Capital in (the third decade of) the Twenty-First Century - Remarks by Governor Gabriel Makhlouf at the Irish Association of Investment Managers Annual Dinner

Good evening,

It is a pleasure to attend your annual dinner, to share and hear perspectives on the asset management industry.  My special thanks to Michael D’Arcy for the invite.

Today I want to talk to you about Capital Markets Union (CMU).  And I have four key messages, so let me state them up front: 

• First, I do not believe we can regulate capital markets into existence.  That is not to say we cannot improve existing regulation.  But our focus should be on building capital markets rather than building more regulation.  We need to streamline what we have, making it easier to navigate and more efficient. 
• Second, there are multiple opportunities to grow European capital markets and I believe the most powerful public policy levers to encourage this growth is tax and pensions policy. 
• Third, (and perhaps unsurprising for a central bank governor to focus on) I think risk considerations should be a driving factor when thinking about the future model for asset management, how we supervise the sector and institutional arrangements for its oversight.
  
• Finally, industry has a critical role in making CMU work.  I believe it needs to up its game in terms of the attractiveness, simplicity and cost efficiency of products.
  

Why Capital Markets Union?

I will flesh out these points as I go along, but let me start by outlining my thoughts on why CMU matters, particularly for the European Union (EU).

EU markets are relatively small and in decline.

They are shrinking in a global context. With the EU’s share of global capital markets activity declining much more than the fall in the EU’s share of global GDP^[1].

And this matters for growth and our productivity; a key input for output is innovative and dynamic firms and we need to ensure funding for European growth companies looking to scale up.

Second, EU capital markets are fragmented with limited risk sharing.  Capital market income in the EU is considerably below where it is in the US. 

Third, we have some big financing needs in Europe (in the green, digital, and demographic transitions that I have spoken about elsewhere) so we need to mobilise capital.

A more developed EU capital market offers a solution to some of these needs.

• Capital markets provide greater choice for savers, through a greater range of savings and investment choices (beyond banks), catering for different risk preferences and needs. 
• Capital markets provide for diversified financing needs for the economy and its businesses. 
• Capital markets promote overall macro-financial resilience, with a diversified system between bank-based financial and capital markets likely to be more resilient to adverse shocks.
  
• And in my view the Single Market framework, rooted in the definition of the four freedoms – the free movement of people, goods, services and capital – can only fulfil its potential for the EU’s citizens when it has a true single market for capital.  

 We cannot regulate capital markets into existence

The EU regulatory landscape has evolved over time to address various market failures and arguably is not as efficient or clear as it could be.  There is now an alphabet soup of regulation covering issues like securitisation, insolvency, post-trade, risk capital, pensions, retail investment, shareholder engagement, accounting, before we even start to talk about sustainable finance.

I won’t spoil your digestion with a detailed discussion of this alphabet soup.

What I will say is I wholeheartedly support the objectives of CMU.  And of course high quality regulation plays a vital role in supporting well-functioning capital markets.

But, as I said at the start, I do not believe we can regulate capital markets into existence.

So when we look at regulation in the EU, we need to think about streamlining, looking for efficiencies, avoiding duplication and improving simplicity.

We need to think about better supporting innovation and product development to meet the changing needs of investors and the broader evolution of the global financial sector.

And we need to think about consistency and more appropriate regulatory calibration in order to achieve the right outcomes.

Opportunities to grow European capital markets

This brings me to growth opportunities.  Put simply, I see a huge opportunity to develop capital markets.

The economic case is clear.  And the research is clear. 

• First, the effectiveness of capital markets is an important factor in determining the growth prospects of a country or a region.^[2]
  
• Second, equity-driven financial systems allocate capital more rapidly to innovative investments.^[3]  And
  
• Third, countries with a higher share of equity financing tend to reduce their carbon footprint more rapidly.^[4]
  

Across Europe – in order to grow capital markets – we need to look again at two areas tax and pensions.

Domestic tax policy can better incentivise retail investors to participate in and benefit from capital markets.

So we need to better foster equity financing through well-designed national corporate tax systems.

Minister Donohoe’s leadership on this issue at European level is welcome to investigate ways to reduce the debt equity bias and share best practices and plans to address this bias.^[5] 

Closer to home, in Ireland it is important that we consider potential barriers to investor participation and measures to support their access to a wider range of well-regulated and cost-effective investment products.

The Department of Finance’s ongoing Funds Review provides an important opportunity to address the disincentives which exist for Irish consumers accessing investment and I know this is a high priority for Minister McGrath.  

Relatedly, Ireland will introduce pension auto-enrolment next year.  When we look at countries that have successfully deepened their capital markets it has often coincided with pension reform.

This is an opportunity for Ireland, to mobilise long term, collective investment, to develop financial literacy and to encourage people to better secure their financial objectives over their lives.  

Looking to the future

Looking ahead, the Irish sector has built an international reputation for excellence and expertise. 

Our place as an international financial centre brings with it certain responsibilities. 

It requires a continued commitment to high quality and effective supervision while striving to play a leading role in international policy development in both European and international fora. 

These considerations have shaped our priorities and our strategy at the Central Bank of Ireland. 

While the continued growth of both size and range of activities can benefit the domestic economy, it also requires careful monitoring and ongoing management to mitigate against any potential risks to either investors or broader financial stability. 

In this context, it is important to consider both the functioning of the overall ecosystem as well as its constituent parts. 

The asset management sector is going to change radically over the coming years.  The sector as we know it today, will look profoundly different in a very short space of time.  Technological developments will change how firms offer services and products to clients in response to investors’ changing expectations.  These will also change how regulation and supervision are carried out.

There are two changes I would specifically call out.

The changing nature of distribution – facilitated through technology developments (such as digital platforms, automation, and data-driven insights) – has resulted in the traditional methods of reaching investors evolving rapidly. As asset managers embrace technology, distribution processes should become more efficient, transparent, and accessible.   This should open up new possibilities.  New target markets for firms, but also new options for investment products for investors.  The advent of mobile distribution – where investors can invest in a wide range of investment products and gain exposure to all manner of asset classes from the comfort of their own homes or on their daily commute – brings many benefits but it is not without its challenges.   The Irish fund and asset management sector has a particular role to play here.  We know that enabling investors to participate in capital markets, through better investment choices, is an economic necessity for the Europe.  But it is also important that consumers see the benefits of investing in regulated products, rather than being tempted into unregulated, volatile, products whose value is solely speculative.  Diversified investment funds have a particular role to play, allowing investors to increase their investment opportunity set, to improve the risk/return profile of their portfolio and to entrust oversight of their investments to a professional fund manager.

The other area I would call out is tokenisation. The ability to tokenise financial products has the potential to change significantly how the asset management sector is structured.  This could bring benefits to market participants and service providers in terms of efficiency.  Benefits to consumers in terms of ease of access and eventually lower costs.  And benefits to regulators in terms of real time information access.  Ireland – as a global financial centre – should be leading from the front when it comes to this innovation.  All of us will have a role to play.  Collaboration between industry and policy makers will be paramount to realising the potential of this technology while managing the risks.  

All of this will necessarily result in changes to how we supervise the sector. 

We will need to challenge ourselves on how we are responding to these developments and how we are modernising the regulatory framework and adapting our approach to supervision.

In recent years, there has been significant changes to how we supervise the funds and asset management sector.  This has been driven by two factors:

• First, since 2019 the assets under management in Irish domiciled investment funds have increased by over €1 trillion to around €4.5 trillion.  This is on the back of continued growth over the last 10 years.  In the case of funds, this has meant we have changed our supervisory model to provide a more holistic, risk-based, approach to supervision of the sector. This has built in certain flexibilities to our approach, allowing supervisory effort to follow the risk and respond to macro events in a focused manner; and 
• Second, the nature of European supervision has changed, moving from being focused on the creation of rulebooks to instead being much more focused on supervisory convergence.  As a result, the supervision carried out by the Central Bank of Ireland is increasingly done in a coordinated manner across the EU.  The intention of these Common Supervision Actions is to promote the consistent and effective implementation, interpretation and application of EU rules.  Authorities across Europe are increasing working in tandem to deliver high quality comparable regulatory and supervisory outcomes across jurisdictions.    

For EU regulation and supervision, in order to progress capital markets union, we need frameworks that drive consistency of outcomes.  There will be much discussion on how to make further progress on this over the coming months and years ahead.  The next Commission’s agenda will be shaped by the prevailing themes of ever-increasing interaction and strategic autonomy, which will raise important issues in the context of the sector, including evaluating EU-level supervision and reliance on third countries.   It will be incumbent on all of us to ensure Ireland is active in shaping the nature of these discussions.

The role of industry

Before I conclude, let me share how I see our respective roles. 

Advancing the CMU agenda cannot be simply about public policy.

You have an important role to play:

For EU citizens, the provision of simple, cost-efficient options are essential for empowering citizens to invest their savings in capital markets that serve their long-term needs.

For EU companies, sustainable financing options are critical for fuelling growth and innovation in the EU, especially for SMEs.

But public authorities also have an important role:

We need a more conducive ecosystem for public companies, and to foster pan-European markets particularly for market infrastructures.

We need to support innovation and be open to new products and services.

We need to adapt and be responsive as industry evolves and changes.  

This is why the Central Bank is transforming how we regulate and supervise the financial system. To meet changes and challenges of an increasingly connected global financial system, we must adapt to keep pace with change and meet the new risks and emerging challenges.

We are moving away from a mandate-driven approach to a sectoral approach to supervision, where consumer and investor interests, safety and soundness, and the integrity of the system will be embedded at the core of all our regulatory and supervisory teams.

In the context of this sector, we will be establishing a single Capital Markets & Funds Directorate. This will bring together parts of the capital markets universe which are currently housed in different parts of the Central Bank. This change is being made to ensure a more integrated and holistic approach to this diverse sector.

It is evident the objectives of the asset management sector, of public policy makers, and of Europe, are intrinsically aligned when it comes to meeting the aims of Capital Markets Union. 

This is why we must all play our part to build a true capital markets union in Europe.