The quote of “Who do I call if I want to call Europe?” attributed to former US Secretary of State Henry Kissinger was no doubts referring to a foreign minister counterpart to discuss geopolitical issues, but it may also just be as valid when considering EU regulations and practices for corporate borrowing requirements.
Financial rules and customs don’t pop out of a hat. They reflect the business history, economic, cultural and legal features of a country, as well as the financing function available to companies carried out by financial markets, banking sector and, in some cases, governments.
The US has the significant advantage over the EU of offering across its 50 states similar property, contract, insolvency and federal tax laws. In contrast, legislation out of Brussels has generally aimed to create a minimum set of rules among its member countries to offer a more level-playing field among the various operators competing in the bloc.
There are clear differences between EU countries. The bloc’s financial scenario is made up of a diversity of local markets, with countries having their own special features in relation to the financial system—as well as deeply anchored obstacles.
For the sake of simplifying a complex issue, let’s consider the EU without the UK (to be discussed apart in the article). It’s easy to imagine after the UK announced plans to leave the EU following its 2016 referendum on Brexit.
The main difference in the corporate funding model between the US and the EU (excluding the UK) lays in the predominant presence of banks to provide credit in the latter, while the American model mainly opts for capital market instruments, predominantly in the form of bonds and equities, as the most efficient way to raise funds.
Selling shares to the public in a company is one of the main ways for it to raise funds. However, differences in corporate governance between the US and EU means the regulation focus diverges. In the US, shareholding in companies is generally dispersed and fragmented thus giving managers a strong level of power, while in the EU there is ownership concentration in which a small number of shareholders may control the firm.
US supervision focuses on ensuring that the management team on the board looks after the interests of shareholders rather than its own. In the EU, regulations seek to make sure that large investors on the board look after the interest of all shareholders--not just their own.
According to a Fitch Ratings’ November 2016 report, there are no doubts bank loans dominate total corporate debt stocks in the EU. For example, bank loans represented 88% of the total EUR11.2 trillion total debt stocks in the eurozone in the January-September 2016 period, while bonds the rest. In the US, where capital market instruments are well established, bonds represent around two-thirds of corporate borrowing.
In contrast to the banking dominance in EU corporate funding, the UK model is very similar to the market-orientated US one. The UK has a “light” watchdog approach with players fighting it out within the regulatory framework and market forces determining the survival of the fittest.
As with the sale of any financial instrument, the role of financial marketing holds great importance for equities and bonds.
When a company sells shares, it seeks investors that understand its “story” and are willing to believe in the long-term growth prospects. Investment bankers target to have large institutional investors on board and from their demand set the price target range. Lawyers make sure the initial public offering (IPO) complies with local regulatory requirements.
In the US, until regulators approve an IPO filing the company’s executives are not allowed to publicly promote their stock. When that quiet period ends, executives and the IPO’s bankers are free to meet potential investors and hold road shows in international financial capitals.
This quiet period is of significant importance in the US, where regulators are particularly vigilant about information given by the company ahead of an equity sale. Since retails investors are an important part of buyers of IPOs, the SEC has among its priorities making sure that any company statement is accurate and not misleading so as not to unduly influence investors in purchasing the security.
Google’s IPO set for August 2004 was almost stopped by the SEC after Playboy magazine published an interview with the founders of the company.
When it comes to selling corporate bonds, the market is dominated by institutional investors—both in the US and EU. In the Old Continent, considering the relatively small size of retail investors in this sector, regulators consider institutional ones capable of looking after themselves as long as the information the bond issuer gives out is not unfair or misleading.
In fact, one of the criticisms often heard in the EU among corporate bond investors is that equity buyers receive a great amount of information from the same company selling the two types of securities because regulatory disclosure rules are more stringent for share sales.
In contrast to the EU approach, the US’ SEC requires corporate bond issuers to provide the same level of company information and disclosure for both equity and bond investments as retail investors are noticeable purchasers of fixed-income securities.
Violations of securities laws are actively enforced by the SEC, or the US Department of Justice when it comes to criminal matters. Those found guilty know they may face lengthy prison sentences and punitive fines. The concern of breaking the rule of not revealing new substantive information to some potential investors (i.e. large institutional ones with deep pockets) over other ones keeps company executives and bankers on their toes during road shows and their lawyers wide awake at night.
In the EU, on the other hand, prosecutions are fewer, with a lower number of convictions very rare and less people serving time in jail.
The EU model of bank financing took a hit in recent years as banks retrenched, amid the financial and economic crisis, and reduced their assets following new requirements to lift capital and boost balance sheets.
EU banks became more risk averse. Many of their traditional corporate clients were starved of credit and policymakers weren’t happy about it.
Fixed-rate bank lending turned to be more expensive than selling bonds. The US model in which financial markets play a larger role in allowing firms to find the capital needed gained popularity among EU countries.
The European Commission is seeking to promote a capital markets union. The project aims to put aside barriers to the free flow of capital within the EU, as well as lift funding to companies via bonds and equities, to boost the bloc’s economic growth.
Market-orientated cheerleaders may want to keep in mind the stability of the banking financing model, which is relationship-driven, in times of crisis as the case of Germany’s Volkswagen demonstrated. At the end of 2016, the German carmaker announced plans to extend the maturity of a EUR20 billion credit facility from banks after being effectively shut out of the bond market following the U.S diesel-emission scandal as investors preferred to wait on the sidelines for its outcome.
EU corporate behemoths, especially those with stable and strong balance sheets such as infrastructure ones, have no problems raising funds via capital markets. Over the last year, consumer-goods giant Unilever, French pharmaceutical company Sanofi and German insurer Allianz are among bluechips managing to sell bonds with paltry returns.
Although the capital markets union drive will surely aid the growth of alternative market solutions for corporate funding needs—allowing for some catching up with the US--bank financing is likely to continue providing the bulk of the overall EU supply of debt.
EU financial markets are likely to remain too fragmented for them to bridge the gap with the US model, although differences will narrow.