Expanding the European Economy: The Role of Capital Markets

• Event Context: The Milken Institute London Summit (December 5, 2017) convened four financial leaders to discuss expanding the European economy through capital markets, addressing job creation, and resolving the gap between wealth creation and middle-class prosperity.
• Core Premise: Access to financial capital acts as a multiplier for human and social capital; without it, economic stagnation occurs, as seen in the disconnect between post-2008 wealth creation and the lack of benefit felt by the lower-middle class.
• Panelists:
  • Grace Billings (J.P. Morgan): Focus on SME financing and ESG investing.
  • Damien Broderick (QSuper/QIC): Perspective on defined contribution vs. defined benefit pension systems from Australia.
  • Giuseppe Lento (Verde): Analysis of European fragmentation, NPLs, and the need for a unified capital market.
  • Bob Shankman (Shankman): Focus on securitized debt, private equity, and the role of regulation in risk innovation.

Structural and Regulatory Challenges in Europe

• Fragmentation: Europe is not a single market; differences in language, law, and regulation hinder the creation of liquid, non-banked capital markets compared to the U.S.
  • The U.S. benefits from a single set of rules and a unified currency, whereas the Eurozone lacks this cohesion, making it difficult to disintermediate banks effectively.
• Banking Over-concentration: European banks hold assets relative to GDP that are significantly larger than U.S. banks, indicating an "overbanked" system with high non-performing loans (NPLs).
  • In France, the three largest banks hold assets equivalent to the three largest U.S. banks despite France having a much smaller GDP.
  • Regulators in the Eurozone, unlike the U.S. post-2009, could not force rapid asset sales or recapitalization without risking the disintegration of the currency union itself.
• Regulatory Drag: Excessive regulation, particularly post-Dodd-Frank and European equivalents, has reduced banks' willingness to lend to high-risk SMEs, the primary drivers of job creation.
  • Approximately 80% of European small businesses finance through bank loans, which have been restricted by risk-averse regulatory frameworks.
  • The Capital Markets Union aims to diversify funding sources beyond bank lending to equity markets and institutional investors.
• Risk Appetite: Over-regulation attempts to remove all risk from capital markets, inadvertently stifling innovation and eliminating investment options suitable for different investor risk profiles (e.g., young vs. elderly investors).

Pension Systems and Savings Allocation

• Defined Contribution (DC) Shift: Australia has successfully moved toward a defined contribution system with compulsory contributions (currently ~9% base, boosted to ~18% with government matching incentives).
  • DC systems transfer longevity risk to the individual, who often lacks the financial literacy to determine the correct savings rate for retirement.
  • Europe is globally trending toward defined contribution models as sponsors struggle to meet defined benefit liabilities, but often without the robust second-half system design (longevity protection) seen in the Australian model.
• Savings Traps:
  • Japan: High corporate liquidity (120% of GDP) and zero/negative interest rates have created a "savings glut" where entities prefer holding cash or sovereign debt over risky investments, stifling growth despite available capital.
  • Europe: Similar conservatism exists; high savings rates are not translating into investment due to risk aversion and a lack of diversified investment vehicles beyond housing and sovereign debt.

Growth Drivers and Future Opportunities

• SMEs as Engines of Growth: Small and medium enterprises are responsible for 67% of job creation globally.
  • A 1% boost in the growth of high-growth businesses in the UK correlates with a 2% GDP impact, highlighting a significant multiplier effect.
• Private Equity Expansion: Private equity firms now control more companies than are listed in the U.S. and are among the largest employers.
  • Panelists note a responsibility shift: private equity must be held accountable not just for returns, but for job growth and social outcomes.
  • Emerging fintech companies (e.g., Amazon, PayPal, Alibaba) are leveraging customer data to act as alternative lenders, though regulatory questions remain regarding when they constitute banks.
• Geographic Opportunities:
  • Latin America: Viewed as a high-potential growth engine where urbanization drives credit access and wealth creation; firms are investing in local currency bonds (Brazil, Colombia) to catalyze this cycle.
  • Africa: With UN projections of 3 billion additional people, sub-Saharan Africa represents a critical future market; capital deployment must occur now to prevent migration pressures on Europe.

Social Responsibility and Political Risks

• Populism Warning: A failure to deliver broad-based economic growth and safety is fueling populist movements that threaten the European project.
  • Giuseppe Lento stated that if the Eurozone does not grow, "this is the last chance" to fix itself; a 5-10% shift toward populist parties could result in anti-capitalist governance that damages the economy.
• ESG and Social Investing:
  • J.P. Morgan and other firms are pivoting toward Environmental, Social, and Governance (ESG) criteria, moving beyond negative screening (what not to invest in) to positive impact investing (e.g., funding education, retirement plans).
  • Socially Responsible Investing (SRI) is evolving to focus on positive economic activism rather than just avoiding extractive industries.
• Financial Literacy: Panelists identified education and financial literacy as critical bottlenecks; technology may displace up to 30% of UK jobs in the next 15 years, requiring a reformed education system and capital markets that fund retraining and new entrepreneurial ventures.

Forward-Looking Statements and Decisions

• London's Resilience: Despite Brexit, London maintains a deep capital market; the Alternative Investment Market (AIM) has raised £100 billion for 3,500+ small companies, supported by tax incentives like the EIS and VCT schemes.
• Strategic Deployment:
  • Shankman plans to deploy capital in Europe over the next 4-5 years, betting on the Eurozone's survival and the opportunity to disintermediate overbanked systems.
  • QSuper intends to leverage the Australian DC model's lessons to guide European pensioners, emphasizing the need for better retirement planning tools.
• Innovation in Credit: The creation of new financial markets, such as environmental sulfur bonds in the 1980s, serves as a model for solving modern challenges through targeted financial engineering.
• Closing Argument: The panel concluded that while technology and demographics present long-term challenges, the immediate imperative for the financial community is to unlock capital flows to provide prosperity, safety, and meaningful lives to citizens, ensuring democracy remains viable.