Unlocking Europe’s Growth Through Alternative Sources Of Financing

As Europe’s bank-centered financial model is being challenged, European authorities should create alternative sources of external finance to enhance its resilience and reliability of credit supply to the real economy, argues Goldman Sachs.

Huw Pill and team at Goldman Sachs in their February 19, 2015 research report titled: “Unlocking Europe’s economic potential through financial markets” point out that the global financial crisis and the international regulatory response have challenged Europe’s bank-centered financial model.

Bank-centered financial model may weigh on Europe’s growth

The GS analysts note that the Euro area’s economic recovery from the global financial crisis remains anemic and has lagged behind its Anglo-Saxon peers. The analysts anticipate Europe’s potential growth rates over the medium term to be little over 1% p.a.:

Europe's lagging recovery

The Goldman Sachs analysts note Europe’s financial system is bank-centered as banks provide around 70% of European firms’ external financing, with the balance contributed directly from securities markets. In the U.S., these percentages are reversed:

Bank-centered financial system Europe

Elaborating on the Trans-Atlantic differences, the analysts point out that the European banking sector is significantly bigger than its U.S. counterpart. As can be deduced from the following graph, in the Euro area, total bank assets sum to over three times GDP, while in the U.S., the ratio is less than one:

Europe banks' larger share in GDP

However, the Goldman Sachs analysts note this banking model has been challenged by the experience of global financial crisis and the international regulatory response that followed it. They point out that there is an obvious risk in relying heavily on bank finance if the banking sector is itself subject to stress. They note in all jurisdictions, larger companies with direct access to capital markets have performed better than smaller companies that rely on banks and have been hindered by the credit crunch.

The analysts also point out that thanks to the Basel III arrangements requiring banks to hold more capital, bank loans have become more costly. They note this will be detrimental to those companies and economies that are more reliant upon banks for external financing.

Need for alternative sources of finance

To underscore their view point on bank-dependence in the Euro area, the Goldman Sachs analysts point out that in the EU, half of all workers are employed by firms with fewer than 50 employees, while in the U.S. that proportion is only around one-quarter.

More SMEs in the Europe

The analysts note as a rule, small businesses can’t issue directly on publicly-traded securities markets, since insufficient information is available for investors to assess corporate performance and creditworthiness, and hence small and medium-sized businesses are more likely to rely on banks.

Pill et al. note if Europe developed more large companies, its financial sector would naturally become less bank-centered. The analysts have identified three dimensions that would facilitate Europe in fcing the new global financial environment.

First, they suggest better integrated banking system to facilitate improved capital and credit allocation. Second, the analysts suggest a deeper and more liquid continent-wide capital markets to diversify funding needs for the real economy. Lastly, Pill and team suggest a well-managed securitization program can improve firms and households’ access to financing by broadening banks’ funding opportunities.