Now that banking union has begun, the European Commission is focusing on two figures: European firms get approximately 80% of their external financing from banks and the remaining 20% by issuing bonds, while the figures in the US are, broadly speaking, the opposite. To bring us closer to the US situation the European Commission has set itself the goal of integrating and fully developing the different European capital markets by creating a capital market union. As will be argued in this article, more diversified sources of funding will allow borrowers to make the most of the advantages that each source offers although each alternative entails risks that must be taken into account.
Academic literature tends to distinguish between two basic types of financing channels: one indirect, based on banks acting as intermediaries between depositors' savings and loans to borrowers; and the other via the capital market, where those requiring funds obtain them directly from investors by exchanging different types of securities. The capital market is actually made up of a number of different markets: in addition to the traditional stock and debt markets there are new specialised markets where instruments are traded to better manage risk (derivate markets) or to broaden the base of potential investors (securitization and structured finance markets).
However, in addition to these two basic sources, widespread use of the internet is helping another channel to emerge based on the concept of crowdfunding. Projects are advertised on crowdfunding platforms and obtain funds via a large number of small contributions made directly by investors, mostly individuals. These contributions can take the form of loans (crowdlending), shares in earnings (equity crowdfunding) or even advances on the sale of a new product.
Each channel has its strong points in terms of promoting economic growth, so they are complementary in nature.1 Since banks establish long-term relations with their customers, they can collect more information on debtors and monitor what their loans are used for. This advantage is crucial in financing firms that do not generate easily transferrable information on their projects, such as SMEs and start-ups. Crowdfunding platforms can also be very useful for such companies if their innovative methods manage to pass on to investors reliable information about the projects being advertised. However, for those companies that do generate easily transferrable information, direct funding via the markets allows funds to be quickly reassigned towards those firms with the best prospects. This helps companies to grow rapidly, which promotes innovation. Moreover, the wide variety of instruments traded on the markets means that risk can be distributed more efficiently among those investors with a greater capacity to assume it.
The European Commission believes that Europe's financial system is too biased towards bank intermediation and therefore, so the argument goes, it is more likely to be unstable and delay economic recovery after an episode of stress. Recent studies point out that the high leverage of banks makes them very sensitive to shocks in asset prices that entail changes in value of collateral or capital, so they usually react by extensively expanding or contracting credit throughout the cycle.2 In the eyes of the Commission, this high procyclicality of bank credit is what justifies a regulatory effort to promote less procyclical alternative channels. However, encouraging greater use of alternative channels to finance companies could give rise to other risks.
In the case of capital markets, the growing intermediation in credit markets by asset management companies is, according to the International Monetary Fund (IMF), one of the main sources of risk. Intermediation is performed via certain investment vehicles (hedge funds, money market funds, mutual funds, listed funds and venture capital funds) which buy up corporate bonds, profiting from contributions from savers looking for alternatives to deposits and from the tougher regulatory requirements faced by banks to meet demand for corporate financing.3 The IMF's concern is that, once the stimuli applied by the different central banks start to be withdrawn, the liquidity sustaining these funds may not decrease gradually but abruptly, giving rise to mass asset sales. The real economy would therefore be affected due to the fall in value of collateral, contagion to the balances of other financial brokers and a reduction in financing in general.
The risk involved in this kind of intermediation comes from certain features of the asset management industry. The main risk is that the vehicles used are exposed to liquidity risk as they offer their investors the chance to redeem their positions with a frequency that might not be in line with the liquidity of the underlying assets. This makes them vulnerable to financial panics that could force them to sell their assets at fire-sale value. Another two features increase the risk of systemic contagion, the first being the importance of the management firm's asset reputation as a selection criterion for investors, reflected in the high concentration of this industry: of the total assets under management by the top 500 asset managers in the world, the biggest 10 control close to 25%. The second feature is the tendency of managers to follow very similar investment policies and react in the same way to any change in expectations. Both features are the result of the difficulty encountered by investors in judging the quality and performance of managers, so they evaluate them by comparing their results with those of the rest.
In the case of crowdfunding, the main risk lies in investors taking decisions based on insufficient or inaccurate information. In particular, for this alternative to achieve a critical mass of investors, greater certainty is required regarding the effectiveness of the mechanisms provided by the platforms to pass on truthful information on the management skills of their entrepreneurs, the real destination of the funds and the objective degree of risk of the projects presented.4 In the same way that banks make use of long-term relations to gather this kind of information, platforms invest in mechanisms aimed at determining the reputation of entrepreneurs: they encourage the disclosure of data about the managers (level of training, professional curriculum or track record of successful projects, for example), allow investors to comment on their experience with the firm and resort to third parties with an established reputation to certify project quality. Nonetheless, responsibility for verifying the information provided still comes down to the investors, which could be problematic as the small size of their investment at stake means that each investor tends to count on another making the effort to verify the data. This could lead to herd behaviour in the investor base: investing if someone else invests and not investing if no-one takes the first step. For this reason it is vital to develop a good regulatory framework that establishes the basic data to be disclosed by companies, requires platforms to invest in detecting fraudulent information and provides investors with some protection. Spain has already drawn up a regulatory framework along these lines although a harmonised framework at a European level will be required.
In short, developing alternative financing channels to bank intermediation involves more than just harmonising national regulations to achieve a single capital market at a European level. It requires greater insight into the information problems inherent in each source of financing and appropriate regulations to minimise the risks involved.
Bank Strategy Unit, Strategic Planning and Research Department, CaixaBank
1. See Levine, R. (2002), «Bank-based or market-based financial systems: which is better?», Journal of financial intermediation 11(4), 398-428.
2. Langfield, S. and Pagano, M. (2014), «Bank bias in Europe: effects on systemic risk and growth», Working Paper.
3. These intermediaries are considered to form part of shadow banking, as do dealers (placement agents and providers of wholesale services to other shadow banking segments) and securitisation firms.
4. See Agrawal, A. et al. (2013), «Some simple economics of crowdfunding», NBER Working Paper no. 19133.