4.1 General Principles
The nature and estimated cost of innovations foregone as a result of institutional obstacles will always be shrouded in uncertainty because we can only speculate about what is “not seen,” in the words of Frédéric Bastiat (1850). In a given institutional setting, we see only those market transactions and those entrepreneurial activities that the institutional setting allows and supports; innovations that do not conform to the existing economic order will not attract the required skills and resources and therefore not materialize. Thinking in terms of what is seen and unseen is valuable when pondering how existing rules governing savings, finance, and capital in Europe affect entrepreneurial activity and how they should change.
Europe certainly has no shortage of savings (OECD 2019a). However, as we have already mentioned, the nature of entrepreneurial venturing makes some forms of finance more suitable than others. In other words, the problem is not quantitative but qualitative: the allocation, rather than the volume, of European savings is what matters for entrepreneurial activity. Though plentiful, financial resources in the EU are mainly intermediated through universal banks and institutional investors who prefer large, low-risk, debt-based assets and blue-chip stock over small, risky equity-based investments (Westerhuis 2016). This systemic problem has considerable ramifications for collaborative innovation blocs; one can only speculate as to the number of fundamentally sound entrepreneurial projects that never got off the ground because the financial playing field was tilted against them.
In this chapter, we present reform proposals intended to increase the flow of financial resources to small and new firms with high potential for entrepreneurial venturing. Our proposals aim to ensure that more of the existing resources become available to new ventures at the right time and in the appropriate form and quantities. For these goals to materialize, policymakers should reform existing institutions governing the allocation of capital in Europe. While proven recipes from outside Europe can be adopted, digital platform technology allows entirely new ones to be tried. As such, the reform proposals will enable vested institutions, promote proven alternatives, and experiment with new technologies to allocate more of the available capital to innovative entrepreneurs.
Again, a few basic principles underlie our proposals. First, because the framework surrounding savings and finance often puts entrepreneurs at a disadvantage, we adhere to the principle of neutrality by creating a level playing field for entrepreneurial ventures in the competition for financial resources. When followed, the principle guarantees that entrepreneurs are given a fair shot without being pampered. Second, we aim for increased transparency to reduce asymmetric information problems for investors. Adhering to this principle ensures that entrepreneurs know the criteria upon which the success of their venture will be evaluated, reducing a substantial source of uncertainty in entrepreneurial venturing. Finally, the principle of justifiability enters the discussion when we consider enabling reforms in the banking sector and pension funds. Given the seemingly conflicting aims of providing financial stability and financing productive venturing, the justifiability principle helps balance important functions, thus increasing the probability that reforms are effectively implemented and respected.
As stated, financial resources are not in short supply in Europe; the problem is the way in which they are intermediated. Therefore, we first discuss reforms that prevent some savings from ending up with institutionalized intermediaries, as this would free up resources for start-ups in the form of private and informal investments. Then, we consider whether and how Europe might emulate the successful American model of business angels and VC before addressing reforms that would enable Europe’s historically dominant banking sector and more recently built up pension funds to invest parts of their vast portfolios in growing entrepreneurial firms. Because some of the proposals touch upon the so-called FinTech innovations, we conclude the chapter with a discussion of business models for alternative finance on digital platforms.
Proposals referring to private wealth accumulation and pension funds are primarily addressed to the member state level, as the European treaties do not give strong and effective competencies to European policymakers in these areas (Suse and Hachez 2017, pp. 40–41).1 However, it does seem that the European policy level has ample competencies and instruments to implement reforms for the banking sector and FinTech innovation, while lower levels of policymaking are better suited to promote small-scale, arm’s length financing for early-stage start-ups and the development of vibrant local and regional VC sectors.
4.2 Proposals
4.2.1 Financing Early-Stage Venturing
A large share of savings in European economies currently goes into banks and pension funds (OECD 2018a). This share can be expected to grow in the future, as funded systems increasingly substitute for pay-as-you-go systems and an increasing number of European workers opt for voluntary or collectively agreed upon supplementary pension plans (PensionsEurope 2017). These institutions primarily invest the funds of their clients and beneficiaries in liquid debt-based assets or tradable equities. This preference is unsurprising given the inability of such investors to take an active role in firm management.2 The large economies of scale in managing loan portfolios (e.g., Philpot et al. 1998; Hughes and Mester 1998; Piketty 2014; Fagereng et al. 2016) also cause a bias towards “big ticket” investments and tradable securities. As a result, the resources managed by banks and pension funds can typically not be used for the type of smaller, long-run, equity-based investments that are so central to small and young ventures in collaborative innovation blocs (Kramer-Eis et al. 2017).
The lack of equity capital in smaller ticket sizes constrains (potential) high-growth firms more than others because such firms require regular infusions of external equity to sustain growth (Baumol et al. 2007, p. 205). This reliance increases (relative to debt) with the degree of risk and opacity, both of which are greater among younger and more innovative firms. Therefore, entrepreneurial start-ups usually struggle to raise funds in general and funds from large financial institutions in particular (Tilburg 2009). Part of the problem is that wealth-constrained would-be entrepreneurs do not have a track record, cannot put up collateral or make sizable equity infusions of their own to credibly signal their project’s worth to outside investors. Higher levels of private wealth accumulation could remedy this problem of asymmetric information (Nykvist 2008; Parker 2018) or even enable the entrepreneur to make equity infusions that are large enough to capitalize the firm at inception. Such capitalization is essential for later venture success and performance (Henrekson and Sanandaji 2016).
Moreover, greater private or family-based savings could increase the pool of potential business angels and other informal investors who can help entrepreneurs overcome liquidity constraints in the early stages of venture creation (Ho and Wong 2007). The entrepreneur’s family can be crucial in this respect, especially in regions where family ties are strong (Dilli and Westerhuis 2018). Conversely, a lack of private wealth impedes entrepreneurial venturing; any arrangement channeling savings and asset control away from large institutional investors and back to private individuals is, therefore, likely to increase the supply of equity capital and “soft” loans in smaller ticket sizes with early-stage entrepreneurs, even if much of it will end up in lower mortgages and savings deposits at banks.
Proposal 13: Allow more wealth to accumulate and remain in private hands and make it possible, easy, and attractive to invest such wealth in entrepreneurial ventures.
This proposal complements Proposal 9, which argues for the moderate taxation of private wealth holdings and transfers. While fiscal incentives matter, soft measures can be instrumental in developing a vibrant investment climate, especially when they take the form of information campaigns, matchmaking events, and the development of an effective support and information infrastructure for informal investors. To the extent that private investors allocate their capital towards small equity ticket deals, this corrects for the bias in Europe’s financial system, returning it to neutrality by increasing transparency.
Proposal 14: Allow people to individually choose how and where to invest part of their pension savings.
Not everyone has the inclination and skill to manage a portfolio of early-stage equity investments. Moreover, financial literacy remains low, and people are generally susceptible to behavioral biases and have a hard time selecting the products and services that best fit their preferences and risk attitudes (Rooij et al. 2011; Madrian et al. 2017). This justifies significant regulation on how different options should be presented and those who prefer that their pension savings be invested in low-risk assets should, consequently, always have a secure alternative. But while policymakers must strike a balance between public and private interests to justify the reforms, allowing people to invest some of their pension savings in entrepreneurial ventures can democratize capitalism, especially when combined with, e.g., crowd investing platforms (Shiller 2013; Mollick and Robb 2016; Stevenson et al. 2019). This facilitation could help jumpstart Europe’s embryonic professional angel and VC sector, to which we turn next.
4.2.2 Financing Scale Ups
Venture capital investments as a share of GDP, and the ease of getting credit in EU member countries and the USA, 2017
Country | VC investment, % of GDP | Ease of getting credit score (0–100) | Country | VC investment, % of GDP | Ease of getting credit score (0–100) |
|---|---|---|---|---|---|
USA | 0.400 | 95 | Belgium | 0.033 | 65 |
Denmark | 0.032 | 70 | Spain | 0.043 | 60 |
Luxembourg | 0.030 | 15 | Austria | 0.026 | 55 |
Finland | 0.055 | 65 | Poland | 0.011 | 75 |
Ireland | 0.040 | 70 | Bulgaria | 0.010 | 65 |
Portugal | 0.010 | 45 | Czech Rep. | 0.002 | 70 |
France | 0.055 | 50 | Italy | 0.005 | 45 |
Sweden | 0.060 | 55 | Romania | 0.003 | 80 |
Netherlands | 0.044 | 45 | Greece | 0.000 | 50 |
UK | 0.076 | 75 | Croatia | n/a | 55 |
Germany | 0.035 | 70 | Cyprus | n/a | 60 |
Estonia | 0.006a | 70 | Malta | n/a | 35 |
Latvia | 0.006a | 85 | Slovakia | n/a | 70 |
Lithuania | 0.006a | 70 | Slovenia | n/a | 45 |
Hungary | 0.021 | 75 |
Proposal 15: Pension funds and other institutional investors should, on an experimental basis, be allowed to invest more in equity in general and in venture capital specifically.
In implementing a reform of this kind, policymakers should judiciously consider the balance between public and private interests. Crucially, such a scheme should be combined with cuts in capital gains taxes and the effective tax treatment of stock options in young entrepreneurial firms, as discussed in Chap. 3. Only a broad-based policy effort would enable VC firms and other actors in the entrepreneurial ecosystem to supply their services profitably and design the appropriate incentive contracts needed to build innovative firms (Henrekson and Rosenberg 2001; Kaplan and Strömberg 2003; Lerner and Tåg 2013; Udell 2015). A sizable and efficient VC sector cannot evolve without significant demand and a favorable fiscal climate.
Proposal 16: Develop competencies for private equity and venture capital investment in the field and avoid promoting VC capital with funding directly.
At the same time, this proposal calls into question the approach suggested under, e.g., the Investment Plan for Europe, the so-called Juncker Plan (European Commission 2015a), which provides sizable additional public funding. The plan’s target now stands at 500 billion euros by 2020, some 32% of which was allocated to small firms up to 2019 (European Commission 2019b). Unfortunately, the requisite competence to channel these funds to young, high-growth firms is lacking (Schneider 2015b). The problem with VC is not a lack of money or skills per se. Rather, a substantial degree of “skin in the game” needs to be retained to avoid moral hazard as returns and the risk of failure are likely to depend on entrepreneurial effort and investors’ commitment to the venture. Too much “easy” public funding may actually reduce the chances of success. Even professional fund managers will make expensive mistakes and invest in projects with high risks and low returns if allowed to play with “other people’s money” (Kay 2015). Therefore, reforms should aim at strengthening the demand and supply of private VC funds and ensure that incentives to invest are strong while the potential to offload losses onto taxpayers is kept to a minimum.5
Proposal 17: Reduce barriers to the sale, acquisition, and IPO of VC-funded start-ups to facilitate profitable exits.
It may seem, with mostly large incumbent firms currently buying up small ventures for strategic reasons, that this proposal would strengthen their position. However, what we intend here is that improved access to exit markets will intensify competition among potential buyers, which will then increase the value of innovative entrepreneurial ventures. If policymakers help build the skills, enhance the incentives, and create the demand for VC, the European VC sector is likely to flourish to the benefit of all venture creation. This sector is urgently needed to restore a level playing field in the competition for available financial resources, but we warn against propping up VC with (more) public funds.
4.2.3 The Role of Banks
Total assets of domestic banking groups and foreign-controlled subsidiaries and branches in relation to GDP in euro area countries in 2008, 2015, and 2016. Note: Data for domestic banking groups and foreign subsidiaries are consolidated, and hence include branches and subsidiaries that can be classified as other financial institutions (OFIs), except insurance companies. Source: ECB (2017)
As a result, more than 50% of European SMEs report bank loans and overdrafts as relevant sources of finance (Lee et al. 2015; Udell 2015; Kraemer-Eis et al. 2017). While the absolute size of the banking system is not problematic from the perspective of an entrepreneurial society, how banks allocate their credit is (Hernández-Cánovas and Martínez-Solano 2010). Here, Europe’s banking system exhibits some worrying trends with respect to regulation, consolidation, leveraging, and lending practices. While the roots of these developments can be traced back decades (Westerhuis 2016), they are far from irreversible; the EU has already used its significant competencies to implement reforms in the banking sector. For example, under the Banking Union and Capital Markets Union programs, European banks can offer their services across the Union when they obtain a “passport.”6 The recent financial crisis can be used as a cautionary tale to motivate the implementation of more initiatives.
It is well established that Europe’s universal bank-based system mixes inherently public with private functions (Liikanen et al. 2012; Vickers Commission 2013; Bordo and Levin 2017). The system combines the public function of providing access to a payment system based on secure assets free of default risk with the for-profit allocation of capital to viable projects. The combination implies that regulations to secure the first objective may limit banks’ ability to achieve the second. While (implicit or explicit) public guarantees to (large) banks serve a public function, they also mean that banks can finance their assets at a significant discount in the market (Davis and Tracey 2014; Schich and Aydin 2014; Toader 2015). In a competitive market, this would be good news for customers because competition would force banks to pass on their lowered funding costs by providing cheaper credit to all. Public guarantees without such competitive pressures give banks a strong incentive to take on high risks and play a “heads I win, tails you lose” strategy (Gropp et al. 2013).
Unfortunately, the European banking sector is far from competitive (Apergis et al. 2016). Due to economies of scale and scope, aggregate market shares of 80% or more for the five largest banks in a country are not uncommon (ECB 2017, p. 32). The result is not cheap credit but monopoly rents for bank employees and shareholders (Molyneux et al. 1994; Carbó et al. 2009). Moreover, because public guarantees mean that taxpayers are ultimately liable for any losses beyond a small equity buffer, regulators must strictly supervise the lending practices of banks, especially those deemed “systemically important.” Following the financial crisis of 2008, European regulators tightened their supervision and now enforce a harmonized set of stricter European rules (e.g., European Banking Authority 2019). The regulation aims to reduce the risk of a single bank collapsing by imposing risk-weighted reserve requirements and subjecting banks to stress tests (Focarelli and Pozzolo 2016).7 However, the unintended consequences of such tightened regulation are further bank concentration and even less credit flowing to ventures that cannot offer high-quality collateral, strong and long track records, or reliable cash flow predictions.
As previously mentioned, Europe’s fiscal and social security systems are also strongly biased towards large portfolios of professionally managed assets and debt-based finance (Kay 2015). The imbalance makes financial markets in Europe highly concentrated, largely debt- and bank-based, and biased against small- and medium-sized firms in general and young, innovative ventures in particular (Liikanen et al. 2012; Pohl and Tortella 2017; Miklaszewska 2017). Ironically, regulation to limit the micro risk for individual banks, funds, and portfolios thus creates systemic and macro risks by eliminating diversity and shifting investment away from small-scale experimental ventures. To maintain a competitive return on equity, the system as a whole is highly leveraged, and citizens end up investing their savings in liquid, marketable assets. These assets have a low real return because they do not finance innovative and productive ventures (Bezemer and Hudson 2016) but instead go to large incumbent firms with strong balance sheets, further entrenching the status quo.
Proposal 18: Maintain the systems of bank loan guarantees for start-ups and ensure that (appropriately anonymized) credit decision information becomes publicly available.
Strictly speaking, this proposal violates the neutrality principle, but given the existing biases against start-ups in banking, the risk is small that it would tilt the playing field far in their favor. The proposal would gain further traction if policymakers linked it to provisions enhancing transparency for other types of investors.
Proposal 19: Increase the mandatory equity ratio in banking gradually to 10–15% to allow them to responsibly take on more risk in their lending portfolios.
We do not expect this measure to cause banks to start lending massively to early-stage, high-risk ventures. That is the province of venture capitalists. However, this proposed change will make it easier for entrepreneurial ventures to acquire additional funding and grow in the later, less risky stages of their life cycle. With more “skin in the game,” banks will be able to enter earlier in a firm’s life cycle, responsibly assuming slightly more risk (Admati et al. 2010). Mandatory higher equity ratios also give them the incentive to do so. Lower leverage implies lower returns on equity, which should lead banks’ shareholders to push for higher returns on the bank’s portfolio and shift credit towards riskier, but more rewarding ventures that can on average afford higher interest rates and risk premia.10 Of course, the rates for mortgages, large corporations, and governments would also rise—but credit to these sectors of the economy is currently too cheap, arguably fueling unproductive speculative bubbles rather than productive investment (Bezemer and Hudson 2016). The gradual phasing-in of the proposal would enable banks to use retained profits to increase equity, and portfolio impacts should be closely monitored during the transition. As such, the proposal is justifiable as it serves both private and public interests, while its simplicity satisfies the principles of transparency and neutrality.
Nevertheless, a higher equity ratio across the board is a second-best solution, as it is unable to yield the more diverse banking system we need to cater to the diverse demand for financing in the entrepreneurial society. Traces of diversity in banking are still found in Europe: in Germany, for example, a few very large and highly leveraged banks (e.g., Deutsche Bank and Commerzbank) coexist with many small, often locally operating banks (Sparkassen) that operate in different niches. A multitude of small, locally embedded banks survive in Italy as well.11
In such situations, there is a risk that minimum equity ratios cause a reduction in diversity that makes the entire system more vulnerable (Haldane and May 2011). A first best approach would, therefore, allow some banks to operate in a low-risk low-return niche with high leverage, while others could opt for a smaller, riskier, and high-yielding portfolio with more equity on their balance sheet. The market, rather than the regulator, would then determine each bank’s required equity ratio. This end state is desirable but would require that banks cease the essential public good functions that currently justify and motivate their strong regulation and supervision. Only when the public interest is firmly secured can banks be set free to intermediate the savings they attract as they see fit based on their customers’ and financiers’ risk-return preferences, with contestability and competition leading to the best business models in a variety of niche markets.
The more diverse and entrepreneurial banking sector envisioned above sits uncomfortably with banks’ legally sanctioned ability to attract deposits in current accounts. Due to public guarantees and technological development, these deposits have largely replaced the publicly issued alternative—cash—as the preferred medium of exchange and store of value. Thus, commercial banks finance a substantial part of their balance sheet with the type of monetized debt that has come to circulate in the economy as money.12 In the wake of the financial crisis, many have questioned banks’ prerogative to create money by giving credit, and monetary reform has been proposed for a variety of reasons (e.g., Benes and Kumhof 2012; Vickers Commission 2013; Wolf 2014; Dyson et al. 2016). Our point here is that freeing up the balance sheets of Europe’s banking industry just a little would help channel a small share of total savings to young and innovative ventures—a change that could have a huge impact on promoting an entrepreneurial society.
Proposal 20: Introduce central bank digital currency to replace deposits at commercial banks as the dominant risk-free store of value and medium of exchange.
The implementation of such a fundamental reform close to the heart of the European economy should not be rushed. The operation can be compared in scope and complexity with the introduction of the euro two decades ago and will require a comparable amount of planning and a broad public discussion before it can be implemented. Some technical issues will need to be addressed to realize this proposal, but bitcoin and other cryptocurrencies show that the technology is there for central banks to use. The advantage of CDBC over private cryptocurrencies should be obvious, as central banks are the only party that can guarantee and stabilize the value of a digital currency, eliminating the kind of volatile and speculative trading plaguing private cryptocurrencies. That being said, an implementation of the proposal would be nothing short of a monetary paradigm shift, and such shifts are not to be implemented lightly. However, once completed the reform would also make monetary policy more effective, by (re)establishing a more direct link between the money supply (M1) and the monetary base (M0) (Bordo and Levin 2017). It is therefore encouraging that central banks inside and outside the EU are currently discussing and researching this issue, with several experiments being planned or under way. Such developments will help achieve a more diverse banking sector that can cater to the diverse financial needs of small and large, young, and old firms in Europe to the benefit of entrepreneurial society.14
Overall, the focus of the discussion in this section has been on creating a situation in which banks and institutional investors can responsibly intermediate funds, directing more of Europe’s savings to deserving new ventures without jeopardizing the stability of the system. If banks are to play a role in the financing of tomorrow’s firms, they should perhaps (be forced to) withdraw from also providing our medium of exchange, as the two activities seem incompatible. Modern technology offers the opportunity to rebalance public and private interests in the banking sector and correct this apparent flaw in our current financial system. But new technology also allows for alternatives to banking altogether. We now turn to a discussion of such “alternative finance.”
4.2.4 Experimenting with New Technology to Finance Venturing in All Stages
Proposal 21: Implement a light-touch regulatory regime for equity crowdfunding and peer-to-business lending.
Vigilance on this matter is well founded: German regulation (the Kleinanlegergesetz) recently threatened to limit crowdfunding for real estate investments and was averted only at the last moment (Crowdfunding Insider 2017). While its proponents typically cite stability, investor protection, and other seemingly compelling reasons, restrictive regulation risks preventing valuable services from emerging in the first place. In our view, a regime of tight supervision but loose regulation, akin to the one implemented in the UK, would better encourage experimentation with this new form of finance. Peer-to-business lending warrants a similar approach, especially considering that it proved to be an important buffer against the impact of the financial crisis in countries where it existed (Mills and McCarthy 2014).
Moreover, these systems of alternative finance benefit entrepreneurial start-ups more than they do large, incumbent firms and corporate groups. Crowdfunding platforms are better than traditional finance channels at handling smaller ticket investments (Polzin et al. 2017). They also reduce opacity and information asymmetry because their open character generates access to valuable information in addition to handling financial resources (Polzin et al. 2018b; Toxopeus 2019).
Proposal 22: As part of its efforts to allocate the Juncker Fund, the European Investment Bank could experiment with a euro-denominated European crowdfunding platform and match successful campaigns with public funds.
Member states and local authorities running similar national and local support schemes could adopt this proposal’s logic as well. It fits well under the neutrality principle, given that projects in the platforms compete on a level playing field that is not biased against small, risky, and radically innovative projects.
4.3 Summary
Summary of proposals regarding savings, capital, and finance, specifying the level in the governance hierarchy where the necessary decisions should be made
No. | Principle(s) | Policy area | Proposal | Policy levela |
|---|---|---|---|---|
13 | Neutrality and transparency | Private wealth | Allow for more wealth to accumulate and remain in private hands and make it possible, easy, and attractive to invest such wealth in entrepreneurial ventures. | MS, REG, LOC |
14 | Neutrality and justifiability | Pension funds | Allow people to choose how and where to invest part of their pension savings individually. | EU, MS |
15 | Neutrality and justifiability | Pension funds | Pension funds and other institutional investors should, on an experimental basis, be allowed to invest more in equity in general and in venture capital specifically. | EU, MS |
16 | Neutrality and justifiability | VC | Develop competencies for private equity and venture capital investment in the field and avoid promoting VC capital with public funding directly. | MS, REG, LOC |
17 | Neutrality | VC | Reduce barriers to the sale, acquisition, and IPO of VC-funded start-ups to facilitate profitable exits. | EU, MS |
18 | Neutrality and transparency | Banks | Ensure that (appropriately anonymized) credit decision information becomes publicly available in the system of bank loan guarantees for start-ups. | MS, REG |
19 | Neutrality and justifiability | Banks | Increase the mandatory equity ratio in banking gradually to 10–15% to allow them to take on more risk responsibly in their lending portfolios. | EU |
20 | Neutrality and justifiability | Banks | Introduce central bank digital currency to replace deposits at commercial banks as the dominant medium of exchange. | EU, MS |
21 | Neutrality | FinTech | Implement a light-touch regulatory regime for equity crowdfunding and peer-to-business lending. | EU, MS |
22 | Neutrality and transparency | FinTech | As part of its efforts to allocate the Juncker Fund, the European Investment Bank could experiment with a euro-denominated European crowdfunding platform and match successful campaigns with public funds. | EU |
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