Financial market activity of life insurance companies and pension funds

BIS Economic Papers No 21
January 1988

Abstract

An important development in the financial markets of several industrial countries in recent decades has been the growth of long-term institutional investors and their increasing domination of the capital market. Aided by both demographic and financial market trends, it seems likely that this development will continue in the future. However, the nature and the importance of this change - including the global dimensions of the trend towards institutionalisation - have often been overlooked or underestimated by market commentators and observers. Even fund managers themselves are often unaware of the conditions faced by institutional investors in other countries.

This paper sets out to remedy these lacunae by providing a detailed survey of the behaviour of long-term institutional investors in the capital markets, thus offering a background for informed discussion of policy and of likely future developments. he principal aims of the study are to show the causes of institutional growth, the nature of institutional investors and the implications of their activities and growth. The paper is in the form of a transnational comparison of institutional sectors in the United Kingdom, the United States, Germany, Japan and Canada. The study draws on material from interviews with fund managers, econometric and statistical analysis, and studies of the individual countries' financial sectors.

After an introduction and brief definition of the business of life insurance and pension provision in general terms, the paper shows the levels and changes in size of the institutional sector in the five countries over the last twenty years. The size of the sector is obviously a key determinant of the degree to which institutions dominate financial intermediation. Underlying causes of growth can then be analysed against the background of these country experiences. Rates of return, taxation and portfolio regulation are particularly highlighted, and it is noted that taxation and regulation are at least partly policy variables. The analysis thus shows how policy-makers may sustain or reduce the growth of institutions. The portfolio distributions of the institutional sectors are then similarly analysed. Given the size of institutions, portfolio distributions give an idea of the degree to which institutions have influenced the locus of intermediation between securities markets and bank lending. Determinants of historical shifts in portfolio distributions are suggested. Although relative rates of return are important, as might be expected, portfolio regulation and the nature of institutions' liabilities also have a clear influence.

Following these largely historical and descriptive sections, the paper analyses the current behaviour of institutions in detail, using as raw material interviews with fund managers, and estimates the effects of institutions on the capital market econometrically. These sections allow the implications of institutional growth to be assessed, as well as giving further detail on the nature of institutions. In the analysis of current behaviour, the participation of institutions in financial innovation is assessed, together with recent changes in organisation and behaviour in relation to fund management. Results suggest, inter alia, that institutions - in contrast to popular belief are rather cautious in their response to financial innovation, though their behaviour and organisational structures are in a state of flux. In the econometric analysis, the effects of institutions on the demand for different capital market instruments is assessed both directly and via their effects on personal sector behaviour. Results of other studies which have estimated the effects of institutions on saving are also reported.

These complementary analytical sections give a view both of the current influence of the institutional sector on capital market developments arid of the average effects of institutional behaviour on capital markets over the historical period. On balance, it is concluded that institutions are beneficial to the capital market. For example, they may increase both the supply of funds and the efficiency of the allocation of funds. On the other hand, there are some reservations regarding their increasingly short-term investment horizons in some countries.

The growth of institutions raises certain policy issues, for example regarding their tax-privileged status and the usefulness of portfolio regulation. The analysis given in the paper casts light on some of these issues. For example, given the conclusion that institutions are beneficial to the capital market, their tax privileges may be justified, though it is noted that some arguments may be advanced against these. Meanwhile, laws enjoining prudent portfolio diversification are probably superior to controls on portfolio distribution as a means of prudential control, given the low rates of return and potentially higher risk that strict portfolio controls entail. Finally, experience in the United States suggests that government guarantees of fund assets may prove costly unless some control is exercised over the circumstances in which plans may be terminated.