Foreign Affairs

May/June 2001

 

Continental Shift: The Securitization of Europe
By Robert C. Pozen

 

A dramatic shift is underway in the structure of European finance. Breaking with the past, European companies are increasingly financing their operations through securities instead of bank loans. This transformation, along with the growing integration of Europe's capital markets, could create business and investment opportunities in Europe as attractive as those enjoyed in the United States over the last decade. These changes could also help head off the looming pension crises facing many European nations.

During the 1990s, the United States experienced what is known as the securitization of finance. Money markets, corporate bond markets, venture capital, and publicly traded equity substantially displaced bank deposits and loans as both savings vehicles and sources of corporate finance. In 1999, traditional bank loans to U.S. companies fell to barely 12 percent of GDP, while U.S. stock and bond markets each soared to values of more than 150 percent of GDP. Private savings and investment patterns shifted as well. Over the last decade, the share of American household assets held in bank deposits dropped by half, from 25 percent in 1990 to 12 percent today. Meanwhile, Americans nearly doubled the share of their savings held in mutual funds and individual stocks, from 22 percent in 1990 to more than 39 percent today.

This securitization movement helped drive the surge in the U.S. financial services industry during the 1990s. A similar trend is now emerging in Europe, along with similarly promising business opportunities.

Super Markets

Over the next decade, the 15 members of the European Union (EU), with their 375 million people and combined GDP of nearly $9 trillion, will likely be joined by a number of eastern European and Baltic states. This expanded European market would then total more than 500 million people -- nearly twice the U.S. population -- and enjoy a combined GDP close to or larger than America's $10 trillion output. Although European stock and bond markets are now only half the size of their American counterparts (measured as percentages of GDP), they could grow dramatically if the EU successfully integrates its capital markets.

The EU's introduction of the euro has already accelerated the growth of the region's financial markets. For the 11 members of the European Monetary Union, the common currency nullified national requirements for pension and insurance assets to be invested in the same currencies as their liabilities -- a restriction that had long locked the bulk of Europe's long-term savings into domestic assets. Freed from foreign-exchange transaction costs and risks of currency fluctuations, these savings have fueled the rise of larger, more liquid European stock and bond markets, including the recent emergence of a substantial junk bond market. These more dynamic capital markets, in turn, have placed increased competitive pressure on banks by giving corporations new financing options and thus lowering the cost of capital. The euro's impact will expand even further when euro bills and coins go into circulation in January 2002.

Since the euro's debut in 1999, the booming pan-European bond market has forcefully challenged the dominance of banks in European finance. Two decades ago, more than 80 percent of European corporations' external finance came from banks. Even by 1995, Europe's corporate bond markets remained small, issuing less than $50 billion in bonds that year -- only one-sixth the value of Europe's syndicated bank loan market. But since 1998, the issuance of bonds rated by Standard and Poor's as "investment grade" has more than doubled, totaling more than $200 billion last year. Meanwhile, the issuance of junk bonds tripled from less than $4 billion in 1997 to more than $12 billion last year. The total value of the eurozone's bond markets now nearly matches the region's GDP; this ratio, however, still remains well below the American bond market's 166 percent of U.S. GDP, leaving plenty of room for growth.

As a result of this bond market boom, the historic stranglehold that European banks have had on credit provision has given way to competition, more market discipline, lower capital costs, and greater openness about companies' finances. Since the euro's introduction, for example, the number of European companies whose securities have been rated by Standard and Poor's has climbed 38 percent. Today, European banks can hardly expect to win back lost business by pitting commercial loans against such dynamic capital markets. Instead, they will likely emulate their American counterparts by converting their predictable revenues from mortgages and credit cards into securities that they can later sell.

The euro is also spawning an equity-investment culture among European citizens. Lower interest rates and uncertainty about the solvency of national pension systems have prompted millions of Europeans to transfer their savings from the safe havens of bank deposits and government bonds to higher-returning investments such as mutual funds and individual stocks. Over the past five years, for example, Italians have poured their savings into mutual funds -- and the share of their assets held in bank deposits and government bonds has dropped from nearly 80 percent to just over 50 percent. Likewise, in the first half of last year alone, the number of Germans owning company shares increased by 25 percent, while the number of Germans investing in mutual funds surged 70 percent, from 4.7 million to 8 million.

As a result, European stock listings and trading volumes have soared, and new stock exchanges such as the pan-European Easdaq and the German Neuer Markt have taken off. Over the past generation, the value of European stock markets has grown at a compound rate of 20 percent a year, from barely $200 billion in 1979 to $7.4 trillion in early 1999. Among the eurozone nations, stock markets are now worth nearly 90 percent of GDP. These burgeoning stock markets, in turn, are spurring the growth of hedge funds and venture capital, as well as initial public offerings, which raised a record $47.1 billion in Europe last year.

In short, the euro has catalyzed a transformation in European finance that is now seeping into politics and popular culture. Continental Europe is growing more responsive to market forces and more receptive to a wider range of choices and a higher level of risk. This translates into growing political support at the EU level for a single, open market in financial services.

Big Breaks

At the national level, governments are already making reforms to encourage the growth of their financial markets -- most notably in Germany, the EU's largest economy. Gerhard Schroder, Germany's Social Democratic chancellor, is now passing market-friendly tax reforms that could transform the German and European economies. His government has cut corporate capital gains taxes in half, effectively liberating $300 billion in appreciated stock holdings for investment in promising new enterprises. It has lowered taxes on the earnings that companies do not distribute to shareholders, from more than 42 percent to less than 27 percent. And it has cut taxes on corporate dividends to half the current personal income tax rate, the highest bracket of which is slated to drop from 51 percent to 42 percent by 2005.

Germany is also considering ground-breaking pension reforms, including the creation of prefunded pension plans to supplement the existing "pay-as-you-go" system (financed by current contributions). These reforms would be significant even if they were limited to Germany's $2.7 trillion domestic economy. But if Schroder's reform package succeeds, it could also spur other European governments to follow suit.

Despite such progress on the national front, however, advancement has been slow at the continental level. Policymakers, corporate leaders, and financial media across the region all recognize the loss of economic potential caused by a fragmented financial market. Indeed, the rhetoric of European Commission (EC) studies, legislative initiatives, and resolutions conveys a palpable sense of urgency and frustration. In the mid-1990s, the EC set an ambitious agenda for achieving a truly open, unified financial services market by 2005. Just last year, a committee of experts appointed by the commission called for moving up that deadline, warning that delay could result in "unnecessary costs and a suboptimal European economic performance." Despite such prodding, however, many national governments continue to shelter domestic financial interests under the name of "consumer protection" by imposing regulatory costs that effectively tax cross-border financial transactions and thereby lower investment returns. Such barriers are particularly problematic for foreign corporate takeovers, mutual-funds markets, and pension funds.

Over the past seven years, particularly since the debut of the euro, European mergers and acquisitions activity has surged, nearly doubling from $800 billion in 1998 to more than $1.5 trillion in 1999. But companies seeking cross-border takeovers still face difficult obstacles. National "champion" companies often mobilize political support against foreign acquirers, as Telcom Italia did in opposing a takeover bid from Deutsche Telekom two years ago. In the 1999 "war of the handbags," Italy's Gucci successfully fended off a takeover bid from France's Louis Vuitton by issuing shares that sharply diluted minority holders' values -- without their permission.

These tactics were disconcerting to many investors. But even more troubling are two recently proposed amendments to a new takeover code passed by the European Parliament. The first proposal would allow companies to employ defensive tactics like Gucci's with impunity and without seeking shareholder approval. The second provision, requiring EU corporate directors to maintain "a view to safe-guarding jobs," would constrain many mergers that would inevitably result in redundant positions. Unless these two amendments are de-fanged or eliminated in the final EU takeover code, the new directive could impede the long-overdue integration of corporate Europe.

Legal obstacles may also prevent the development of a truly integrated European mutual-funds market. Sixteen years ago, the EU adopted a law providing a standard "passport" for European mutual-fund managers to register their offerings and do business smoothly across borders. This law, along with recent amendments that extend the passport to cover most money-market funds, was a step in the right direction -- but much more work remains.

Today there are more than 21,000 mutual funds in Europe -- nearly three times more than in the United States. Since 1995, their total holdings have more than tripled, from o1.2 trillion to o3.6 trillion. Half that gain came in the past two years alone, as mutual funds became the fastest-growing segment of eurozone savings.

This growth has remained largely within national boundaries, however, because the rules governing mutual funds have been left to individual countries to decide. The result is a crazy quilt of regulations on the disclosure of fund investment and performance, advertising, registration fees, and the distribution of customer reports. In many countries, local funds still enjoy tax advantages over cross-border funds. And in some countries, bureaucrats have shown fantastic creativity in orchestrating delays, expenses, and red tape for mutual-fund providers incorporated in other EU countries. Thus, the average European mutual fund is less than one-sixth the size of the average American fund, and European fund fees average 50 percent higher than those in the United States.

To correct these distortions, the EU should move toward a single regulator for mutual funds throughout Europe. At a minimum, the EU should set uniform standards for calculating returns, advertising performance, disseminating customer reports, and other aspects of fund marketing. It should also allow mutual funds sold in various countries to achieve economies of scale by investing in a common pool of assets. These changes would bring significant savings and benefits to both financial companies and individual investors throughout the continent.

Retirement Securities

Pension reform may be the single most important policy choice Europe faces in this decade. Germany, France, Spain, Italy, and other European countries rely primarily on pay-as-you-go state pension systems and will soon face major fiscal burdens as their retirement populations increase and their work forces shrink. Raising taxes or cutting benefits would be politically unpopular ways for these countries to close their financing gaps. A better way to address the problem would be to increase the returns on pension funds by pooling resources and investing in higher-returning securities.

The EU has made a positive step in this direction by introducing legislation that would permit private employment-linked pension funds to invest up to 70 percent of their assets in equities, giving them far more latitude than they have under current rules. Yet an even more effective step would be to allow European pension-fund managers to freely invest in a diversified portfolio of securities, using the same standards of care and judgment that a reasonable person would apply to his or her own investments -- a principle known as the "prudent person" standard.

In its own 1999 report, the ec found that from 1984 to 1996, pension funds using prudent-person standards reaped annual returns averaging 9.5 percent, while funds with quantitative restrictions averaged annual gains of only 4.3 percent. For an individual, this performance gap makes a staggering difference when compounded over a working lifetime. For a policymaker, it should be compelling grounds for reform.

European pension funds could yield even greater returns if pooled across the continent, thus achieving lower costs and greater economies of scale. For example, contributions to Germany's public pay-as-you-go retirement system are projected to produce annual investment returns of less than one percent for people born after 1970. Market-based private and employment-linked pension plans operating on a pan-European basis could deliver much higher returns, especially if fund managers were free to invest by prudent-person standards.

But the cross-border barriers for pension funds are even greater than those for mutual funds. Currently, European pension-fund managers do not even have a "passport" for doing business in other EU countries. Some countries insist that their pension funds be managed by individuals physically stationed in a local office or by specialized institutions established in a local jurisdiction. These barriers impose significant costs on pension investment.

So far, the EU has been unable to come to grips with the politically sensitive demand that employment-linked pensions receive equal tax treatment among its member states. But unless this issue is addressed, it will be difficult for companies to consolidate their pension plans across Europe or for employees to take their benefit packages with them to new, cross-border jobs. The result will probably be a continued preference for national pension systems instead of larger, EU-wide models that could produce higher returns for beneficiaries.

Whether Europe can find the right balance between national sovereignty and open markets will be put to the test in current negotiations over EU legislation to guide employment-based pension reforms. The levels of pension contributions and benefits will likely stay under national control, since these are fiscal issues that affect a country's budget. But the investing of pension funds could and should take place on a pan-European, if not global, basis.

An integrated, market-based approach to all pension investments could do more than just help defuse Europe's retirement time bomb. Trillions of euros invested on a continental scale could turn a serious fiscal threat into reliable fuel for capital markets. Integrated financial markets could become engines of innovation, growth, and jobs in Europe, while creating profitable new opportunities for financial institutions and individual investors around the world.

Robert C. Pozen is Vice Chairman of Fidelity Investments and President of Fidelity Management and Research Company.