Setting long-term goals in volatile market conditions

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Capital markets are needed to improve the funding of European corporates. But what drives financial integration and private cross-border risk-sharing, at the core of market-based systems? Certain legal and economic conditions are essential for the organic development of larger and more-liquid capital markets across the EU. While the Action Plan on Building a Capital Markets Union (CMU) champions the ‘bottom-up’ approach, some top-down action in the form of common institutions might be necessary due to pre-existing legal systems, market infrastructure and the economic interests in all 28 member states.

The effectiveness of quantitative easing (QE) programmes and the path towards a normalisation of monetary conditions are sources of great concern for central banks around the world. QE is beginning to produce an impact on inflation expectations in countries like Sweden, where the intervention was quite substantial (close to 20% of all local government bonds are held by the central bank). There are also signs of increasing risk-taking behaviour, impact on market prices and redistributive effects. The prospect of a prolonged period of low inflation, however, was considered particularly worrisome for investments and economic growth.

A structural shift towards more market-based finance is inevitable and Europe needs to find its own model. In normal times, financial institutions provide liquidity in the market, but we are not in normal times, as central banks are the key source of market liquidity. This is causing a vast restructuring of the financial landscape and bank business models, but it will take some time for capital markets intermediation to develop further in Europe. Bank financing will continue to play a major role. More needs be done to improve the functioning of “money market funding of capital market lending” at European level, with central banks providing the backstop as “dealer of last resort” to anyone running dealing activities (whether or not a traditional credit institution).

The stability of centralised market infrastructures, such as CCPs (central counterparties), is increasingly taking the centre of the discussion on crisis management. The regulatory framework around margining requirements and crisis management must take into account multiple risks, such as what comes after the ‘end of the default waterfall’. The current regulatory framework does not take into account the negative network effects of crowded trades. Safeguards must be put in place in order to deal with increased risk that is not picked up by current initial and variation margining models.