Philanthrocapitalists meet the world’s poor: international development in the fintech era

Daniela Gabor and Sally Brooks

“Within the global development landscape, few funding areas are hotter right now than financial inclusion” (Inside Philanthropy, May 2016)

“The significant progress in moving away from cash that Bangladesh has made in such a short amount of time is due to the government’s strong leadership, the innovation of the private sector and citizens’ openness to a digital future”  (The Better Than Cash Alliance)

On day one of this year’s World Economic Forum at Davos, OXFAM named US philanthropists Bill Gates and Mark Zuckerberg on the list of ‘just eight men own as much wealth as half of humanity’. Why, the question was then raised, are we bashing ‘philanthrocapitalists’ like Gates who had donated so much of their wealth to tackling global poverty?

Philanthropists, we argue in a new paper, are far more influential in international development than commonly understood. After the 2008 crisis, international development has embraced financial inclusion as the new development paradigm. With this, development interventions are increasingly organised through a new alliance of developing countries, international financial organisations, ‘philanthropic investment firms’ and fintech companies, what we term the fintech-philanthropy-development (FPD) complex. The FPD version of financial inclusion – know thy (irrational) customer – celebrates the power of technology to simultaneously achieve positive returns, philantrophy and human development.

‘Transform mobile behaviour into financial opportunity’

The premise is simple. Poverty can be tackled faster if the poor have better access to finance. And something unpredecented is happening with the world’s poor in Sub-Saharan Africa, Asia, Latin America and the Caribbean. Roughly 1.7 billion of the 2 billion without formal access to finance have a mobile phone. These generate ‘digital footprints’ that can be harnessed by big data and predictive algorithms to better understand, and thus include, the ‘unbankable’. Transforming mobile behaviour into financial opportunity.

The FPD origins can be traced back to the Alliance for Financial Inclusion. Created in 2011 with funding from the Bill and Melinda Gates Foundation (BMGF) and endorsement from G20 as key to achieving the sustainable development goals, AFI brought together policy makers from ninety developing countries united in their commitment to work with private actors and international development organisations (the World Bank) in order to ‘reach the world’s 2.5 billion unbanked’. By 2014, the Omidyar Network (backed by Ebay founder Pierre Omidyar) would become the second philanthropic investment organization officially partnered with AFI. That same year, AFI launched the Public Private Dialogue Platform (PPD), promising the private sector ‘an unprecedented opportunity’ to connect to policy makers who are regulating new and high growth markets. In 2015, Mastercard, Visa and the Spanish bank BBVA have become AFI members, with more partnerships to be formalized in the future. Meanwhile, the AFI acts an umbrella and incubator for a growing number of global and regional FI programmes such as the UNDP-Funded ‘Mobile Money for the Poor’ (MM4P) and ‘Shaping Inclusive Finance Transformations’ (SHIFT), among others.

Thus, the FPD complex sees the growing influence of a digital elite in development interventions. The public-private partnerships are predicated on the idea that technology and big data can play a critical role in advancing financial inclusion. For example, the Omidyar Network is investing in fintech companies whose strategic goal is to ‘disrupt traditional risk assessment’ by, for example, predicting customers ‘appetite for risk’ based on ‘patterns of calls and text messages’, or even inviting them to participate in online games and quizzes that generate behavioural data that can be fed into predictive algorithms. The promise is to connect lenders to upwardly mobile customers. Through these strategies of what Izabella Kaminska has called ‘financial intrusion’, consumers’ ‘digital footprints’ are being created, without their knowledge, and used or stored for future commercial use.

A cash-lite future

India’s recent demonetization initiative has received global attention. Widely judged as a misstep, the decision to withdraw 86% of all cash from circulation is typically explained as fight again shadow economy. But there is more to India’s initiative. It represents one (important) element of its adoption of  the FPD approach to development.

Indeed, the state agreed to play an important role in the harvesting and commodification of digital footprints, by opening up its direct relationship with the poor to fintech. A spinoff from the AFI, the Better than Cash Alliance, encourages developing countries to digitalize social transfers, thus reaching the ‘unbankable’ at a stroke through the long arm of the state. Housed at the UN as implementing partner for the G20 Global Partnership for Financial Inclusion, the Better than Cash Alliance promises that a ‘cash lite’ Finance for Development agenda would put the UN’s Sustainable Development Goals within reach (Goodwin-Groen 2015).

The Better than Alliance has proved adept at illustrating the benefits of a cash-lite future. Digitizing payments from government to people can save the government of Bangladesh US 146 million per year across 6 social safety net programs. India, a member since 2015, saves USD 2billion by paying cooking gas subsidies digitally.

While such savings appeal immediately to governments worldwide, a Bankable Frontier Associates report made clear what is at stake in the ‘journey towards cash lite’. For financial service providers, the opportunities for FI via digital payments do not arise from increasing use of bank deposits by the previously unbanked, since bank accounts are not ‘daily relevant’. Rather, opportunities ‘come from financial service providers using the digital information generated by e-payments and receipts to form a profile for each individual customer’. This digital profiling then enables providers to offer more appropriate and relevant products.

Thus, data and algorithms become critical to pushing the risk frontier in low-income countries, as fintech companies create, collect and commodify behavioral data, within an ‘ecosystem’ fostered by networks of philanthropic investors, development finance institutions and donors and policy makers in participating countries.

Another, potentially more problematic issue arises in this process. Traditional microfinance lenders mobilised peer pressure in ‘solidarity groups’ to discipline borrowers to be ‘good financial citizens’. In the fintech era of international development, the mantra is ‘know thy irrational customer’ via algorithms. Cignifi for instance promises to continuously track changes in customers’ mobile behaviour, as mobile phones generate data that capture users moving from ‘one behavioural state to another’. This would allow lenders to create choice architectures that nudge customers in the direction of desired behaviours to preserve mobile-data-based credit score.

While the ethics of nudge are increasingly being debated, digital financial inclusion combines the inherent opacity of nudge techniques with that of predictive algorithm design, technically complex and subject to commercial confidentiality, in ways that have remained remarkably free from scrutiny.

While these programmes have adopted the language of inclusion and access, the question is who is actually accessing whom? Since the 2008 financial crisis a tendency to see its victims, rather than the system that created it as most in need of correction, has become entrenched. Meanwhile the possibilities of ‘fintech’ together with discovery of the ‘nudge’ toolbox has created new opportunities for financial capital to reach ever more remote consumers. As if the crisis never happened, this is the sub-prime ‘moment’ recast, perversely, as development policy, turning poverty in the developing world into a new frontier for profit making and accumulation.


There is nothing “simple” about the European Commission’s securitisation proposal

On May 23, 2016, 83 scholars from Europe wrote to the European Parliament to call for a careful consideration of the European Commission’s proposals for a new market for STS securitisations, part of the Capital Markets Union agenda. Members of the ECON Committee of the European Parliament are currently working on this proposal. Read the full letter here  – Open letter to MEPs – STS securitisation.



Why isn’t the Commission talking about government debt?

One more cue to how controversial government debt markets are in Euroland these days.

The European Commission’s progress report on Capital Markets Union, manages to make no reference whatsoever to the issue of government bond markets, their life after the ECB’s QE (bound to end someday) and their critical role in capital markets integration. It’s all about securitisation, corporate bond market liquidity and covered bonds.

Compare this with early views on what it takes to create a market-based financial system in Euroland. In May 1999, Alexandre Lamfalussy, recently appointed head of EuroMTS  and former head of the European Monetary Institute (that would become the ECB), had this to say:

 “We’ve seen an accelerated move to a market-centric system from the bank-centric system that has tended to prevail in Europe,” Lamfalussy said in London last month. “I have no doubt that a market-centric system is more efficient, but there’s a question whether it is stable.” The key to stability, he concludes – for the pricing of corporate as well as public debt – is a liquid and transparent government debt market.’

This is a story of shadow money – the ongoing struggle to define a social contract for liabilities issued against sovereign collateral.

Who is writing the IMF’s recent history?

No, this is not a blog about the impossible triangle IMF-Commission-Greece. I am skeptical anything new can be said about it.

It’s about something perhaps more fundamental: the IMF’s willingness to confront its inglorious past on the free movement of capital.

A couple of months ago, in February 2016, the Fund released a working paper by Atish Ghosh and Mahvash Qureshi, of the Research Department. That paper traces the historical processes through which capital controls became anathema to policy communities around the world, including the IMF. It doesn’t hide behind pretty memes (capital flow management) and technical language: visceral opposition to capital controls,  it argues, arose from the free market ideology of the 1980s and 1990s! It’s the politics.

The IMF Research Department, that paper shows, doesn’t need to hide behind closed doors to read Keynes, Eric Helleiner or Kevin Gallagher* . It can now do it in the open.

Skeptics of IMF’s revolutionary transformations (and I am one, as I argued here for IMF’s view of capital controls and here for global banking), would point to the institutional pathologies of the IMF. The Research Department has far greater liberty to engage in/with heterodox  alternatives, but that doesn’t always translate into profound institutional change.

What is different here: Lagarde has just nominated Atish Ghosh, together with the Princeton historian Harold James, to ‘chronicle defining moments in the Fund’s history’.

Professor James and Mr. Ghosh will write the Fund’s official history from 2000 to 2015, a period characterized by the global financial crisis, the crisis in Europe, and the growing role of emerging and developing countries in the world economy — all defining moments in the Fund’s history

This history  will include the pre-2008 near fall in oblivion (‘assisted’ by Venezuela’s oil money helping large countries pay back the IMF), the Eastern European and then Greek/Irish/Portuguese adventures, Blanchard’s reign with shifts on capital controls, on DSGE ‘supremacy’, on fiscal multipliers, on ‘we need to build analytical capacity for understanding global finance’. Cant wait to read it.

Daniela Gabor

*odd that the paper does not reference Helene Rey’s dilemma, but small miracles…


UK Economy is more unbalanced than ever

This article is taken from EREP’s 2016 budget report.

At the end of February, Chancellor George Osborne made an admission: ‘the economy is smaller than we thought in Britain’. The tone has changed since November when, following the unexpected discovery of a spare £27bn by the OBR, the Chancellor triumphantly declared, ‘our long term economic plan is working.’ As it turns out, the UK economy is around one per cent, or £18bn, smaller than the OBR predicted, leaving the Chancellor with at least £5bn in missing tax revenues this year alone, and more in future years (estimated at £9bn per year by the Institute for Fiscal Studies). There is no chance he will keep to his own misguided fiscal rule.

EREP have consistently argued that the supply-side optimism implicit in the OBR forecasts was unwarranted. We were right. Economic indicators across the board have deteriorated significantly since the November forecast. Even the service sector, the single remaining engine of the UK’s imbalanced economy, is now showing signs of mechanical failure. The Markit UK services PMI – a key indicator of activity in the services sector – fell sharply in February. There is no chance that UK growth will be 2.4% in 2016, as claimed by the Chancellor in November.

Osborne’s tax shortfall is the result of much lower than predicted wages and prices. The broadest measure of inflation, the GDP deflator, has fallen to zero, while wage growth has slowed substantially to around two per cent – the OBR had predicted wage growth of three to four per cent over the rest of this parliament.

Despite weakening wage growth, retail sales have remained strong: the most recent figures showed year-on-year spending increases in excess of two per cent. Retail sales strength has driven in part by lower prices resulting from the sharp decline in oil prices. But while households in other major economies largely saved the windfall from lower oil prices, those in the UK spent it, and more. The UK household savings ratio, at 4.4% of disposable income, is now the lowest on record.


And despite weakening wage growth, the UK economy is now entirely reliant on continued household consumption spending. Contrary to Osborne’s claim that growth ‘is more balanced than in the past’, the UK trade deficit is a drag on economic activity and business investment –  which only recently regained pre-crisis levels – fell sharply in February.

How have UK households increased spending despite wages remaining well below pre-crisis levels? Unsecured consumer credit is growing at around nine per cent per annum – the fastest rate since 2005. At over 140% of disposable income, UK household debt is higher than in the US, Japan or the largest European nations. Even the optimistic and now-discredited OBR forecasts predicted the household debt-to-income ratio would need to rise to 160% by 2020 for growth to be maintained and the deficit eliminated.

A recent report by the Money Advice Service – an independent body set up by the government – reports that 8.2 million adults in the UK – one in six of the population – are over-indebted. Among poorer regions, such as the Welsh valleys, the figure rises to one in four. The problem is particularly acute among young people, those in rented accommodation and those with children.

It is exactly these groups – working families and young people – whom the Chancellor will target in the next round of austerity. In the previous Parliament, austerity was targeted at the most marginalised: the sick, the disabled and the unemployed. Since these people have least voice in society, they are unable to put up resistance. Cutting the incomes of working families will be more difficult, as Osborne’s U-turn on tax credits shows.

By reducing working peoples’ incomes, Osborne is attempting push the burden of debt onto the household sector. The strategy will fail – without wage growth, consumer spending will eventually be constrained, dampening growth and pushing Osborne’s deficit-reduction strategy yet further off track. That deficit reduction is not really the ultimate aim of Osborne’s strategy is made plain by his intention to continue cutting tax for those on higher incomes.

There is no long-term economic plan; Osborne’s strategy is one of redistribution by taking from those who least can afford it. As the latest figures show, his strategy has backfired.


The report’s authors include:

Ann Pettifor & Jeremy Smith on “The British economy is even “smaller” than the Chancellor asserts”

John Weeks on the Chancellor’s “Growing record in fiscal mismanagement”

Jo Michell on “A weakening economy, reliant on consumption and debt”

Graham Gudgin & Ken Coutts on “A history of missing fiscal targets”

Richard Murphy on “Tax in the 2016 budget”

Information on EREP is available here.

The ECB as lender of last resort….or on the short memory of central bankers

ECB President Draghi speaks to France's Central Bank Governor Noyer and ECB Member of Executive Board Praet in Barcelona

Peter Praet, member of the Executive Board of the ECB, gave an interesting speech on the ECB’s lender of last resort (LOLR) activities in crisis on February 10, 2016.

The ECB, he argued, had a two-folded approach: a ‘monetary approach’ LOLR and a ‘credit approach’ LOLR.

The ‘monetary’ LOLR, following the classic advice from Walter Bagehot, lent European banks base money (reserves) if these banks had acceptable collateral. The purpose:

to create new reserves, on demand, for cash-stripped banks with viable business models, and thus to help these banks go through an emergency liability substitution operation without being forced to make large- scale fire sales of assets that would lead to insolvency

This approach, he suggests, was used in the first phase of the crisis, immediately after Lehman, when banks became reluctant to lend to each other, and in the second phase, the European sovereign debt crisis. In his account, the ECB bears no responsibility for either, the crisis being rather a combination of the confidence fairy and the sovereign-bank loop, somehow only ‘diabolical’ in Europe:

The second phase of the crisis came as a consequence of a much more targeted and disruptive loss of confidence: the sovereign debt crisis. This was special to Europe; it brought on the development of redenomination risk and thereby threatened the integrity of our currency. Banks’ exposures to selected governments came under intense market scrutiny and entire national banking systems lost access to wholesale funding.

The ‘credit’ approach involved the provision of emergency liquidity assistance – the now famous ELA. In contrast to the ‘monetary’ LOLR, this involves a more discretionary approach, whereby national central banks assume the responsibility, and the potential costs, for supporting banks without eligible collateral.

Imagine that Praet decides to read his own research before writing this speech. He chooses a 2008 paper he wrote with Valerie Herzberg, entitled ‘Market liquidity and banking liquidity’, while both were at Bank of Belgium. Here is a copy-paste of their arguments:

  1. Interbank funding is itself becoming increasingly dependent on market liquidity as a growing proportion of interbank transactions is carried out through repurchase agreements.
  2. This increasing reliance on secured operations means that (European) banks are mobilising a growing fraction of their securities portfolio as collateral.
  3. Banks are increasingly mobilising their traditional government and corporate bond portfolios to finance less liquid, but higher yielding forms of assets that again can be reused as collateral.
  4. In periods of stress, margin and collateral requirements may increase if counterparties have retained the right to increase haircuts or if margins have fallen below certain thresholds.
  5. Asset liquidity may no longer depend on the characteristics of the asset itself, but rather on whether vulnerable counterparts have substantial positions that need liquidating.

This, we argue with Cornel Ban in our paper ‘Banking on bonds’, is the untold story of the European sovereign debt crisis. Not a story of a confidence fairies and redenominations risks, but of rapidly growing European repo markets before the crisis (1 above), of European banks mobilizing their portfolios of European government debt as collateral (2 and 3), of runs on collateral markets, including the government bond markets of the European periphery (4), that reflected more the funding pressures of large banks involved in US shadow banking than the fiscal probity of sovereigns (5). The European sovereign debt crisis was a story of fragile collateral in market-based banking, rather than the convenient eruption of redenomination risk.

More importantly, we argue, the ECB increased stress in collateral markets exactly as Praet predicted in point 4: in its lender of last resort operations, the ECB increased margin and collateral requirements, made margin calls, and in general worsened funding conditions at critical junctures in the crisis, both for European banks and European sovereigns.

Thus, we show that the ECB has played a critical role in trying to energize the integration of national repo markets in the Eurozone in the early 2000s. It decided to treat all Eurozone governments as equal collateral for its collateral framework – the terms on which it lends, via repo operations, against collateral. With this, it hoped private repo markets would follow suit, and accelerate integration of European financial markets. Anticipating objections that this effectively encouraged fiscal indiscipline in Europe (objections so loudly formulated by 2005 by Willem Buiter that Trichet was forced to defend the ECB’s collateral decisions in the European Parliament), the ECB adopted the risk practices of repo market participants: daily mark-to-market, margin calls and haircuts.

In doing so, the ECB could argue that its collateral policies had no substantive impact on government bond markets for two reasons. First, banks had little incentive to use government bonds to borrow from the central bank, since its repos carried higher haircuts than private repo transactions (where haircuts were zero for government debt) and ECB-held collateral could not be re-used in the repo market. Second, the ECB stressed that its collateral policie accommodated market views of credit quality. If markets distrusted Germany, its bonds would fall in market value. Like any repo market participant, the ECB would mark German collateral to market and make margin calls. Rather than disrupt, the ECB argued that its collateral policies reinforced private market discipline.

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By trying to strike a delicate balance between its financial integration priorities and its independence, the ECB made a radical departure from how central banks in EMU countries had previously managed lending operations, including lender of last resort. These central banks rarely marked to market and never made margin calls when lending to banks (except the Dutch central bank), and few used initial haircuts.

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By 2012, the ECB recognized that market collateral practices matter, but refused to include its own practices in that analysis. Vitor Constâncio noted that ‘the decline in collateral values translates in additional collateral calls possibly compounded with higher haircuts and margins requirements. A system in which financial institutions rely substantially on secured lending tends to be more pro-cyclical than otherwise’. He could have added: ‘ a system in which the central bank relies substantially on secured lending tends to be more pro-cyclical than otherwise’. The graph below is illustrative – it shows that the ECB was making increasingly large margin calls throughout 2012, and those calls only diminished once it announced OMT.

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Short memory vs. politics and accountability? Had Praet followed through with his 2008 analysis, he would have had to make the ECB an active actor in the crisis. The dominant narrative that he reproduces in his 2016 speech –  that it miraculously came to the rescue of inept governments in the periphery – does not hold under scrutiny of his 2008 predictions. The European public – including governments – would have good reason to hold ECB accountable for its disruptive role in the European crisis.

China’s economy at a crossroads

With impecable timing, we are organising a one day conference on China in Copenhagen, on January 26. The blurb below, program and registration here.

Since the global financial crisis, it is becoming increasingly apparent that China matters for the stability and growth of the world economy. Yet questions of how, why and to what extent have not been settled. Pessimists predict a hard landing that will spread deflationary pressures across the world, while optimists retain their faith in the ability of China to learn from its experiments and keep the engine running. In this conference, we engage regulators, academics and market participants in a conversation that explores critical questions of macroeconomic rebalancing, debt and currency management, RMB internationalization, monetary policy and capital account liberalization.

Christopher Balding, Peking University, HSBC Business School
Luke Deer, Post-Doctoral Research Fellow, University of Sydney
Daniela Gabor, Associate Professor, University of West England
Tao Guan, Senior Fellow at CF 40, former Director-General of Balance of Payments Department, State Administration of Foreign Exchange (SAFE)
Patrick Hess, Senior Financial Market and China Expert, European Central Bank
Hu Hongbo, First Political Secretary, Chinese Embassy of Copenhagen
Yang Jiang, Senior Researcher, Danish Institute for International Studies
Zhang Jun, Director of China Centre for Economic Studies, Fudan University
Annina Kaltenbrunner, Lecturer, Leeds University Business School
George Magnus, Associate at Oxford University’s China Centre
Allan von Mehren, Chief Analyst and Head of International Macro, Danske Bank
Anders Svendsen, Chief Analyst, Emerging Markets Division, Nordea
Niels Thygesen, Professor Emeritus, University of Copenhagen
Jakob Vestergaard, Senior Researcher, Danish Institute for International Studies
Ming Zhang, Director, Department of International Investment, Institute of World Economics and Politics, Chinese Academy of Social Sciences (CASS), Beijing


Central banks have to get off the liquidity death star before they can destroy it


Streetwise Professor warns that clearing and collateral mandates create a ‘sort of liquidity death star’ because collateral-based funding (through repo markets) creates systemic liqudity vulnerabilities: margining leads to spikes in demand for liquidity, that in turn forces sales in illiquid markets, with further price volatility and margining. The mechanics of fire-sales and liquidity illusions are well known to regulators since Lehman (read Tarullo here), though the solution – clearing houses – doesn’t do away with the problem since it increase reliance on collateral sourced through repo markets.

Two further points.

  1. Central banks cannot fight the liquidity death star until they get off it. For a central bank to fight the liquidity death star, the Professor argues, it will need to ease collateral constraints by expanding the definition of ‘good’ collateral. This, of course, was the first measure that central banks across the world took after Lehman. But accepting ‘bad’ collateral won’t solve liquidity problems as long as central banks’ extraordinary lending relies on the same collateral practices that created (funding and market) liquidity problems in the first place.

Since the late 1980s, central banks have increasingly used repos to implement monetary policy, lending against collateral    instead of outright purchases of government bonds (the traditional form of open market operations). The turn to repos in monetary policy implementation prompted central banks to adopt the collateral risk management practices used by repo markets – the graph below shows that as the ECB took over from national central banks, it marked the beginning of a new regime for lender of last resort, where ECB marks collateral to market, and calls margin on a daily basis*.

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Consider this scenario. When liquidity demand spikes and collateral constraints tighten, financial institutions turn to central banks. As good lenders of last resort seeing the death star approaching, central banks lend against ‘bad’ collateral.  But at the same time,  to protect themselves against credit risk, central banks mark-to-market and call margin if that ‘bad’ collateral falls in market price. Central bank margining means that a financial institution borrowing from the central bank against bad collateral faces the same funding pressures that it would experience in private funding markets.  This is exactly what happened to European banks during the sovereign debt crisis – with ECB making large margin calls at the height of the crisis in 2012.  The traditional crisis intervention – providing banks with funding liquidity – becomes pro-cyclical.

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The money view – developed by Perry Mehrling and others – provides important insights. A crisis of market-based finance needs central banks to be much more than lender of last resort. As  dealers, or market-makers of last resort, central banks need to support the monetary quality of collateral-based liabilities, that is, to support (collateral) market liquidity. This is what OMTs did in Europe. A much messier world of central banking, as Mario Draghi well knows.

2. The repo ‘paradox’ – the growing post crisis collateral-based regulatory regime has not been matched by significant regulation of repo markets. At global level, the FSB has watered down plans to impose minimum (through the cycle) haircuts on all collateral – including government bonds. Latest plans leave out repos between banks and repos with government collateral. There is little left after that. In Europe, the Commission and Parliament have finally agreed on transparency requirements for repo markets, without any structural regulations. With the Capital Markets Union plans in full swing, transparency is as far as Europe will go.

Daniela Gabor

*for more on the ECB and the European repo market, read Gabor, D. and C. Ban (2015) Banking on bonds, Journal of Common Market Studies

Capital Markets Union: the view from London

Today, I attended a CMU event organised by Bruegel and HM Treasury at Westminster. The keynote address from the City Minister Harriet Baldwin was followed by a panel with market participants (the buy side – asset managers and insurers – and a credit rating agency), a Commission official and a Treasury official. The view from the government: UK a staunch supporter, celebrating the CMU as an excellent initiative of the type that Brussels and the EU should be generating more often. Having a UK Commissioner in charge of CMU clearly helps. Beyond the consensus ‘CMU is a good idea’ and between the lines, I noticed three issues.

  1. ‘It is our strong belief that institutional change is not required to achieve the objectives of the CMU. Single supervision would not add anything’

This is one of the sensitive points in CMU, and a lot of energy spent in documents and meetings to pretends that’s not the case. Although the Commission and several member states (see the 5 presidents report) would prefer to create a supranational regulator for integrated capital markets, UK opposes it strongly. According to this view, ESMA – the candidate for a pan-European regulator – is best placed to ensure that national regulators implement supervision effectively. In the context of the Brexit referendum, ‘the last thing we need is institutional change’ captures well the British politics of the CMU.

Is there a danger that European states repeat the pre-crisis mistakes with cross-border banking? The banking crisis demonstrated that the prevailing regulatory nationalism  was ill suited to deal with the coordination issues between home and host regulators. Ask any Eastern European banking supervisor.

The pessimistic British response to this question points to the foot dragging on the institutional architecture of the Banking Union. The hesitations and compromises there are steadily eroding (market) confidence in the ability of European politicians to create strong pan-European regulatory bodies. The optimistic view is that supervisory convergence that harmonizes rules would be enough to put the CMU on strong foundations.

One of the panelists questioned the premise of the optimistic view that for a single market it is enough to have common rules (and I would add, a rather fuzzy notion of ‘convergence’). In accounting, the application of rules (international standards) is not uniform – the fragmented enforcement of rules effectively entrenches the type of cross-border barriers that CMU aims to remove. The Commission recognises the validity of this point but is prepared to put the question aside because it wishes to avoid politically divisive topics.

So instead of calibrating the regulatory architecture to integrated markets, CMU envisages as next step a comprehensive review of post-crisis regulation. Given the complaints from the industry on the post Lehman ‘regulatory tsunami’ (loud and clear at this event too), expect this ‘proportionate regulation’ agenda to accelerate the process of watering down regulation that is already unfolding.

Recall this argument when your UK pension fund with exposure to German SME securitisation takes a massive hit due to large defaults in a market illiquid during crisis. And pray that ECB has normalised ABS purchases.

  1. ‘CMU will not harmonize borrowing costs for SMEs until there is a mechanism for rebalancing sovereign risks in Europe’

Market participants typically focus their CMU interventions either on deploring ‘regulatory tsunamis’ or identifying CMU areas that would improve synergies of their business model. In an unusual departure from the script, one panelist sought to make constructive criticisms. And it picked the elephant in the CMU room: government bond markets.

It is surely a measure of the creative genius of European regulatory politics that a project on furthering the integration of debt markets manages to say nothing about the largest debt markets in Europe (in Eurozone, EUR 6.8 trillion out of EUR 14 trillion outstanding in August 2015). Before Lehman and the sovereign debt crisis, the European agendas for financial integration used to stress the critical role that government bond markets play in financial markets, as proxy for risk-free interest rates, benchmark and hedging instrument for positions in other fixed income markets, and reserve ‘safe’ asset. The ECB made the integration of sovereign bond markets a priority, and used its lending collateral framework to accelerate it (by treating all Euro sovereigns as identical in terms of credit risk). The 2002 Collateral Directive was designed with the same ambition in mind – to allow private financial institutions to raise funding cross-border regardless of what sovereign collateral they use.

So can we have integrated capital markets with fragmented government bond markets? One of the panelists argued that  securitisation performance across countries reflects credit differences between sovereigns (the graph below, in a rather bad photo, mea culpa). So much for reviving the European securitisation market.


Yet the CMU authorities have tended to fudge this question because answers are as politically divisive as the issue of supranational regulator. If CMU was to make government bond markets a priority, what would concrete policy measures look like? Put differently, if CMU is about persuading German savers to give money to Portugese corporations without a bank in between*, what would it take to persuade that German saver to give money to the Portugese government? Or even more complicated, how much would a Portuguese SME need to pay a German saver to borrow when that saver is reluctant to lend to the Portuguese government?

Here the CMU official supporters answer the usual European way – not a priority to think about it.

  1. ‘ As public policy makers we have to deal with competing objectives, and balance them carefully. The FTT / CMU is a good example’

Private finance agreed that the FTT plans are at odds with CMU. Putting the FTT genie back in the bottle has been a priority, particularly for the European banking lobby**.

Yet the FTT genie has proven more resilient than many expected. Recent statements suggest a new impetus to finish negotiations, as France independently decided to extend its own FTT to intraday trades. This raises interesting questions of coordination between DG FISMA, that is designing CMU, and DG Taxud, that designed and (still) defends the FTT in the working groups of the 11 member states. The best that the former can do is to follow negotiations closely and ensure that member states are aware that the tax should minimize impact on market liquidity and NEVER EVER include the repo market.

The repo market has always enjoyed a privileged position in the minds of European regulators – particularly the ECB***. The Green Paper on CMU made some oblique references to it, stressing the importance of collateral fluidity to ensure that securitization activities can be funded in cross-border repo markets. ‘Fluid’ collateral appeals to the pre-crisis image of the repo market as an engine for financial integration that led European regulators to endorse the creation of a market architecture governed entirely by private rules. Since the crisis, we know that private architectures creates systemic vulnerabilities – this is why the FSB has identified repo markets as markets systemic to shadow banking. Yet so far the only reform European regulators are prepared to contemplate has been increased transparency of repo transactions, despite warnings from the ECB that ‘The interaction between CMU and shadow banking reform needs to be addressed. This interaction is not addressed in the Commission’s Green Paper, but it is relevant.’

The priority remains funding for SMEs. Repo, shadow banking, government bonds, and supranational regulation, are not a priority of CMU. The art of political compromise in Europe rests precisely on that ability to postpone critical questions. If we try very hard to ignore these questions they may go away.

* best translation I’ve heard of the CMU ambitions.

** the EBF response to the CMU Action Plan stresses that ‘ If European lawmakers are indeed serious about CMU, they also need to recognise the importance of liquidity in financial markets. Proposals such as the Financial Transaction Tax (FTT) and Bank Structural Reform (BSR) are at odds with the objectives of CMU. Dropping these proposals will greatly enhance the chances of success for CMU’.

*** for those interested in the FTT on repo markets, you can read more here: A step too far? The European FTT on shadow bankingJournal of European Public Policy 

Daniela Gabor

Putting the Capital Markets Union on sustainable foundations

Last week, the European Commission launched its Action Plan for a European Capital Markets Union (CMU). By European standards, this ‘most significant EU proposal for the last 10 years’ has proceeded at rapid pace under the leadership of the British Commissioner Lord Hill. For those attuned to the complexities of European politics, the CMU is a peace offering from Brussels (Berlin/Frankfurt) designed to showcase the strategic benefits that UK (and its City) enjoys from EU membership. Its (referendum) politics aside, the CMU’s ambitions are great: SME financing and job creation, growth via capital markets. Yet, we argue, if the CMU is to make a substantial and lasting contribution to investment and job creation in Europe, it must be accompanied by reforms that address systemic risk in securities-based financial systems and enhance pan-European supervision of securitization and repo markets.

The crisis of European banking after the collapse of Lehman was a crisis of market-based banking. European banks engaged in structured finance and other off-balance sheet activities were threatened by insolvency in 2008, leading to significant bail-out costs for European sovereigns. According to IMF research, 18 out of the 25 TBTF European banks vulnerable due to their trading activities required bailouts after 2008.  Since, as the IMF put it, ‘the vast majority of global finance is intermediated by a handful of large, complex financial institutions’,  initial regulatory efforts focused on reforming banks that had migrated to leveraged, interconnected, market-based activities. This also involved – through the FSB – global initiatives to curtail banks’ involvement in shadow banking, particularly in securitization and repo markets.

In this context, it is remarkable to see the growing consensus that growth in Europe requires more market-based finance. The European Commission makes the following case:  banks are still repairing balance sheets, new regulatory regimes increase their costs, making lending – to SMEs and other businesses – expensive. Allowing banks to engage more in capital market lending via securitisation, and to fund it in short-term money markets, would improve lending conditions in Europe, restarting growth. Those familiar with Perry Mehrling and Zoltan Pozsar’s work will recognise this ‘money market funding of capital market lending‘ as shadow banking.

Ironically, all evidence suggests that a Capital Markets Union is unlikely to improve SME financing. It’s unclear how much European SMEs are constrained not by limited access to finance, but by shortage of customers (i.e, demand). Stefanie Schulte, from RWGV, a German cooperative banks association, argues that even in the United States, the country upheld by the Commission as the model country in terms of capital markets, SME loan securitization is small and supported by public guarantees.  Here in Europe, when Germany recently tried to help SMEs issue bonds, the result was a wave of defaults and insolvencies. That experience suggests that the policy goal should not be to to reduce SME’s reliance on bank lending, but to nurture competitive and viable relationship banking. The argument of an over banked Europe compared to US is also bogus, Schulte argues:

   U.S. Federal Deposit Insurance Corporation (FDIC) counts more than 6400 credit institutions, among them thousands of small, privately owned, regionally active community banks. Community banks provide almost half of all small business loans in the U.S. In addition to this, there are more than 6000 credit unions. Per 1 million citizens, there are more than 40 banks and credit unions in the U.S. Now compare this to Europe: Here, Germany is one of the few countries with a relatively high density of banks. There are nearly 23 banks, credit cooperatives and savings banks per 1 million [German] citizens.

Four issues are essential to address for a sustainable CMU:

First, it is of paramount importance that key principles of “good securitisation” are not watered-down through pressure from large, international banks. Insisting that banks have a “skin in the game” is meant to avoid the perverse incentives that led to the global financial crisis. At the levels discussed now, however, risk retention requirements are too small to matter. Similarly, ongoing industry pressure to include synthetic forms of securitization in the CMU framework completely undermines the key notion of “simple” securitisation. The current ambiguity on whether to allow tranching in the forms of securitisation that are to be deemed ‘high quality’ also severely undermines the notion of simple and transparent securitization – since tranching by its very nature renders securitized products complex and opaque. A sustainable CMU must stand firm on the core principles – allowing only truly simple securitization in the framework, and insisting on substantial risk retention on the part of issuers. If it does not, it risks undermining rather than enhancing prosperity and growth in Europe.

Second, the CMU is likely to further increase the systemic importance of large banks in capital markets. Until recently, regulators in Europe were contemplating banking separation reforms to address the problem of too-big-to-fail banks. With the CMU, TBTF banks are likely to become larger still, as they will play key roles in reviving securitisation as issuers and market-makers. For their market-making activities, banks rely on collateralized funding markets, where borrowing against collateral makes leverage cheapest. So when the CMU speaks of the importance of “collateral fluidity”, it is essentially saying that we should ensure that collateral based funding for large banks remains unregulated although there is compelling evidence since the global financial crisis that banks run on each other in wholesale funding markets. Two implications result from this: (1) the sustainable CMU must abandon the notion of “freely flowing” collateral, instead adopting the (already watered down) minimum haircut requirements framework developed by the FSB and (2) serious banking separation reform must be pursued in parallel.

Third, regulators should take note that national supervisory regimes for capital markets are neither converging nor consistent. A pan-European agency that regulates European capital markets directly will be necessary to mitigate the cross-border nature of systemic risk in integrated capital markets, just as the Banking Union proved indispensable to adequately supervise large, cross-border European banks. Integrated capital markets are still vulnerable to sudden shifts in market liquidity, as the global financial crisis demonstrated that even very large markets can see liquidity evaporating rapidly. Without a pan-European regulator that can take countercyclical measures, it is difficult to see how systemic risks arising from European capital markets could be effectively addressed. An institutions-based regulatory regime – the one we have been building since 2008 – is ill suited to address (capital) market fragilities. A sustainable CMU must recognize that integrated capital markets cannot have segmented regulation.

Fourth, the action plan unveiled last week promotes a private Capital Markets Union. While the Commission has been reluctant to spell out the implications for government bond markets, it is important to recognize that the cornerstone of financial systems, government bond markets, have been (further) segmented by first the banking and then the sovereign debt crisis. Recent improvements are mainly due to the ECB’s quantitative easing (QE) and OMT commitments. Yet such unconventional monetary policies are designed to be temporary, while Europe has seen growing pressures for revisiting the preferential regulatory treatment of government bonds. Alberto Giovannini, one of the early architects of the European financial architecture, reminds us that ‘a very large proportion of the securities-based financial system requires means of transactions, and riskless government securities are best candidates’. How can capital markets function without risk-free sovereigns? Credit ratings and market liquidity will matter even more, thus sharpening the existing asymmetries between ‘periphery’ and ‘core’ (read Germany) governments.  Since the latter are more inclined to run budget surpluses, the second answer is exactly what brought us the 2008 crisis of shadow banking: private sector takes over the provision of ‘safe assets’.  A sustainable CMU should aim to eradicate existing asymmetries in market liquidity so that integrated government bond markets support the convergence in the costs of market funding for businesses across Europe.

Daniela Gabor and Jakob Vestergaard

The essay is based on ongoing joint work. We are grateful for comments from Vincenzo Bavoso and Frédéric Hache.