Differences in Europe’s banking union and capital market union

A superb speech by Poul M. Thomsen of IMF.

He points that in order to understand differences between building banking union and capital market union, we need to look at key differences between bank based and market based finance:

Before getting to our concrete proposals for how to promote CMU, I want to define the issues a bit better by reminding you about some basic differences between bank-based and market-based finance.

Remember that the core funding base of banks is risk-averse depositors while that of the capital markets is yield-seeking investors. Through a long and bitter experience with financial panics we have developed a system where one fundamental difference between banking and the capital markets is the special privileges that banks enjoy under the public financial safety net.

This safety net has multiple strands. Banks enjoy the right to retail deposit insurance, backstopped by the state but funded by the industry. In addition, they enjoy the right to draw liquidity from the central bank against eligible collateral, and the right to place excess liquidity at the central bank—the safest counterparty in the land. All of this makes banks safer, but can also create moral hazard, meaning an incentive to take risk when one knows one is protected from some or all of the downside.

There is more. When banks fail—and fail they still do—the government’s promise to stand behind their retail deposits creates a natural role for government in their wind-up: this is why we have state-directed bank resolution, as distinct from private corporate insolvency. And, both to offset the moral hazard effects and to contain the financial stability risks arising from the mixing of leverage and maturity transformation, banks are prudentially regulated and supervised with the explicit mandate of reducing their probability of failure.

Contrast this with a relatively pure form of capital market intermediary: the mutual fund. Where banks focus on taking deposits with a promise to return them on demand and at face value, mutual funds take equity with the prospect of higher returns but also a disclaimer on potential losses. In the mutual fund industry, savers are exposed directly to the end-users of their funds with no public backstop; official oversight is mainly focused on ensuring transparency and good conduct by fund managers, with no explicit mandate to limit losses, and is often of an ex post nature, with a heavy emphasis on enforcement, contrary to ex anteprudential oversight in banking. Risk-taking here is modulated primarily by market forces.

One more point. Banks lend based on relationships and proprietary information. Given the relatively level playing field among banks—they all benefit from the same safety net—information gathering forms the essence of competition in banking. You collect as much data as you can on your borrowers, you nurture your customer relations in the pursuit of repeat business, and you never share your data with others. And information, of course, costs money—when we borrow from banks we pay for a broad range of overheads.

Mutual funds, in contrast, invest at arm’s-length. Here, the name of the game is reliable, comparable, publicly available information. The fund buys a tradable security after its managers have skimmed the prospectus—a much less costly endeavor than gathering bespoke information—and they don’t know much that other fund managers don’t also know. Here, success depends on wise investment choices, proper valuation practices, and portfolio diversification. For the recipients of mutual fund investments—the issuers of debt and equity securities—the benefit lies in being able to access savings with less margin taken by the middleman, and thus a lower cost of funds.

In view of these basic differences between banking and the capital markets, it is not surprising that plans for banking union have focused on the creation of a centralized supervisor of systemically important banks—the Single Supervisory Mechanism; a centralized bank resolution framework—the Single Resolution Mechanism, backed by a central fund soon to be backstopped by the European Stability Mechanism; and a common European Deposit Insurance Scheme—EDIS.

Thus, the two different forms of finance requires different approaches to development and regulations:

In contrast, the general principles that I just sketched suggest that the primary focus of efforts to create a CMU should be more on ensuring greater transparency; reducing variability in investor protection regulations; and improving insolvency regimes, both to improve recovery values and to facilitate smooth market exit. One key theme here is to facilitate market discipline, which requires an approach that is distinct from explicitly seeking to reduce the likelihood of failure through intrusive prudential supervision.

Really useful to think about several things in finance….

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