European Union: Capital market fragmentation and the cost of non-cmu

In a recent speech, ECB President Christine Lagarde said that when the financing needs of an economic transformation exceed the capacities of fragmented financial markets, developing a capital markets union becomes crucial. This is the point at which the EU has arrived. According to European Commission estimates, financing the energy and digital transition will require more than EUR 700 billion annually. One way of reducing capital market fragmentation is by lowering the cost of information gathering for investors, e.g. through the harmonisation and, where possible, simplification of standards and regulations. This would increase the risk bearing capacity of investors and lower the cost of financing for issuers. This would represent an important step on the road to a much-needed capital markets union.

In a recent, important speech, ECB President Christine Lagarde made a strong call for action to establish a capital markets union. Faced with “an immense financing challenge, the moment for action is now. So I encourage all of us to be bold and not to let this moment pass.” The financing challenge concerns the huge investment needs in terms of the energy and digital transition. According to the European Commission, “additional investments of over EUR 620 billion annually will be needed to meet the objectives of the Green Deal and RepowerEU” whereas the digital transition -bridging the EU’s investment gap in this area- is expected to cost at least EUR 125 billion annually. Interestingly, C. Lagarde made a comparison with the US where the development of railroads in the 19^th century and the associated financing needs led to the development of capital markets to tap the domestic and foreign investor base. This was necessary considering that the banking system was too fragmented to be able to meet the investment needs throughout the country. According to the ECB President, history teaches us “that a capital markets union emerges when there is a need to finance an economic transformation that exceeds the capacities of fragmented financial markets.”

Capital market fragmentation can have many causes. Investors may prefer domestic assets -preferred habitat- because they have a better understanding and an easier access to information. Investors may be less familiar with foreign assets and may consider that the cost of information gathering is too high. International differences in terms of regulations -e.g. insolvency laws- increase this cost and may act as a barrier to international investments. International differences in terms of listing rules may reduce the willingness of companies to tap international capital markets.

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