Investment banking in Europe: where we are and where we are going

Investment banks play a central role to support the economy by creating the conditions for the efficient flow and allocation of capital. The key question of this paper is whether the size and the structure of the investment banking industry in the EU is functional to the characteristics of European investors and companies. Our goal is to provide a better understanding of the recent evolution of the investment banking market in Europe, to identify key trends in the industry, and to discuss the implications for the economy, the companies and the regulators and policymakers of Europe. As a result of our analysis, we obtain a map of which type of banks support which type of deals, a map that regulators and policymakers can use to monitor the evolution of the industry over time and possibly identify critical parts of the market that require targeted intervention.

Di seguito la ricerca realizzata nel 2020 dal Centro di Ricerca BAFFI CAREFIN dell’Università Bocconi in collaborazione con Equita.

Buona lettura.

Prefazione alla ricerca a cura di Equita

It is a great pleasure for Equita to celebrate the seventh year of our partnership with Bocconi University, aimed at analysing and promoting the capital markets.

During the last 6 years, we focussed mostly on the Italian capital markets, analysing their key features, players and performances, and we made a number of policy recommendations that over time contributed to regulatory improvements and initiatives. The key point has always been that we, as a country, desperately need strong capital markets for our companies to grow and to diversify their sources of funding. This has always been true, but it has become even more necessary after the financial crisis.

On the other hand, we gradually realised that inefficient capital markets and a sub-scale investment banking industry have now become European issues. The wealth of the European economy is built on a diverse set of companies that need an efficient ecosystem to fund their growth. For Europe to flourish, it is absolutely key that we have well-functioning equity and debt capital markets, and this is even more relevant today given that the majority of European companies have less access to traditional bank credit than a decade ago. And yet, despite all the evidence, no one is taking action to address the weakness of European investment banking and the disappearing capital markets infrastructure needed to finance Europe’s small and midsize companies.

This year’s research focuses precisely on these topics and gives very clear evidence that the European investment banking industry is in trouble – and that something should be done about it.

The key facts can be summarised as follows:

• European investment banks have been losing market share to US banks for more than a decade. US investment banks have strong competitive advantages compared to their European peers. They enjoy a high level of concentration, consistent pricing discipline, a very large and profitable domestic market, the quality of their services tends to be very good and they benefit from their regulators taking a consistently pragmatic approach. As a result, their market share in European investment banking has increased, at the expense of local competitors, and the trend is unlikely to be reversed;
• Technology, competition of US players, passive investing, low interest rates, decreasing trading volumes, regulation (including Mifid 2) and growth of private capital at the expense of liquid markets have deeply affected the European capital markets and the profitability of most European players. Revenues in sales and trading have decreased dramatically and even large European banks have been dismantling part of their capital markets activities;
• In the absence of a renewed effort for a real European banking union, it is unlikely that European players will join forces in cross-border mergers to create European Investment Banking champions: the economic rationale is simply not there. Moreover, capital markets for smaller companies tend to be local, even more so during the last few years due to the decreasing liquidity for smaller caps. Therefore, local brokers, investors and markets must be protected and promoted for European companies to prosper;
• And finally, for the last decade European regulators have been mostly focused on increasing transparency, protecting investors, improving disclosure and promoting growth markets. But nothing has been done to make sure that investment banks and investors (particularly the ones focusing on smaller caps) can prosper and guarantee efficient capital markets for European companies. Quite the opposite, with initiatives such as the Mifid 2 directive, which demands the completely unnecessary unbundling of the cost of research from trading fees. These rules are destroying the research industry, increasing concentration, cutting the research coverage of European companies and making it impossible for weaker research institutes to survive.

Why does it matter? Because this is threatening the ecosystem which is essential for European companies to thrive.

• Large US global players are not interested in managing transactions for smaller companies, which are the backbone of the European economy. With no dedicated players (investment banks and investors), smaller companies will find it more and more difficult to access the capital markets (debt and equity).
• The existing strong pro-private capital bias creates inequality in terms of access to investment opportunities and poses risks in terms of liquidity for a number of investors, including pension funds. The bias will not be reversed unless regulators take action. Despite 2019 being a very positive year for the equity markets in general, liquidity in the European equity markets has shrunk, particularly in the small cap sector. The large decrease in the number of European IPOs during the year is further evidence of that.
• The systemic risks posed by the enormous growth of passive investing are unknown. It is difficult to imagine what could happen in the context of a major financial crisis, with particular regard to the real underlying liquidity of ETFs. Some of the risks related to illiquid investments have become clear during 2019 in the well-known Woodford and H2O cases.

The wider consequences of all of the above are by now abundantly clear to everybody: less coverage of smaller caps, fewer brokers focused on anything other than the very large listed companies and consequently weaker interest from institutional investors in the companies that represent the backbone of the European economy. This will not stop. Trading, research and investing in small caps have become uneconomical and as a result, only large corporate equity and debt issuers will be of interest to global banks and investors. The current environment is stifling competition and is unduly favouring global banks, investors and companies.

The situation is complex, the markets forces are strong, and it is necessary for Europe to have a well-planned strategy, particularly after Brexit. Potential solutions could include: simplifying the regulatory framework, incentivising initiatives to promote the markets and revisiting state-aid rules where necessary.

More specifically:

• Revisit and simplify rapidly Mifid 2. It is clearly too complex and has created regulatory burdens and costs that make it impossible for most smaller players (brokers and investors) to be profitable. The unbundling of research must be tempered or completely reversed, although this per se will not solve the problem as most investors have already drastically cut the revenues that they pay to the sales & trading industry.
• Adjust and interpret state aid rules to make it possible for individual countries to promote and incentivise local players and markets. There is clear market failure when it comes to developing efficient markets for smaller companies, and it is mostly local investors who invest in small-caps. Therefore, regulators should encourage the establishment of dedicated investors and change state-aid rules to allow local governments to incentivise them.
• Incentivise public markets vs private markets. Initiatives could include preferential tax treatment for companies going public or financing themselves through bond issues. Changes in European rules could also be considered to avoid tax arbitrage for managers of private capital funds versus entrepreneurs or managers of public funds. The current interest rate level, which makes it relatively easy for private equity players to create value by simply de-leveraging the companies that they invest in, creates a disproportionate advantage compared to active investors in public securities.
• Consider ways to favour active investors. The large concentration of power and assets in the hands of a few large US passive asset managers is not desirable and not in the interest of the healthy development of the European markets. Active investors are essential to contribute to pricing and underwriting publicly-issued securities in a way that will never be matched by the passive investors.
• Consider ways to favour European investment banks and local players. Initiatives could include: (i) establishing proportionality in compliance with regulations, making it easier for smaller brokers, investors and issuers to operate in the market; (ii)promoting tax breaks on research published regarding smaller companies; (iii) simplifying companies’ access to markets by removing any regulatory arbitrage among countries (for example harmonising and simplifying filing rules and making reviewing times and practices consistent throughout Europe).

In summary, the European investment banking sector is a key component of our economy and it requires specific attention by regulators and a wide-ranging strategy. For too long nothing has been done: action must be taken now before it’s too late.