The case for an EU capital market union

Economics heavyweights like Enrico Letta and Mario Draghi have rekindled the eternal debate over the importance of putting capital market integration centre stage in EU reforms to revitalise the Union’s economies.

Still, EU governments fail to adopt substantial reforms or will simply agree to measures that, de facto, reinforce existing market fragmentation and endanger financial stability at a time when the EU struggles with the US and China to safeguard its financial and technological independence. The initiative to create an EU capital markets union was first proposed by Commission former president Jean-Claude Juncker in 2014. After more than a decade, the free movement of capital in Europe remains an impossible dream.

An EU capital market union should deepen and integrate national capital markets to form a single, large and well-diversified capital market. This solution will offer businesses, especially SMEs, across Europe the opportunity to raise capital from the capital markets in addition to bank financing. Institutional and retail investors should be able to invest their money cheaply and securely across national borders. Of course, for this to happen, the major capital market players should be subject to standardised rules and supervision.

In the local context, in the last few decades, SMEs have been able to access finance from private investors, often without the need to provide collateral. Typically, banks and other institutional lenders require real estate and similar physical assets as collateral for loans. The primary bond market offers small businesses attractive opportunities to obtain finance, often at lower interest rates and with less onerous conditions than those imposed by banks.

But if there is no easily realised collateral to guarantee the repayment of bonds, how might a small investor have a measure of reasonable protection from an SME borrower who might default? Collateral-based lending enforces loan repayments by instilling a fear of loss of the collateral. Credit rating can be the answer.

A credit rating is a credit opinion rendered by a third party, the credit rating agency, that makes an objective, independent evaluation of creditworthiness and expresses it through a published rating scale that compares degrees of creditworthiness across ratings.

The long-term sustainability of the local debt market can be achieved when the EU capital market union becomes a reality

The substitution of a credit rating for hard collateral as the basis for issuing a bond to an SME can be effective only if the credit rating is credible. Credibility, in turn, derives from the rating agency’s competence, as evidenced by its adherence to high ethical standards and best practices. So why is it proving difficult to introduce a credit-rating service to inject liquidity and confidence into the local equity and bond markets?

Two decades ago, an attempt was made to introduce a credit rating service to enable banks to partially automate the granting of loans to SMEs and minimise the subjective element in forming a creditworthiness opinion in a loan assessment.

An IT system sold by a major rating agency was tested to assess the accuracy of its credit ratings on a sample of local SMEs’ bank loans. It did not come as a surprise to many observers of the local financial scene when this credit rating project for SMEs was abandoned, as “businesses in Malta operate on a different model in the way they manage their finances”.

Credit rating systems for SMEs produce a score determined by an algorithm that considers several data points related to a business’s financial history. The data is collected from several sources, including debt collection services, debt review companies, public records from government institutions and banks or commercial companies, and by suppliers or other parties.

Businesses with an effective debt management system that includes accurate cash flow forecasting, experienced management and staff, and sound governance frameworks usually receive a high credit rating, which inspires confidence among potential investors.

The local equity and debt markets have a serious disadvantage due to their small size and limited diversification. It is no wonder that the lack of liquidity in the secondary private equity and debt markets is one reason some private investors shy away from it, even though bond issues are almost invariably oversubscribed.

Understandably, many institutional and even small private investors prefer to tap into international capital markets to minimise risk. The long-term sustainability of the local debt market can be achieved when the EU capital market union becomes a reality.

Short-term market props financed by taxpayers to keep a sluggish market alive will not suffice.  We need to upgrade the standards of our equity and debt markets by introducing a credible rating system for corporate borrowers.

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