Uldis Cērps, CEO of Finance Latvia

Keynote speech at the Boardroom Lunch event organized by the Stockholm School of Economics and Pedersen & Partners

It is a billion-dollar question how to develop capital markets from scratch. I had the opportunity to be a part of such a process 30 years ago here in Latvia. We can all see that despite the presence of world-class infrastructure for trading, clearing, and settlement, capital market development here is still an unfinished business. However, the purpose of my speech is to highlight initiatives at the European level to strengthen capital markets in Europe. But I will also use this opportunity to offer some personal reflections on what needs to be done specifically in Latvia.

First – on the “business case” for Capital Markets Union. Or, as it is presently called – Savings and Investment Union. Why now? For those of us who take a keen interest in economic history, we can see that the impetus for financial market development always comes from the real economy:  in other words, when economic reality requires financing on a scale that is not available from existing sources and cannot be provided by existing fragmented financial markets. Jeffrey Gordon and Kathryn Judge from Columbia University have shown[1] that prior to the construction of the railroads, the US banking system was dominated primarily by small local banks that were ill-suited to provide the financing needed to finance the railroads and the industrial expansion that followed. The bond market then stepped in, creating national and international channels for debt and then equity financing. Investment in the railroads grew from about USD 90 million in the 1830s to nearly USD 5 billion in the early 1900s. Most of the financing was in the form of bonds, and up to one-third of it came from foreign investors. In Latvia in the early 1990s, policymakers missed the opportunity to use privatization as an engine for capital market development. This is not surprising, given the high level of state capture at the time, as companies were transferred from public to private ownership in ways that were not entirely transparent. The situation has changed since the early 1990s, and it is now up to today’s policymakers to demonstrate that they are truly committed to deepening and increasing the efficiency of the financial system by listing a significant number of the currently state-owned companies.

If we shift the focus from the United States 200 years ago (and Latvia 30 years ago) to the European Union today, we can see that we have enormous financing needs ahead of us. The European Commission estimates[2] that the green transition will require an additional average annual investment of EUR 620 billion by 2030. In addition, the digital transition will require EUR 125 billion per year. This amounts to almost EUR 750 billion per year in new financing needs for these two common European transformation initiatives. At the current level of credit growth in the euro area of 1.6 percent, net new annual lending is only around EUR 200 billion, which is not enough to fill the gap[3]. In addition, the lack of deep capital markets also hampers the ability of European banks to make riskier loans, as they cannot be easily securitized, sold to bond funds, or otherwise turned into capital markets products.

It is also unrealistic to expect the financing gap to be filled by European governments. Currently, the average debt-to-GDP ratio in the euro area is 88%, which is historically high and has only been earlier observed in advanced economies only once – after World War II[4].

This is where the idea about a more integrated and efficient European capital market comes in. The idea of developing a Capital Markets Union is not entirely new, as it is the brainchild of  the EU Commission President Jean Claude Juncker. While progress has been made since the CMU initiative was launched by the EU Commission in 2015, capital markets in Europe remain fragmented. The goal of a single European capital market remains only partially achieved, despite two comprehensive action plans by the EU Commission since 2015[5]. In terms of size, the EU’s bond and venture capital markets still lag behind those in the United States – by a factor of 3 and 5, respectively.

What are the real issues that remain to be addressed in the EU? These initiatives fall broadly under two categories – those that can be done by the government and those that depend on the private sector.

Let’s first look at the initiatives that can be taken by the government particularly at the EU level. The two measures that will have the greatest impact are politically difficult to agree on. The creation of a single European safe asset requires mutualization of government debt in the euro area, which is not realistic in the short to medium term. The largest government bond market in Europe – France – is capitalized at just USD 4.4 trillion[6][7]. By comparison, the US Treasury market is capitalized at USD 51.3 trillion. It can be argued that common borrowing by EU member states is already taking place through the landmark NextGenerationEU recovery instrument policy program, but the volume of this program is less than EUR 1 trillion[8] (the size of Luxembourg’s government bond market). The lack of a common euro-denominated reserve asset is a problem that will not be solved in the foreseeable future. A common tax treatment of capital market investments is also an initiative that goes beyond the current mandate of the EU institutions and would require a very strong political will, as EU member states continue to compete with each other to offer the most favorable tax regime for individuals and companies. Changes to the tax rates are also politically very sensitive. The current debate in Latvia on the budget for 2025 is a good case to illustrate this point.

So, if common tax policies and common borrowing are out of the question, what else can be done? The approach taken by the EU Commission since 2015 to improve the functioning of European capital markets through incremental changes has produced many good results but has not led to a breakthrough.

A less politically contentious issue is regulatory and supervisory change. The idea of a “European SEC” predates the idea of a European Capital Markets Union. Some of the supervisory functions in European securities markets are already centralized in the Paris-based European Securities and Markets Authority (ESMA), such as the oversight of credit rating agencies. However, most supervision is currently decentralized. A European SEC with a sufficiently broad mandate could not only better deal with cross-border actors and risks, but also be a strong force for further promote market integration and development. The expansion of ESMA’s mandate was also recommended by Mario Draghi in his recent report[9]. Draghi recommended that ESMA should evolve from a body coordinating national regulators to a single common regulator for all EU security markets by giving it power to supervise large multinational issuers, cross-border financial markets,  and all central counterparties. Latvia has a positive experience with its 4 largest banks being directly supervised by the ECB. In the EU, we could build on the positive track record of the Single Supervisory Mechanism (SSM) in the supervision of euro area’s largest banks to identify the actors and services of the European capital market that could be better supervised by a centralized European supervisor.

This naturally leads to the question of a single rulebook for capital markets. In many respects, the single rulebook already exists, but EU capital markets directives are implemented through national legislation, resulting in individually insignificant but collectively potentially impactful differences in implementation. A single rulebook supported by a directly binding legal framework at the EU level (EU regulation) could provide a more robust alternative.

Another idea that may have potential support is further harmonization of insolvency frameworks. There are still differences in European insolvency frameworks, and these differences impose additional costs on anyone who wants to understand the insolvency risk of their cross-border investments.

This leads me to believe that more could be done by private sector actors. Let me give you just one example. The European equity market is served by three times as many exchange groups, and 20 times as many post-trade infrastructure providers as in the United States[10]. This leads to greater market fragmentation and less efficient markets. There is a case for further consolidation of exchanges and market infrastructures. However, these are commercial decisions that cannot be forced by the governments or regulators.

In conclusion, we are at a critical juncture in the development of a single market for equity, debt, and venture capital in Europe. In terms of the scale of demand, it increases significantly as the EU embarks on a comprehensive program for the digital transformation and greening of our economies. In terms of institutional structure, we know from experience in this country that it is not enough to establish a world-class stock exchange, a central depository, good securities laws, and a regulator. As a small country, we will benefit from economies of scale, from being closely integrated into a larger system, and this applies to the establishment of a common European securities supervisor with a common rulebook, and clear rules of the game that are exactly the same across the EU single market. We will also benefit from improvements it the supporting “ecosystem” – insolvency laws, an improved securitization framework, and more legal certainty through directly binding EU regulation. This will still leave a lot of policy space for smart political choices that should be made at the local level, such as listing key state-owned enterprises and using privatization proceeds wisely to improve the country’s physical and human capital.

[1] Gordon, J. N., & Judge, K. (2018). The origins of a capital market union in the United States. Capital Market Union and Beyond (Franklin Allen et al., eds.(MIT 2018)), Columbia Law and Economics Working Paper, (584).

[2] European Commission (2023), 2023 Strategic Foresight Report – Sustainability and people’s wellbeing at the heart of Europe’s Open Strategic Autonomy, July.

[3] The aggregate lending portfolio of the euro area banks is EUR 12.1 trillion.

[4] https://www.imf.org/-/media/Websites/IMF/imported-flagship-issues/external/pubs/ft/weo/2012/02/pdf/_c3pdf.ashx. Downloaded on September 26, 2024

[5] The most recent plan, adopted in 2020, aimed to achieve a green, inclusive and resilient economic recovery, make the EU an even safer place to save and invest, and integrate national capital markets into a genuine single market.

[6] Government debt at 88.1% of GDP in euro area – Eurostat (europa.eu).

[7] https://www.weforum.org/agenda/2023/04/ranked-the-largest-bond-markets-in-the-world. Downloaded on October 26, 2024.

[8] https://commission.europa.eu/strategy-and-policy/eu-budget/eu-borrower-investor-relations_en. Downloaded on October 25, 2024.

[9] https://commission.europa.eu/topics/strengthening-european-competitiveness/eu-competitiveness-looking-ahead_en#paragraph_47059.

[10] https://www.ecb.europa.eu/press/key/date/2023/html/ecb.sp231117~88389f194b.en.html.