevertheless, there is much to suggest that investment behavior will have to change in the medium term: In view of the ageing population and the increasing burden on state pension systems, the importance of private capital investments can be expected to increase.
Support for SMEs and start-ups
Small and medium-sized enterprises (SMEs) and start-ups play a key role in the green transformation of the economy. Not only do they bring new sustainable technologies to the market, they are also often faster in applying and scaling innovative solutions. According to the International Energy Agency (IEA), technologies that are currently still under development could account for around 35% of the necessary greenhouse gas reductions in the energy sector. Green start-ups in particular often work closely with regional industries - such as car manufacturers in Germany - and thus make an important contribution to the decarbonization of local value chains.
However, start-ups and young SMEs are particularly dependent on capital market-based financing, especially venture capital (VC). Venture capital is usually made available on the private capital market, unlike shares and bonds, for example, which are traded on public capital markets - the stock exchange. VC funds, for example, are therefore also covered by the Capital Markets Union, as they have so far been subject to different standards in the EU member states.
As start-ups usually have no traditional loan collateral - if they do, then only intangible assets such as patents or innovative business models - and are often unprofitable in the initial phase, they have little access to bank loans. Their increased default risk is at odds with the strict risk models and regulatory requirements in the banking sector. Sustainable technologies in particular are often associated with high technological risks, uncertain market opportunities and regulatory uncertainty.
Because, as described above, neither banks nor private investors in the EU provide sufficient funding, especially for later financing rounds (the scale-up gap), European start-ups are often reliant on US venture capitalists or relocate their headquarters to the US altogether. Although equity funding from development banks such as NRW.BANK or KfW can help here, in 2023 they were also unable to prevent two thirds of IPOs by start-ups that were originally financed with European VC from taking place outside the EU.
Although seed capital in early financing rounds is increasingly coming from European sources, it is often limited to the start-up's country of origin. Southern and Eastern European member states with underdeveloped VC markets in particular lack sufficient access to financing. However, Germany's venture capital volume in relation to GDP was also below the EU average in 2023. The overall low market volume for venture capital - around 0.1% of GDP in the EU compared to around 1% in the US - weakens Europe's green competitiveness, makes European start-ups dependent on the currently particularly volatile US capital market and slows down the use of innovative technologies in the European single market.
It is expected that the Capital Markets Union will make more funds available for venture capital and distribute them more efficiently within the European Economic Area. Deeper integration should help to better spread risks and promote the professionalization of European VC investors. Large institutional investors such as pension funds from the Netherlands or Scandinavia could also invest more in European VC funds in the future with more uniform capital market regulations - similar to what their US counterparts are already doing. Otherwise, warned former French Finance Minister Bruno Le Maire, there is still a risk that “our start-ups will be born in Berlin, grow up in Paris - and become big in Washington, New York or San Francisco.”
Spreading green financial products and standards
Finally, the Capital Markets Union is intended to strengthen the EU's role as a global hub for sustainable financing and promote cross-border trade in sustainability-related financial instruments. With the EU Taxonomy, the Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD), the EU already has comprehensive regulation in place to classify the sustainability of investments and collect financial market-relevant ESG data. You can find more information on this in our articles on the EU taxonomy, SFRD and CSRD.
This means that the EU is already much better positioned in the area of sustainable finance than in other capital market segments. This is reflected, for example, in the high issuance of green bonds and the importance of the euro as the world's leading currency for green financial products. According to the Luxembourg fund association ALFI, the EU and other European countries accounted for 85% of the global net assets of sustainable funds at the end of 2023. The EU is also leading the way in harmonizing standards for sustainable financial products with projects such as the European Green Bond Standard and ESMA's requirements for ESG labeling of funds.
Despite the growth of green capital markets, there is still a home bias and regulatory uncertainties are hampering their integration. In addition, the green transformation is likely to require a broad diversification of the financial instruments used.
However, many of these financial products - such as green and ESG-linked Schuldscheine - are often country-specific features or, as in the case of green securitizations, are still hardly or not at all widespread in the EU. The latter in particular are considered to play a decisive role on the path to a green capital market and banking union. Cross-border trading in securitized (bank) loans could help to spread default risks and increase credit capacity for green projects. Smaller SME financing projects could be bundled in order to achieve a “capital market-ready” volume. However, this requires an effective European regulatory framework to prevent the financial imbalances and lack of transparency that contributed to the global financial crisis.
What challenges remain?
Even if there is a supposed consensus in the EU's political discourse on the need for deeper capital market integration, there are still considerable hurdles to its timely implementation and its contribution to transformation financing.
(1) Political implementation: In recent years, incremental progress has been made towards a capital markets union. In particular, the harmonization of insolvency and tax law - two areas that remain national responsibilities - has not yet been conclusively clarified. Furthermore, in some member states with strong financial sectors, such as Luxembourg or Ireland, there is mistrust of greater centralization of market supervision by ESMA. There are also practical challenges, such as ESMA's insufficient staffing and financial resources to effectively take on additional tasks.
(2) Control of investments: Critics of the green capital markets union point out that a blanket expansion of capital market financing and the associated fall in capital costs would fundamentally benefit all companies and sectors - regardless of their emissions profile. In order to prevent climate-damaging business models from being promoted as a result, the Capital Markets Union must be closely interlinked with other climate policy measures. These include sustainability reporting, an ambitious green industrial policy and effective emissions trading. This is the only way to ensure that the additional financial resources mobilized flow specifically into the green transformation - for example into sustainable start-ups or green financial products - and that the expected positive effects are not counteracted. There is also a risk that the Capital Markets Union will be misunderstood as a substitute for other investment-promoting measures - which could mean that urgently needed initiatives to increase the overall level of investment in the economy fail to materialize.
Ultimately, it is important not to see bank-based and capital market-based financing as opposites. Both approaches have their own advantages and disadvantages and provide different categories of companies - including those with a sustainable focus - with access to financing. When implementing the Capital Markets Union, particular care should therefore be taken to ensure that indirect effects on non-capital market-oriented companies remain limited and that the synergy potential of both approaches - for example through securitization - does not lead to additional burdens for SMEs.
