March 11, 2015

We Must Resist Becoming "Bank-Centric" in the US

Hester Peirce

Former Senior Research Fellow
Summary

If the United States wants to keep the capital markets in its economy working, its regulators should resist efforts to turn the current, multi-faceted financial system into a banking system. Instead they should work to foster dynamic capital markets that bring investors and companies in need of funds together. Only then will entrepreneurs all over the world dream of building their businesses here.

Contact us
To speak with a scholar or learn more on this topic, visit our contact page.

Aspiring entrepreneurs have long dreamt of building their businesses in the United States. This country historically offered people the opportunity to establish companies and reap the rewards or to fail and then try again. What made this possible is not only the nation's adventurous and optimistic spirit, but the equally spirited American capital markets. The Europeans are catching on to the value of capital markets, at the same time the United States is making it more difficult for people with great business ideas to find people with money to finance them.

A business looking to get off the ground, expand geographically, or develop a new product can try to get a bank loan. Bankers-constrained by their capital structure, lots of rules, the prospect of regulatory second-guessing, and their inherent conservatism-may not be a promising source of funds. A business might instead or additionally turn to the capital markets, which match institutions and people who have money to invest with businesses ready to put that money to good use.

Investors in capital markets sometimes buy debt securities, which promise a fixed rate of return. Often, however, investors seek more than just to get repaid with interest; they would rather have a share of the company's profits, should the company succeed in its endeavors. By buying stock, investors can put their money into companies in exchange for an ownership stake. By doing so, they sign up for the downside along with the upside, but a diversified investment portfolio means that profits on one investment can offset the losses on another. Shareholders who want or need to cash out of a company can return to the capital markets to sell their piece of a company to someone else who is ready to invest.

Capital markets are an important part of the U.S. financial system. The United States has thriving corporate debt and equity markets, along with its banks of all sizes. This diversity stands in contrast to many other countries, which have bank-centric financial systems. In some places, a few large banks essentially decide which companies and projects get financed. Banks played a much more important role than the capital markets in Europe, but that may be changing.

In a speech last week, Jonathan Hill-who heads the European Commission's Directorate General for Financial Stability, Financial Services and Capital Markets Union-explained the importance of the capital markets part of his mandate:

"Put at its most simple, its aim is to link savings with growth. We want to remove the barriers that stand between investors' money and investment opportunities; overcome the obstacles that are preventing those who need financing from reaching investors; and make the system for channeling those funds-the investment chain-as efficient as possible."

The speech followed the European Commission's release earlier this year of a green paper, "Building a Capital Markets Union." As the paper notes, mid-sized companies in the United States "receive five times more funding from capital markets than they do in the EU," and equity markets are about twice as big as in Europe.

A big focus of the green paper is getting the regulatory framework right. A sound regulatory framework is a key ingredient for any jurisdiction that cares about its capital markets. Michael Piwowar, a commissioner at the Securities and Exchange Commission, explained in a speech last year that "effective regulation leads to capital market development. Capital market development, in turn, leads to economic growth. Economic growth improves standards of living ... in a number of ways, including reducing poverty and promoting savings, investment, innovation and job creation." For this "virtuous circle," as Commissioner Piwowar calls it, to work, the right regulatory framework needs to be in place.

As Mr. Hill notes, Europe has much work to do on its capital markets regulations. Even though the United States is starting in a better place, we too could make regulatory changes that would improve our capital markets. The SEC, which is responsible for regulating American capital markets, has proven itself time and again reluctant to make much-needed adjustments to rules that inhibit economic growth.

A nudge from Congress in the form of the JOBS Act put capital formation issues on the SEC's agenda, but it remains to be seen whether the SEC's final rules on small securities offerings will be workable or will sit unused. Requiring very small companies to produce audited financials or get the blessing of every state securities regulator before raising money are examples of unworkable requirements. Obligations on large, public companies are also a growing burden on capital formation. Meanwhile, the Federal Reserve is working through the Financial Stability Oversight Council to turn broker-dealers, hedge funds, investment advisers, and insurance companies into bank-like entities with large portfolios of Treasury securities.

If the United States wants to keep the capital markets in its economy working, its regulators should resist efforts to turn the current, multi-faceted financial system into a banking system. Instead they should work to foster dynamic capital markets that bring investors and companies in need of funds together. Only then will entrepreneurs all over the world dream of building their businesses here.