Viewpoint: From fragmentation to integration – Unleashing the power of Europe’s capital markets

If Europe wants to stay ahead of the curve and be able to follow – and eventually lead – its international counterparts, the new European Commission should have a focused agenda that balances regulatory simplicity with forward-looking strategies. This is particularly the case in the areas of capital market integration, bank competitiveness, digital finance and sustainability.

Over the past few decades, Europe’s financial system has grown in size and complexity but remains largely bank-centric compared with more market-oriented systems. Important efforts have been made to diversify, deepen and integrate the European Union’s financial markets, including significant legislative initiatives like the Capital Markets Union (CMU) and the Banking Union.

A patchwork of inadequacies

Progress remains uneven and has stalled in some areas. Europe continues to grapple with fragmented banking systems and market infrastructures, and inconsistent regulatory enforcement across member states. As highlighted by both the Enrico Letta and Mario Draghi reports, this inconsistency causes competitive imbalances, hampers the effectiveness of the European financial market, leads to financial instability and reduces investor confidence.

For Europe to meet its ambitious goals in achieving the green and digital transformations, as well as strengthening strategic autonomy, huge investments are needed.

This investment gap cannot be bridged by public funding and bank financing per se. Equity markets, private debt and capital should be mobilised. However, a well-functioning capital market requires the clear oversight of all actors involved (e.g. issuers and investors, infrastructures, intermediaries, institutional investors).

Yet despite the deluge of rules enacted since the mid-1980s, harmonisation simply isn’t enough. There is still much room left to national enforcement powers which paves the way to gold-plating and significant asymmetries in supervisory practices.

As a result, EU capital markets lag behind other international markets. Europe has a low share of global equity and corporate bond markets, and fewer risk-capital investments. While the CMU has led some improvements, hurdles like limited integration and low participation levels by retail investors remain, requiring further regulatory action to increase market depth and investor confidence.

For CMU to flourish, a well-functioning Banking Union should go hand in hand. Europe’s banking sector, although large and well-capitalised, suffers from lower profitability, fragmented regulations and valuation disparities when compared with global counterparts. Yet despite the work of the European Central Bank and the European Single Supervisory Mechanism, the Banking Union still isn’t complete. There is no single rulebook for banking in the EU.

While the existing regulatory framework is substantial, it also hinders the creation of synergies from cross-border mergers and acquisitions (M&As) and stifles pan-European consolidation.

Uneven playing field practices when financial institutions fail, the absence of a common backstop to the Single Resolution Fund, the absence of a liquidity provision mechanism in resolution and the lack of a European deposit insurance scheme (EDIS) all present significant risks to long-term financial stability.

Staying ahead of the curve

A new CEPS report (undertaken jointly with its sister organisations, ECMI and ECRI), ‘Staying ahead of the curve: Shaping EU financial sector policy under von der Leyen II’, urges the EU to adopt a comprehensive agenda for advancing EU financial regulation and market efficiency.

The report identified the need to enhance enforcement structures, which involves allocating improved resources and implementing faster processes while involving European supervisory authorities to better manage increasing regulatory complexity. Alongside, a return to principles-based legislation is necessary to reduce overregulation, which can stifle innovation and reduce competitiveness.

“Competition-based measures should be adopted to improve market efficiency, reduce fees, and promote transparent, competitive investor outcomes through passive investment products”

Apostolos Thomadakis, CEPS

EU banks must become competitive on the global stage and this requires a regulatory framework that is both flexible and efficient, with proportionality for smaller banks. Crisis management and deposit insurance systems need strengthening, ensuring consistency when public funds are used during bank resolutions.

Instead of engaging in unproductive political debates about EDIS, efforts should focus on achievable steps that can foster more effective banking sector integration.

Unlocking EU savings through affordable, sizeable funded pension and long-term savings schemes will make Europe more attractive to both domestic and international capital. There also needs to be accurate diagnoses of what the capital market needs to be able to develop further, particularly concerning the EU securitisation framework – these are essential for avoiding any misguided policy recommendations.

Competition-based measures should be adopted to improve market efficiency, reduce fees, and promote transparent, competitive investor outcomes through passive investment products. Integrating trading and post-trading infrastructure will address fragmentation and ensure fair competition across trading venues, central securities depositories and clearing systems.

At the end of the day, a comprehensive overhaul of the financial services landscape is essential if the EU is to eliminate structural inefficiencies, ignite market dynamism, and fuel sustained economic growth.

Failing to undertake reforms in this crucial area not only hampers these ambitions but also imposes a significant opportunity cost, as well as potentially stalling other ambitious reforms – including those advocated for by Letta and Draghi.

In short, if the comprehensive yet necessary agenda outlined in this report is not seized upon with gusto by policymakers, then the EU risks undermining its broader economic and financial goals – to the detriment of us all.

Apostolos Thomadakis is head of research at the European Capital Markets Institute (ECMI) and research fellow, financial markets and institutions unit, at the Centre for European Policy Studies (CEPS)