Sustaining Investment in the Draghi Report: an Analysis
Introduction and purpose of the article
The first section of Draghi's report is now considered by many analysts as the future (and current) “Economic Bible” of the European Commission. There is no doubt that European competitiveness requires a revolution, but equally, there is no doubt that such a transformation comes with high costs—not just metaphorically, but in terms of substantial real investments. Substantially more than Marshall Plan’s investments.
To sustain them, it is fundamental to show why Europe’s financial sector was unable to make proper investments in recent years.
So, our article will start by showing the (1) weaknesses within the European financial sector. Just like a doctor diagnosing a patient, we must first identify the sick components of the European financial system. By understanding these, we can delve deeper into the root causes of the sector's inefficiencies, which will represent the second pillar of our article, i.e. (2) the root causes of these weaknesses.
Finally, much like prescribing treatment, we will explore potential remedies and their side effects in the last section entitled (3) “Draghi’s proposals and possible criticisms”.
1)Weaknesses within the European financial sector
1.1) Low profitability of EU banks
The low profitability of European banks remains a critical challenge, especially compared to their U.S. counterparts. As illustrated in the following graph, U.S. banks like J.P. Morgan, Bank of America, and Wells Fargo far surpass the market capitalization of the top 10 EU banks combined.
Why is banks' profitability so important?
The crucial point is that enhancing bank profitability (making banks' investments more profitable for banks) is essential for a more efficient allocation of capital and for ensuring the capacity to finance the broader economy.
Thus, creating a more efficient and profitable banking industry will give Europe more capacity to sustain the required investments.
1.2) Underdeveloped systems that support venture capital
At the same time, ensuring banks' profitability is not enough.
While banks are central to traditional financing, they are not best equipped to fund innovation, which requires a greater presence of patient and risk-tolerant equity investors, such as venture capital firms.
Draghi highlighted how Europe's excessive reliance on traditional banking structures creates a bottleneck for economic growth, as the lack of alternative financing options limits the flow of capital to innovative, high-growth sectors. Addressing this imbalance by fostering systems that support venture capital and other equity markets is critical for making the EU’s financial system more efficient and enabling it to better support long-term growth and competitiveness.
1.3) Underdevelopment of the second and third pillars of the pension system
Even though European households' savings are considerably higher than their US counterparts (€1.390 billion vs. €840 billion), the former have lower wealth because their savings are not channeled into productive investments. This is especially due to differences in pension wealth.
The pension system is traditionally structured around three pillars: first - public pensions (mandatory, the ones you pay to the State); second - occupational pensions (the ones given by employers to match your pension with your wage) and third - private individual pension plans (like long-term investments in the stock market).
Draghi’s report showed how “The relatively low level of pensions (in the second and third pillars) is a missed opportunity for Europe, as pension funds—by design—are intended to transform current savings into future consumption through long-term investments.”
Just to have a comparison, in 2022, the level of pension assets in the EU was only 32% of GDP, while total pension assets amounted to 142% of GDP in the US and to 100% in the UK, as shown in the following graph.
2) Root causes of these weaknesses
After having outlined the three main financial sicknesses, we will deeply analyze the root causes of these weaknesses.
Three core problems are shown: overly strict financial rules, inefficiencies in the EU Budget and, finally, fragmentation (of regulations).
We will start with the latter.
2.1) Fragmentation (of regulations)
The importance of this part can be highlighted through two channels: difficulties in enlargement and non-harmonized taxation regulations.
First, the differences in regulatory principles applied in different countries’ financial systems make it more difficult for new banks and funds to expand, creating unnecessary costs that make the businesses less efficient. Moreover, from the security point of view, such differences can be exploited for tax evasion, making it not only obsolete, but also not fulfilling its primary mission.
Second, the discrepancies in taxation regulations create unnecessary difficulties that hinder European investment. The problem is in the difficult regulatory landscape, where the risk of double taxation of income is high, and to mitigate it, some expert advice can be required. This feature essentially limits the individuals' access to investment, including through the third pension pillar, not allowing financial markets to release their potential. This is directly reflected by the size of the venture market, the share of which in the economy of Europe is four times lower than the one in the US. This essentially limits the equity funding options, which mostly affects the start-ups and nascent firms, stalling the innovation potential.
Last, but not least, is the “home bias” of banking systems. Indeed, the domestic banks are protected by regulations from the banks of other Member States, making healthy competition limited and less efficient. Such regulations decrease the capacity for financial market unification, hindering the complete monetary union and limiting competitiveness.
2.2) Excessively difficult and prudential rules
The excessively strict and complex regulatory framework in the EU (post-2008), while aimed at ensuring financial stability, is hindering the profitability and efficiency of its banking sector.
Let’s use a very bright and simple paper from Georgetown University to explain economically why this is the case. The following image highlights the challenge of balancing three regulatory-economic priorities: financial innovation, market integrity and clear rules. It argues that achieving all three simultaneously is nearly impossible, and trade-offs must be made. For example, prioritizing clear rules and market integrity requires broad prohibitions, which stifle innovation. A clear historical example is the environment post-1929, where the separation of commercial and investment banks led to clear rules and a stable environment but blocked innovation and economic growth.
Similarly, focusing on clear rules and innovation leads to oversimplified regulations that may compromise market integrity (i.e., financial stability). The historical example associated with this is the deregulation wave of 1999, which aimed to enhance innovation but also introduced risks, culminating in the 2008 financial crisis.
Finally, emphasizing market integrity and innovation demands overly complex regulations, making compliance, coordination, and enforcement burdensome. The historical example associated with it is post-2008 Europe, and it’s the target of Draghi’s criticisms.
Draghi’s report argues that regulations made after 2008 are excessively difficult and strict, especially those affecting the securitization market and those established at the Basel agreements.
This first has a direct negative effect on banks' profitability (point (1.1)) since overly cautious rules limit banks' flexibility to transfer risks and unlock additional capital for lending.
Secondly, the EU’s rigorous implementation of Basel frameworks is often seen as “gold-plating,” creating an overly complex environment that discourages venture capital activity (1.2) and private investment by individuals (1.3).
2.3) Inefficiency of the EU Budget
The EU Budget, mostly composed of GNI-based (Gross National Income) contributions from Member States, suffers from many weaknesses that render it unable to support the financing needs of the Union.
First, it is not large enough, as by now, it stands at only 1% of the combined GDP of the 27 Members, while the combined budgets of the States represent 50% of GDP. Furthermore, the already limited effective spending power of this budget will decrease in the near future due to the yearly 30 billion euros in repayment planned for NextGenEU starting from 2028 (and until 2058). Such a small common budget makes common investments in areas of strategic interests impossible, keeping public spending in sectors of significance for competition, like semiconductors and artificial intelligence, fragmented and less effective. In fact, common investments are necessary since only a European-level actor would be able to profit enough from the positive externalities.
It is also to be considered that the European Union cannot issue debt to finance its spending (with the important exception of the NextGenEU emergency plan for the Covid recovery), further limiting its possibilities.
Not only this, but the scarce common resources of the EU are invested in sectors of scarce strategic importance for the Union (more than 60% of the 2021–27 Multiannual Financial Framework [MFF] is invested in agriculture and cohesion). Furthermore, in the other areas where Member States do spend together, their efforts are undermined by the problems discussed in the previous sections. Fragmentation: there exist more than 50 spending programs, a situation that harms the financing of big projects, prevents investments from reaching scale, and creates overlaps. Complexity: accessing resources for the private sector is made extremely difficult by fragmentation and bureaucracy.
Rigidity: the MFF (aka how the budget will be spent for the next 7 years) is established years in advance and nearly impossible to modify according to new needs.
Finally, at the moment, the EU Budget is not leveraged enough to stimulate private investment through the InvestEU program. This program seeks to attract investments from the private and public sector in areas of strategic interest using EU funds as a guarantee to lower risk for investors and works through the European Investment Bank (EIB) and the different National Promotional Banks (NPBs).
3) Draghi’s proposals and possible criticisms
3.1) Capital market harmonization (towards a capital market union, CMU)
In this part, Draghi's proposal is to modify the current structure of the European regulatory system. First, he proposes to transform the European Securities and Markets Authority into the European Security Exchange Commission, a single common regulator for all EU security markets instead of the “regulator of regulators”, as it is now. Its main sphere of competence would be major financial institutions with international outreach. In addition, Draghi proposes to add more independent members to the organ to make it less dependent on individual Member States’ interests: currently the body is composed of countries’ representatives. Finally, a certain division of powers is proposed: while the legislation would outline a framework and strategic principles, the Commission would perform regulatory and supervisory tasks.
To avoid the Member States’ opposition, Draghi proposes to divide the powers between the European and local regulators along the lines of the division between the ECB and the national banks, for example, leaving the oversight of local issuers to the national bodies.
From the point of view of investments, the main proposal is to harmonize the insolvency regulation, which would harmonize the approach to risks among European investors, as well as work on overcoming double taxation risk in the fiscal law.
3.1.1) Risks
The main risk concerning the connection between European markets lies in the response to shocks and crises. While in some scenarios, a large united market could absorb negative effects, there is still a risk that a higher level of unification will amplify economic shocks. It means that a crisis that could have been limited to one country or region could affect the entire European Union.
Another concern is the difference in the level of economic development between different countries. The EU is an uneven organism, with members having vastly different levels of development. Critics of the CMU argue that a more united market could benefit disproportionately more the countries that are already well-off, creating a disadvantage for the less developed ones and widening the development gap even more.
3.2) Deregulation and its risks
Let’s go back to the “Innovation Trilemma” outlined in part (2.2).
Draghi’s idea is to relax the strict choice of market integrity a bit, allowing more straightforward rules and continuing to allow an innovative financial environment. The consequence of the “Financial trilemma” is a shift to a more hybrid regime, shown in the following image.
The effects would increase banking profitability, private investments in the financial market (more straightforward rules), and foster joint venture systems, but, at the same time, the challenge is to understand to what extent those regulations should be relaxed since the risk of a financial crisis is always possible.
3.3) More effective deployment of the EU budget
Regarding the weaknesses of the EU Budget described in Section 2.4, Draghi proposes four main solutions.
First, the EU must jointly redefine its strategic priorities and redirect its Budget towards them. The Union needs to define a “Competitiveness Pillar”, comprised of EPGs (European Public Goods, aka projects funded by the EU like NextGenEU) and multi-country industrial projects (projects not financed by the EU but coordinated among Member States), to boost the European economy in the most strategic sectors, like tech and manufacturing.
Second, the EU needs to streamline and simplify access to its financing programs. To achieve this, it is necessary on the one hand to reduce and refocus the number of programs, and on the other hand to lower and harmonize rules and requirements for accessing funds, diminish waiting times and establish a single reference point for requests.
Third, the Budget must become more flexible. It should be possible for funds to be reallocated according to needs.
Fourth, the EU should increase the number of guarantees behind the InvestEU program, to be better leveraged, stimulating private investment.
Draghi also suggests one last measure, parallel to the above-mentioned reforms: delaying the repayments of NextGenEU loans, in order not to harm the spending power of the EU during this critical period.
3.3.1) Problems of the suggested reforms to the Budget
In this part of the report, Draghi restrains himself from openly suggesting more radical reforms, like establishing a central fiscal policy in the hands of Brussels, creating new own-resources, or even increasing the contributions of Member States. This is most probably due to the existence of a staunch historic opposition among Member States to these kinds of measures.
However, the milder solutions he does suggest are not spared from opposition either. Generally, any modification to the allocation of the MFF is expected to spark intense protests. A clear example of this can be found in very recent times, in October, when a leaked document from the European Commission exposed the intention of the latter to group more than 500 spending programs, addressed to regional and local bodies, in 27 national cash pots. This, of course, was in line with the Draghi Report’s proposal to diminish and streamline the number of programs, and it was supposed to free up resources for other strategic priorities. However, the idea was met with stark opposition both from local governments fearing to lose money and relevance and farmers fearing to lose their funds, particularly from heavily affected countries like France and Poland.
Events like this show how difficult any modification to the Budget is. Even admitting that Draghi’s ideas could be effective, their implementation will be a political test for European countries.
3.4) Common European Safe Asset
The most breakthrough idea proposed by Draghi in this section of his report is probably the issuance of a Common European Safe Asset. In his vision, this is a fundamental step both for the achievement of the CMU and to boost the capabilities of the EU Budget.
The Common Asset is the summit of the CMU, as it would provide a safe collateral that can be used in every country and financial activity. It would also set a benchmark to help the standardization of the prices of bonds and derivatives across EU markets. Finally, such an asset would obviously reduce information asymmetries and the above-mentioned “home bias", as everyone all around Europe could buy it at a common price.
Even more relevantly, the Common Asset could be bought by private investors to inject liquidity into European finances: put in a simpler way, Draghi is proposing the issuance of common debt. He presents this as “a more realistic proposition” to finance all the investments needed to revamp European competitiveness, whereas State finances alone shouldn’t be able to bear the cost.
To implement this, Draghi proposes to follow the template already used for NextGenEu, but he also specifies that issuing common debt on a more systematic basis will require stronger fiscal rules for national budgets and more sustainable national debt.
3.4.1) Risks
A big chunk of the risks in this matter are related to free riding. First, an umbrella bond would equalize the terms that each country could use to take on debt. While currently the reputation incentivizes countries to prudently approach fiscal policy, the introduction of a common safe asset would allow mitigate the negative effects of overspending, making free-riding possible and penalizing solvent countries. In addition, the “averaged” reputation of the asset would make borrowing more costly for previously financially prudent countries, essentially penalizing good market behavior. Those two factors, in turn, lead to moral hazard due to the disappearance of the factor of market discipline.
Additional risk is connected to governance. First, the optimal functionality of the Common European Safe Asset is possible only in the case of harmonized fiscal policy, which is not guaranteed considering vastly different approaches to fiscal prudence and spending across Europe. In addition, such a mechanism would essentially limit the States’possibility to regulate their fiscal policy in response to different challenges, which are heterogeneous for every country. This would make their response less effective, hence rendering the entire system more fragile.
Conclusion
The Draghi Report provides a critical analysis of the weaknesses within the European financial system and offers strategic solutions to address them. By highlighting the low profitability of EU banks, the underdevelopment of venture capital markets, and the inadequacies in the second and third pillars of the pension system, the report lays the groundwork for understanding the financial bottlenecks that hinder Europe's competitiveness.
The second part of the analysis reveals the root causes of these weaknesses: regulatory fragmentation, overly strict financial rules, and inefficiencies in the EU Budget.
These systemic issues exacerbate the inability of the European financial system to mobilize and allocate resources effectively, stalling innovation and limiting long-term growth. Draghi’s emphasis on harmonizing regulations, relaxing excessively stringent rules, and enhancing the EU Budget’s strategic focus are pivotal steps toward addressing these deep-seated challenges.
While the proposed reforms hold transformative potential, they face significant political and practical obstacles. Overcoming resistance to budget reallocation, navigating the complexities of regulatory unification, and managing the risks associated with financial deregulation will require a concerted effort from all EU Member States.
Significant effort will be needed, especially if a Common Safe Asset, such as a Eurobond, is approved, as its immense potential to address Europe’s major financial market weaknesses is matched by the scale of the challenges it presents.
If implemented effectively, these reforms could lay the foundation for a more resilient, innovative, and competitive Europe, capable of sustaining the investments needed to secure its future. However, achieving this vision depends on Europe’s ability to unite around a common economic purpose while balancing national interests with collective growth.
“L'Europe se fera dans les crises
et elle sera la somme des
solutions apportées à ces crises”
Jean Monnet
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