Colin Mayer 18 March 2015 Restarting European Long- Term Investment Finance

Key Issues 2 Low growth, low investment, insufficient spend on infrastructure, weak bank lending to the corporate sector, and funding deficiencies of SMEs are all major causes of concern in Europe Is the source of the investment deficit in the structure and performance of the financial system? Or is it rather a problem of low demand for capital? Even if it is supply rather than demand for finance, then there is a question of whether the problem is a transitory one that is slowly being resolved over time as the effects of the financial crisis fade, or a structural one that will persist – as a consequence of new regulation and changes in intermediaries business models Lack of clear diagnosis of the financial crisis entails a risk of Europe hurtling into a series of unjustified policy prescriptions that might not work and might even end up exacerbating rather than alleviating problems

Stylized Facts 3 The European corporate sector has decreased its net borrowing, and in some countries has become a net supplier of funds to the financial system; while capital markets share, relative to banks, has increased, with a large rise in corporate bonds However, SMEs, with limited access to capital markets, remain highly dependent on bank finance, and have seen credit declining markedly; the financial crisis has also left part of the system overleveraged, with their debts encumbering banks’ balance sheets and banks’ ability to provide fresh finance The scarcity of finance for SMEs may have been aggravated by regulation – toughened Basel III capital requirements penalize lending to the corporate sector Low investment and the decline in equity financing may reflect defects of the governance of companies and financial institutions – short termism – as well as undesirable changes in the intermediation chain (the role of asset managers)

The Project 4 Assonime and the CEPR are jointly organising a programme of research, supported by Emittenti Titoli, on corporate financing in Europe to advance our understanding of issues relating to the financing of corporations – especially European corporations – and to provide evidence on the policy issues that are at the forefront of ongoing debates The research programme is divided into two stages: in the first stage, the programme is identifying policy issues that are at the forefront of current debates, in particular those that lend themselves to academic analysis and can be informed by economic research The second stage is to commission research on the issues identified in the first stage and to produce a final report (the White Paper) based on the accumulated evidence This is the Green Paper based on the first stage

Fact no. 1 5 Large differences between companies:  across countries  North vs. South  Germany vs. other euro zone (EZ) countries  between large and small companies

Differences in firms’ profitability,… 6

……return on equity…… 7

….in their capitalization by size… 8

9 … and by country…

….on loan rates…. 10

…on spreads between large and small loans.. 11

…..net financing costs….. 12

13 … in their net financial position …

… and mix of external & internal finance 14

Fact no Overall little shortage of long-term finance:  firms have increased their capitalization (E/A)  large firms have increased bond issuance  BUT small and medium firms are still bank dependent  … and bank loans are very cyclical, while bond issuance is more stable and counter-cyclical

Composition of EZ firms’ liabilities (% GDP) 16

Capital market financing of firms in Europe 17 Source: OECD

Bank loans & security funding of European firms 18 % of GDP. Source: ESRB Report no. 2, 2014

Fact no Bank loans contracted sharply in the crisis:  especially for small and medium firms  credit availability dropped at the same time (or shortly before) firms’ demand for credit: identification problem!  both dropped much more sharply in Italy and Spain than in France and especially Germany

Credit availability as reported by EZ firms 20 Source: ECB Survey on Access to Finance for Enterprises.

Credit standards & demand for credit in the EZ 21 Source: ECB Bank Lending Survey.

Credit standards & demand for credit, by country 22 Source: ECB Bank Lending Survey.

Summary of observations 23 Substantial variations in circumstances across countries and firms Differences between northern and southern Europe Differences between Germany and other euro countries Differences between small and large companies Overall little evidence of a shortage of long-term finance Many companies increasingly in financial surplus Those that have access to bond markets face few constraints Source of countercyclical finance in comparison with bank finance In contrast, financial problems particularly serious for SMEs But even here not clear that supply rather than demand for finance Some evidence of supply problems from financial crisis But not clear that this is generally the case at other times

Explanations 24 Information  Asymmetries of information in SMEs  Central credit risk registers  Private sector providers  Crowd funding/peer to peer lending Regulation  Capital requirements – socially beneficial or raise cost of finance  Risk weighted capital requirements  Solvency II  Statutory funding objective

Insurers’ financial assets 25

Pension funds’ assets 26

The changing face of UK ownership 27 % Individuals Ins. Cos Pens. Funds Other Fin Inst. Rest of World Source: Paul Davies (2014)

Governance 28 Agency problem Short-termism Shareholders versus stakeholders Conflict between shareholders and creditors in banks Followed by debt overhang Particularly relevant to SMEs and family firms Conflict between continuity of family and dispersed ownership

Implications 29 Distinction between demand and supply opaque Poor governance may mean few bankable investments Large companies have little demand Small companies unable to convince lenders Poor governance of banks undermines supply Relations between borrowers and lenders key, e.g. between German banks and SMEs Presence of long-term anchor investors important

Policy 30 Determine underlying causes Identify appropriate remedies Evaluate policy initiatives  Central banks through quantitative easing  Jean-Claude Juncker €300bn investment programme  Seeking to expand SME lending Are they appropriately targeted: e.g. could strengthening bank corporate governance exacerbate risk taking? Importance of relations between public, private, financial and corporate sectors

Questions 31 Have we identified the right issues? Accurately documented the current position? Comprehensively covered relevant literature? Determined correct possible solutions? Suggested appropriate research and policy agenda?