One last chance

The global financial crisis revealed the many weaknesses of the European so-called single financial market. Consequently, the same, or other similarly minded unelected bureaucrats, set about to fix these problems, a task at which they have failed EU consumers of financial services miserably. The single market for financial products is not only non-existing in retail banking services, it is also a failure in the equally important market for long-term savings. State sponsored social security systems are ill prepared to ensure financial security in old age to those joining the labour force today. The present value of future liabilities is a very large and growing number while in many EU countries the ratio of people in retirement to those who are active in the labour force is declining. Therefore, private savings schemes will need to play an increasingly large role in retirement income. 

Financial security in old age is a crucial issue, not just in politics, but also for the economy, as old age income insecurity leads to lower current consumption and higher savings rates, which often lead to lower potential growth. Conversely, the monetary policy function that has addressed every economic and financial crisis since 1997 has led to a reinforcement of the notion that market participants have a put on Central Banks. This was clearly the case last year when following the unwinding of levered positions in March; investors realized that the best way to play the pandemic was to take on as much risk as possible once again. Income and wealth inequality, already a problem before the most recent expansions of QE, have reached a new peak.  

Therefore, the first policy consideration that needs to be addressed is whether investment income should continue to be taxed more favourably than earned income. Secondly, voters should be aware that the financial services industry has lobbied very effectively in order to capture most of the tax benefits of collective investment products and life insurance policies. The former overcharge their customers for what in most cases is closet indexing. The latter is a particularly inefficient industry as the cut taken by the intermediary out of the yield on investment grade fixed income securities is unwarranted in the current ultra-low interest rate and credit spread environment. 

The focus of consumer protection is fraud and miss-selling and not choice nor ease of access. Thus, an EU retired person may invest all of her money in a single stock such as AMC or any in the long list of euro zone banks that subsequently cratered, because these are listed securities, but she may not invest in a KKR fund because private equity funds are for professional investors only. With choice comes competition and lower fees. As it turns out wealth management customers unknowingly bear the brunt of the inefficiency of financial institutions in the euro zone. Indeed, the real question is why should collective investment vehicles or life insurance products have a better tax treatment than one’s own portfolio of securities? What use is the self-assessment of financial acumen introduced by MiFID regulation if qualified individuals are not free to choose how to manage their financial affairs? 

Collective investment vehicles in the EU do not need to make distributions of dividend or interest income nor are their investors taxed when the fund realizes a gain unlike it is the case in the US. Indeed, few industries enjoy more advantages and protection from competition than the EU’s asset management industry. Rather than a single market, 26 national markets pretend to protect consumers by leaving them at the mercy of dominant domestic financial intermediaries. Thanks to complex regulation, the EU private wealth industry may largely ignore the line fraught with conflicts of interest between advice and distribution. This is also the case for the myriad small and medium institutional investors that lack the in house capabilities to conduct investment or operational due diligence and rely on the advice of third parties which are often conflicted. 

An industry that is critical to the future of the EU’s way of life needs to be shaken-up from its foundations. Undertakings for Collective Investments in Transferable Securities funds are the plainest vanilla collective investment vehicles around. The first surprise to a neophyte is that the regulator has set a layer of perhaps well intended risk management rules but which in practice prevents UCITs vehicles form investing in such racy assets as US listed ETFs. Cynics may see this as a protection of the EU financial industry and they would be right for the ulterior motivation of the EU regulator seems to be the protection of the sub-scale and overburdened domestic industry. Next time your friendly bankers recommend an investment in a fund ask them what is the size and the compensation of the investment team. Take that number and compare it to the revenues the fund generates for the investment manager. You will realize that most of the management fees you have paid over time did not go towards managing your investments; they covered distribution costs as well as general overheads. 

Very low taxes generally apply to investment income in the UE, especially when taking into account the ability to defer income and capital gains indefinitely within vehicles or the ability to switch from one fund to another without triggering capital gains taxes. It is not surprising then that many investor show very high risk aversion in their portfolios This is an unintended consequence of the tax regime and perhaps one of the reasons why the EU has fallen behind the US and China in innovation. If investors do not need to take risks to meet their financial objectives, they will not. Consequently, there will be less capital available for entrepreneurs. 

This problem is magnified in Spain where some of the most perverse tax incentives to be found anywhere in the world result in some the largest pools of private wealth making portfolio decisions exclusively on the basis of tax efficiency and not on the basis of risk and reward. As a result, Spain’s level of convergence with the wealthiest EU countries ground to halt with the GFC while the terrible debt burden accumulated in the roaring noughties remains unpaid. 

Nevertheless, we have reached the point where financial repression forces investors to leave their comfort zone and explore alternatives to their fixed income investments. This may set the stage for a renaissance of European technology companies outside the low return on invested capital renewable energy industry. MiFID regulation needs to be updated to accommodate this important new trend or Europeans will miss what could be a once in lifetime opportunity in space exploration, green mobility, data management, or the life sciences.