International Monetary Fund staff members have warned European Union leaders that they need to drive forward the bloc’s capital markets union initiative to integrate national capital markets as they are about to lose their “de facto hub” when the UK leaves.
“European capital markets are split along national lines,” wrote IMF deputy chief of the European department Ashok Vir Bhatia, together with economists Srobona Mitra and Anke Weber, in an IMF staff discussion note presented at the National Bank of Belgium.
“In both banking and capital markets, the focus is domestic, an insularity that has increased in recent times with a strong retrenchment of bonds and bank loans.
“The prospect of a Brexit creates a risk that EU capital markets could be transformed from a hub-and-spokes system with London as the hub to a multi-node network structure. This could entail material efficiency losses, both during the transition and in the future steady state.”
The authors said the UK’s departure could hurt liquidity.
“The large number and volume of financial transactions executed in one place, across a broad range of instruments, creates economies of scale and scope and deep market liquidity, supporting price discovery and lowering transaction costs. Spreading trading and clearing across multiple locations could hurt efficiency.”
The discussion paper said another major problem was that much of the EU’s access to US equity and debt markets was through London, citing “a transatlantic dollar funding pipeline that helps finance large European holdings of US securities” that “would take time to replicate elsewhere”.
The IMF staff said Brexit is a “fourfold” challenge for EU capital markets.
As well as shrinking the overall size of the EU markets, disrupting some vital links and reducing liquidity, they also said the large-scale migration from London to the EU27 “requires urgent upgrades to oversight capacity and financial infrastructure”.
Another barrier was the lack of a uniform rules regarding insolvency, which deterred investors from financing companies in certain European jurisdictions that are seen as less creditor-friendly than the UK.
As part of the capital markets union, the EU has introduced minimum standards through the directive on restructuring and insolvency. But the IMF note said this was “silent on several critical issues, including the hierarchy of [bankruptcy] claims”.
The authors urged the EU to maintain close regulatory cooperation with non-EU countries on all capital market issues.
“This would in particular apply to a post-Brexit UK, given its tight financial links with the EU27.”
A separate report from research group New Financial, released earlier on Tuesday, said capital markets activity within the EU is forecast to shrink to 14% of overall global activity, from 20% currently, when the UK leaves the bloc.
The report said that the UK was the largest market for 24 of 30 capital markets activities across the EU at present. For example in derivatives and FX trading only a fifth of such EU activity takes place outside the UK.
“The EU is losing its largest capital market, and as a result capital markets in the EU will be significantly smaller on the other side of Brexit than they are today,” said the report.
Without the UK, France will be the most significant location for capital markets in the 27 remaining members of the EU, with a market share of 24%, followed by Germany with 21%.
At present the UK makes up 31% of all capital markets activities across the EU.
Report author Panagiotis Asimakopoulos said this would likely mean that a large part of EU capital markets activity will effectively be based offshore in the UK.
Another implication will be that the EU is more reliant on its banking sector for financing.
“EU capital markets will be significantly smaller and less developed than they are today, and the EU economy will be even more reliant on a struggling banking sector than it is today,” Asimakopoulos wrote.
The European Commission launched the Capital Markets Union initiative to try and develop a single capital market in various areas, including securitisation, across the EU.
It has had mixed success, particularly since Jonathan Hill, the financial services commissioner leading the proposals, stepped down in 2016 shortly after the UK voted to leave the EU.
Since the Brexit referendum some EU politicians have called for the UK to be banned from carrying out EU-specific activities post-Brexit, such as raising government bonds for EU members, and trading them.