IMF | Financial Market Reforms Could Lift Europe’s Growth

IMF Blog post | Integrating and deepening banking and venture capital markets would boost output by at least 3 percent, and make business dynamism reforms more powerful

French startup Mistral AI’s recent financing round was led by ASML, a Dutch maker of semiconductor manufacturing equipment. Such cross-border investments—even when small relative to US deals—are not the norm in Europe. Far more often, good projects fail to scale. Among the reasons: Europe’s considerable savings are compartmentalized within national borders, and hard to connect to high-risk, high-return projects.

The main burden falls on Europe’s young and innovative companies, as we show in a new IMF Staff Discussion Note exploring how fragmented and shallow European financial markets continue to hold back their growth. For investors, especially individuals, this means less opportunity to diversify risks and insulate themselves from domestic turmoil by investing abroad. The note shows that differences in banking regulations, safety nets (notably deposit insurance) and insolvency regimes across countries impede cross-border bank lending. Meanwhile, rules that limit provision of risk capital by pension funds and insurers limit the scale of venture capital.

As this Chart of the Week shows, even a moderate reform effort that reduces barriers to cross-border banking could raise European Union GDP by about 2 percent in the long term. These gains would come from better allocating savings across countries and companies, as well as businesses being able to reach potential lenders, which would lower funding costs. Adding reforms to ease legal and tax-related impediments to cross-border venture capital investment, together with measures to expand long-term risk capital through pension and insurance reforms, could bring the estimated gain from financial reforms close to 3 percent.

These financial reforms reinforce significant gains that could come from boosting business dynamism and innovation. Making Europe a more dynamic place to start and grow new businesses—for example by improving the business environment, investing in skills, and supporting research and development—would raise the pool of projects with high potential returns. Combining financial and real economy reforms can lift the long-term GDP gain into double digits.

Europe needs action on three fronts:

• Pressing ahead on the banking union by reducing regulatory and institutional differences, and harmonizing insolvency frameworks.  Completing the financial safety net, including through a European deposit insurance scheme, would reduce adverse sovereign-link bank feedback loops, supporting economic and financial resilience overall.
• Strengthening venture capital and equity financing more broadly by expanding the pool of long-term risk capital, and easing cross-border investment frictions.
• Improving the business environment so that this newly available capital finds more attractive projects to finance.

Innovation and finance go together: reforms that create more promising companies will go further when Europe’s savings can flow freely to fund them.

Authors:
Luis Brandão-Marques, Damien Capelle, Diego Cerdeiro, Rui C. Mano

Compliments of the IMF