Expanding the European Economy: The Role of Capital Markets

Panelists and Context:

• Event: Milken Institute Capital Markets Summit, London, December 5, 2017.
• Moderator: Mike Milken, Chair of the Milken Institute.
• Panelists:
  • Grace Bartlett: J.P. Morgan.
  • Damien O'Neill: CEO of QSuper (Australia's largest defined contribution pension fund).
  • Giuseppe "Gus" B. (Verde Capital, representing Shankman): Investor and analyst.
  • Bob: Shankman Capital (Specialized in credit and flexible investment strategies).

Core Economic Thesis:

• Multiplier Effect: Financial technology and capital access act as a multiplier for human capital, social capital (rule of law), and real assets.
• Job Creation Driver: Small and medium-sized enterprises (SMEs) create approximately 67% of jobs globally; boosting high-growth SMEs by 1% can yield a 2% GDP impact in the UK.
• The Growth Gap: Between the 1970s and 2000, the U.S. created 62 million jobs via SMEs while large businesses saw negative net job growth; Europe lacks this dynamic due to banking-centric finance.
• Failure of the System: Low interest rates and stimulus in Europe have not translated to job growth or middle-class prosperity, driving populist sentiment and political instability.

Capital Structure and Banking Analysis:

• US vs. Europe Models:
  • United States: Post-1970s crisis, financing shifted from bank loans to public/private markets (equities, securitization); banks now hold <20% of corporate loans.
  • Europe: Over-reliance on bank lending (80% of SME financing); banks remain too large relative to GDP (e.g., top 3 French banks equal top 3 US banks despite smaller GDP).
• Non-Performing Loans (NPLs): European banks, particularly in the periphery, are clogged with NPLs, preventing them from lending to productive SMEs.
• Regulatory Impact: Post-2008 regulations (e.g., Dodd-Frank) and European banking rules have forced banks to de-risk and shrink lending to SMEs due to perceived risk, unintendedly stifling growth.
• Disintermediation Opportunity: Investors can step in to buy NPLs from banks and provide alternative capital to companies excluded from traditional banking.

Pension and Savings Systems:

• Defined Benefit (DB) vs. Defined Contribution (DC):
  • Australia has shifted heavily to DC (compulsory contributions), whereas the US/Canada/Europe rely on DB, creating funding gaps as life expectancy increases.
  • Australian Model: Government matching incentives increased average contributions to 18% (target level), though longevity protection remains a future challenge.
  • European Risk: Many sponsors cannot meet DB liabilities; a global shift toward DC is occurring, but without proper design, it risks leaving individuals underfunded.
• Japan's Paradox:
  • Corporations hold liquidity exceeding 120% of GDP; deposits yield zero or negative rates.
  • High cash balances are attributed to a cultural aversion to risk and the tautology that issuing credit creates deposits that remain idle.

Technology and Future Finance:

• Fintech and Big Tech: Companies like Amazon, PayPal, and Alibaba are emerging as lenders by leveraging real-time customer data to assess risk, bypassing traditional banking infrastructure.
• Job Displacement: Technology (AI, blockchain) is projected to displace 30% of UK jobs in the next 15 years, necessitating a shift in education and capital allocation to retraining.
• Private Equity (PE): PE firms control more companies in the US than are listed; they are viewed as a potential engine for job growth if held accountable beyond mere financial returns.
• ESG Integration: J.P. Morgan and Shankman are expanding into Environmental, Social, and Governance (ESG) investing, moving from negative screening to positive impact (e.g., funding education, retirement security).

Regional Growth Strategies:

• Europe:
  • Challenges: Fragmented markets (language, law, regulation) hinder a unified capital market; Brexit adds complexity.
  • Opportunities: High unemployment in educated workforces offers low-cost labor for expansion; potential for bank M&A to consolidate assets.
  • Capital Markets Union (CMU): Essential to diversify funding sources beyond bank lending to equity and debt markets.
• Latin America: Identified as a future growth engine due to low banking penetration (20%) and urbanization, which will drive credit demand and wealth creation.
• Africa: Projected to add 3 billion people; failure to provide local opportunities will create migration pressure toward Europe.

Risk and Regulation:

• Over-Regulation: Excessive regulation aims to remove risk but inadvertently removes innovation and the ability for investors (e.g., young vs. elderly) to select appropriate risk profiles.
• Housing Markets: Criticized for relying on asset values rather than cash flow analysis, leading to boom-bust cycles; securitized debt relies on underlying cash flow generation.
• Sovereign Debt: Historically risky; double-B industrials have 50% of the default rate of AA railroads.
• Market Valuation: Central banks focusing narrowly on inflation may miss overvaluation bubbles in asset markets.

Forward-Looking Statements and Calls to Action:

• Urgency: Europe faces a "last chance" scenario; a 5-10% shift in votes to populist, anti-Eurozone parties could destabilize the region.
• Investment Strategy: Firms are actively deploying capital in Latin America (local currency bonds) and seeking to disintermediate European banks to fund growth.
• Financial Inclusion: Expanding credit access to unbanked populations (via fintech) is critical for unlocking wealth creation in developing regions.
• Systemic Responsibility: Financial institutions must align incentives with societal outcomes (prosperity, jobs) to maintain the social contract and prevent democratic backsliding.