In 2013, the IMF, OECD, FSB and other international institutions issued reports on factors affecting the availability of financing for long-term investment. These reports emerged as a response to commitments made at the G20 Summit in Mexico in 2012. The European Commission contributed to this debate with a Green Paper on LTF published in March 2013. After a public consultation, the Commission published a Communication on Long-Term financing in March 2014 with a wide-range of proposals in 15 action areas, including the role of development banks, securitisation, European Long-term Investment Funds (ELTIFs) and tax and accountancy measures, among other things.
The first legislative proposal to emerge from this work stream was the Commission’s draft regulatory framework for ELTIFs, published in June 2013. Legislative work on the proposed regulation was interrupted by the EU elections but lawmakers eventually reached an agreement in November 2014. Towards the end of 2014, the existing LTF work essentially folded into the new Capital Markets Union (CMU) project of the incoming Juncker Commission. The new Commissioner for Financial Stability, Financial Services and Capital Markets Union, Jonathan Hill, launched a Green Paper and consultation on CMU on 18 February 2015, together with consultations on securitisation and the Prospectus Directive. The Green Paper on CMU identifies five early priorities, including implementing the ELTIF regulation, developing high quality securitisation, standardised credit information on SMEs, private placement, and a review of the Prospectus Directive to ease listing requirements for smaller companies.
In June 2013, Finance Watch responded to the European Commission consultation on Long-term Financing. In early 2014, we advised Parliament negotiations on the ELTIF Regulation, suggesting them not to allow the transfer of funds between ELTIF and non-ELTIF compartments of Alternative Investment Funds (to avoid creating a loophole in the regulation of hedge funds) and to not allow retail investors to invest directly in ELTIFs, but rather to use UCITS as a wrapper to limit the exposure to a single ELTIF and to ELTIFs in general, and to help consumers benefit from the liquidity and transparency requirements in UCITS. We also pushed to reduce the overly positive assessment of securitization as a mechanism for economic recovery in the Parliament’s non-legislative report responding to the Long Term Financing Green paper.
In December 2014, Finance Watch published a position paper on the European Commission’s Long-Term Financing initiative, “A missed opportunity to revive “boring” finance?” We examined critically the assumptions behind the Commission’s approach to capital market financing, analysing in depth some of the systemic risks that it might introduce, and formulating policy recommendations. The paper was accompanied by a cartoon on long term financing (pdf, 9 pages, also available in French, German, Polish, Italian, Dutch and Spanish). The position paper provided as well the basis for a discussion panel on collateral use in our February 2015 conference “The long term financing agenda – the way to sustainable growth?” On the 18th February 2015, following the European Commission’s Green Paper on the subject, Building a Capital Markets Union, Finance Watch published a press release, expressing some concerns on the project. In March 2015 Finance Watch explained the Capital Markets Union through the publication Capital Markets Union in 5 questions, while in May 2015 FW replied to the Green Paper and organised a Webinar dedicated to CMU. In June 2015, Finance Watch’s Secretary General, Christophe Nijdam, spoke at the European Parliament’s ECON Committee public hearing on “Stocktaking and challenges of the EU Financial Services Regulation: impact and the way forward towards a more efficient and effective EU framework for Financial Regulation and a Capital Markets Union”. We also organised a webinar on securitisation (27 July 2015), part of the CMU project, which is available online.
The financial crisis of 2008 did not start as a banking crisis, but as a shadow banking crisis. It showed that traditional banks were more robust and focused on the real economy than some investment banking activities that required a bailout. The CMU is the promotion of shadow banking and of the investment banking model, yet in our view, the lesson from the crisis is that we need more traditional and local banking.
The higher pro-cyclicality of non-bank lending raises a moral question since it means you need an entity that will buy when everyone wants to sell, yet shadow banking does not have explicit and direct access to public safety nets and the crisis has shown the ineffectiveness of private backstops. This means that we must decide between extending access to public safety nets to shadow banking, which would increase moral hazard, or alternatively shrinking the size of – and not promoting – shadow banking.
Lastly, the idea that enough has been done in terms of regulation and that we should now focus on short-term growth is misleading and risky. While much regulation has been put in place since the crisis, most of it is focused on making individual banks more robust but very little has been done to make the financial system as a whole more robust and stable. This is indeed very different: making the system more robust requires, for example, ensuring that financial institutions do not run into trouble at the same time. If one medium-sized bank runs into trouble, this is not a threat to the financial system as, for example, other banks can buy the troubled bank and ensure continuity of service. If, however, most banks experience troubles simultaneously as happened during the crisis, governments need to intervene to bail them out with taxpayers’ money. As long as this is not addressed, we will not have reduced the risk of future crises, which is a pre-requirement for sustainable growth.
- Infographic on high frequency trading
- Webinar on securitisation (27 July 2015)
- Liquidity – a double-edged sword (Blog article, 26 June 2015)
- Statement at ECON hearing on Stocktaking and challenges of the EU Financial Regulation (16 June 2015)
- Capital Markets Union is not a cure-all for SME jobs and growth, may generate new risks (press release, 2 June 2015)
- Response to Commission Green Paper on Capital Markets Union (13 May 2015)
- Webinar on CMU (11 May 2015)
- Capital Markets Union in 5 questions (Publication, 23 March 2015)
- Finance Watch sceptical about key parts of Capital Markets Union plan for sustainable growth (press release, 18 February 2015)
- Response to BCBS/IOSCO consultation on simple, transparent and comparable securitisations (13 February 2015)
- Conference “The long term financing agenda – the way to sustainable growth?” (4 February 2015)
- Response to EBA consultation on simple, standard and transparent securitisations(14 January 2015)
- “A missed opportunity to revive “boring” finance?” (Position paper, 15 December 2014)
- Understanding Finance #1: Splitting megabanks? (Pedagogical Unit, March 2014)
- Finance Watch response to the consultation on Long-term Financing (26 June 2013)
- “Investing, not betting” (Position paper on MiFID II, April 2012)
- Cartoon on Capital Markets Union
- Cartoon on long term financing (pdf, 9 pages, also available in French, German, Polish, Italian, Dutch and Spanish)
- 24 May 2016 Annual Report 2015
- 23 March 2015 Capital Markets Union in 5 questions
- 13 February 2015 Response to BCBS/IOSCO consultation on simple, transparent and comparable securitisations
Long-term financing has emerged as a regulatory theme in response to concerns about excessive short-termism in the world’s financial markets and its impact on economic performance and sustainable development. The theme connects legislative initiatives to reduce short-termism such as high-frequency trading and a financial transaction tax, to a demand-driven agenda to finance long-term real economy needs.
Markets are too focussed on the short-term. The main types of financing today – bank credit, investment funds and public money – are not well “set up” to meet the long term social, environmental and demographic needs of society. But with the right policies, Europe could encourage more long term investment in productive activities, bringing the economic strength, innovation and employment it needs to face the future.
This Q&A is based on Finance Watch’s response to the European Commission’s March 2013 Green Paper on the long term financing of the European economy.
What is long term financing?
Long term financing (LTF) is the provision of stable funding over “an extended time period” for longer-term assets and projects. The EC is looking at how to increase the amount of LTF from savings funds, governments and other sources.
Why is it important?
Long term investment projects often provide public benefits such as innovation and jobs. Long term projects with positive social benefits include investments in transport and energy infrastructure, hospitals, universities, industrial facilities, eco-innovation technologies and R&D, among others.
But long term investments often have long pay-back periods which make them difficult to finance. Financial markets are increasingly focussed on shorter-term investments and financial trading.
Without sufficient investment in long term productive activities, it will be difficult for society to achieve growth and innovation.
Why should I care?
Society faces many challenges such as energy provision, climate adaptation, infrastructure needs and aging populations, to name only a few. Our ability to meet these challenges through our collective efforts depends to a large degree on the availability of long term financing.
Most savers have little idea about or control over what their savings are used for. Your savings could give you a return while funding long term projects that boost the economy and human welfare, or they could be used to fund short-term investment and speculative trading, which aim to make a financial profit irrespective of their impact on society or the economy.
Investment is a power that savers can use. Why not use it to promote good hospitals, good universities, clean energy production and innovations that will create more jobs?
What are the issues?
In March 2013, the European Commission published a Green Paper with proposals and questions aimed at encouraging LTF, covering several areas. Here are some of the main issues:
Banks. Europe’s economy relies heavily on bank lending but many banks are still recovering from the credit boom (and bust) and have little appetite to provide credit for long term projects in the real economy.
Asset managers. Insurance companies, pension funds, mutual funds and endowments hold €13.8tr of assets and should be ideal candidates for buy-and-hold investments, if regulations such as prudential rules on capital and liquidity do not hold them back. But do asset managers have the right expertise and the right incentives to invest for the long term?
Equity markets. An “equity gap” has appeared as investors have turned in recent years to the apparent safety of bonds, reinforcing the trend away from equities as Europe’s population gets older. Another problem is that equity markets suffer from excessive trading, as middlemen paid on commission encourage portfolio turnover, and this in turn encourages short-termism among investors and companies. Company managers, who often have to report financial figures every three months, focus too much on managing their short-term earnings performance and not enough on building a long term growth strategy, which can involve making big investments that take time to bear fruit. Fund managers could put pressure on company managers to build long term strategies but many choose not to because it is easier simply to sell the shares instead.
Bonds and securitisation. Bond markets in Europe are dominated by financial firms, while medium sized and smaller companies find it almost impossible to access the European bond market directly. One solution that the financial industry and the EC favour is to encourage securitisation. This is a financial technique where banks package a number of smaller loans together and split the resulting pool into securities that they sell to investors. Each security contains a small slice of many loans, often grouped in “tranches” according to risk.
Securitisation can increase the amount of funding available but the sub-prime crisis showed it is fraught with dangers: banks have little incentive to ensure that loans are high quality (i.e. they lend too much to people who cannot repay the loans); the complex and opaque tranching process makes it hard for investors to judge the risk of the underlying loans; and there is a high risk of contagion – if the loans turn bad, securitisation means that lots of financial firms and investors will be affected.
Also, securitisation encourages inflexible lending; it is hard for borrowers to alter the terms of their loan if the bank has sold their loan to multiple new owners. As business conditions can vary widely during the life of a long term investment, this is not ideal for LTF.
Tax. The tax system distorts investment in many ways, the best-known being the preference for debt over equity. By allowing companies to deduct debt interest from the amount of profits they pay tax on but not allowing an equivalent tax break for dividends paid to shareholders, tax rules encourage companies to take on more debt and reduce their equity. Being overleveraged can reduce companies’ ability to invest and plan for the future.
What does Finance Watch think?
Finance Watch thinks the EC should adopt a range of measures to promote LTF for productive projects that have long time horizons and positive social benefits, and that don’t already have enough funding (this would tend to exclude real estate, as there is plenty of finance for this already and we don’t want to feed unproductive property bubbles). These measures should aim to increase bank lending as well as non-bank lending.
In more detail:
Banks could help a lot more – with the right regulation
We think banks are ideal providers of LTF but they need to be fully reformed first. Many banks have changed their business models in recent years to favour transactions and fee-based work over more traditional lending. But bank lending has its advantages: it can be flexible if borrowers need to alter their terms, and banks can use their personal relationships and knowledge of customers to make expert credit assessments and manage the loan through good times and bad. Banks can also lend to customers directly without needing to involve (and pay) middlemen.
For banks to play a meaningful role in long term financing, they must first become fit for this purpose. Regulators need to ensure that banks have enough capital for financial markets to trust their solvency, for example by insisting on a leverage ratio and higher capital requirements (see “Basel 3 in 5 Questions”). Regulators must encourage commercial banks to be stable, for example by separating their lending from their trading operations, to avoid the situation where big trading gains and losses destabilise a bank’s lending to the real economy (see “The importance of being separated”). And banks must be supervised closely to make sure they don’t cut real economy lending in a downturn (see open letter)
Asset managers need better long term incentives
Like everyone else, asset managers respond to the incentives they are given and to the training they have received. Some of the training might need to be updated after the financial crisis; the crisis provides an opportunity to reassess discredited financial market beliefs, such as “modern portfolio theory” and the “efficient market hypothesis”, theories on which a lot of finance still relies. This could open the way for a focus on new and better ways to measure the creation of long term value, such as tracking expectations about how much cash a business can generate over time, looking at absolute increases in value rather than comparing share prices with the movements of a stock index, and monitoring “churn”, the rate at which fund manager buy and sell shares rather than keeping them. These metrics, among others, should be standardised across the industry.
The incentives, or pay arrangements, for asset managers should be much longer term, matching the underlying investments, and include bonus clawbacks. There needs to be more in-house expertise about investing in infrastructure and other long term investments and less reliance on outside consultants to decide asset allocations. A review of the fiduciary duties owed by fund managers to their investors would also be helpful. This would ask if investors and money managers are only linked by a commercial contract or if there should be something more, i.e. if managers have an obligation to act in their clients’ best interests (read more about fiduciary duty from Finance Watch Member, ShareAction).
Some institutional investors have longer term investment needs than others. Regulations could encourage better matching of long term projects with longer term liabilities. This would make the financial system safer by reducing the amount of ‘maturity transformation’ in the system (the process in which short term savings and deposits are turned into long term investments, and which can cause problems if too many people ask for their money back at the same time).
Market rules could encourage LTF
Most companies are owned by shareholders who vote on key decisions, such as board appointments or strategic plans. These governance rights are often delegated to fund managers, who don’t always exercise them. Fund managers should be encouraged to vote, for example by paying them extra dividends if they vote or requiring explanations if they don’t.
Regulation could help to boost the types of investment vehicles that are best suited to LTF. For example, inflation-linked infrastructure bonds, the European project bond initiative and other long term vehicles would encourage more long term institutional investment.
The Commission’s proposal for a new type of long term investment fund (LTIF) could also help. LTIFs would make it easier for retail investors to invest in long term projects through dedicated long term funds, whose governance and choice of assets would be specially designed for long term investing.
Making securitisation “safe”
After the disaster of sub-prime securitisation in the last crisis, banks are developing their own quality labels for securitisations in the hope of reopening this potentially lucrative market and avoiding future regulation. Regulators hope to see a regime develop for “good” securitisations that will to fill the LTF gap but without the problems of leverage and poor quality assets from before.
A voluntary label scheme would be a step forward but recent history shows that securitisation needs more than this; it needs very strict regulating. If securitisation is to provide part of the answer, new rules will have to encourage transparency and simplicity, so that the investors who buy securitisations have enough information to make a proper judgement about the loans inside, and maybe to create rights of compensation if the assets turn out to be worse than expected. There should be limits on how securitisations are “tranched” and restrictions on leverage, among many other rules (see question 14 in our Consultation response below for more details). In addition, we think quality labels should only be available for long term productive assets, which would tend to exclude real estate.
Tax and public finance
Finance Watch supports moves to end the tax preference for debt over equity and would like to see more tax incentives used to create incentives to hold investments for longer time periods. Any reduction in the tax base from these measures could be met by raising the tax burden on non-productive sectors such as real estate.
The Green Paper also looked at public sector financing. As the private ownership of public goods and public-private partnerships have on occasion failed spectacularly to deliver the right outcomes for society, there is a clear role for the public funding of public goods. As the EC said in its Green Paper, public intervention would not need to replace private investment but it could help to catalyse it where private markets have failed. For example, national and multilateral development banks could guarantee the first losses of a project or fund its early stages, and governments could create a pipeline of projects to help private investors build the expertise they need to invest more in long term projects
What can I do?
You can choose to invest in productive activities over the long term. Regulations make a difference but it is customers that the financial industry ultimately answers to. If enough retail investors say they want to invest in the real economy rather than funding short term financial bets, providers will soon prioritise products that do this, even if they are less profitable to sell. The new LTIFs could also provide a welcome opportunity for retail investors to vote with their money and invest in dedicated long term vehicles.
You can also choose in which bank to deposit your money. In general, large universal banks with well-developed trading operations lend a far smaller proportion of their balance sheets (less than 30%) to the real economy than smaller banks do (about 70%).