Institutional Investors, Financial Market Efficiency and Financial Stability E Philip Davis ABSTRACT Institutional investors have grown strongly in the past few decades, as a consequence not only of the overall expansion of financial sectors relative to GDP, but also a boost in their share of total financial claims. As outlined in Davis and Steil (2001), the growth of institutional investors can be traced to various supply and demand factors that have made investing via institutions attractive to households. Supply-side factors suggest that institutions have offered their services relatively more efficiently than banks and direct holdings, thus fulfilling the functions of the financial system more effectively, while demand-side factors imply households have enhanced requirements for the types of financial functions that institutional investors are able to fulfil. On the supply side, there is, inter alia, the ease of diversification, liquidity, improved corporate control, deregulation, ability to take advantage of technological developments, and enhanced competition, as well as fiscal inducements and the difficulties of social security pensions. On the demand side, one may highlight demographic aspects (notably funding of pensions and population ageing) and growing wealth. Owing to the dominance of pay-as-you-go pensions and the lack of sustainability of current systems (Davis 1995a), scope for expansion of private pension funding and institutional investment more generally is arguably even greater in Continental Europe than in the relatively mature markets of the US and the UK, where pension systems already have major funded elements. Pension saving is likely to increase sharply over the next twenty years as individuals seek to provide for their retirements following pension reform in pension funds, or as precautionary saving in life insurance and mutual funds. We also argue that the scope for change in EU pension systems as well as growth of institutional investors is enhanced by EMU. The prospective development of institutional investors has major implications for the structure and performance of EU financial markets. Given this perspective, an overview of the likely financial implications of the growth of institutions is very timely. Note that given the lesser development of institutions in Europe to date, much of the paper has to be set out in general terms or using experience from the US and UK, which may be replicated in the rest of the EU in future. We focus successively on the impact of institutional investor growth on the efficiency and stability of financial markets. Efficiency is defined broadly in terms of the ability to perform the underlying functions of financial systems (Merton and Bodie 1995), which are: The provision of ways of clearing and settling payments to facilitate exchange of goods, services, and assets The provision of a mechanism for pooling of funds from individual households to facilitate large-scale indivisible undertakings and the subdivision of shares in enterprises to facilitate diversification The provision of ways to transfer economic resources over time, across geographic regions, or among industries; The provision of ways to manage uncertainty and control risk. Through securities and through financial intermediaries, risk pooling and risk sharing opportunities are made available to households and companies. There are three main ways to manage risk: hedging, diversifying, and insuring. The provision of price information, thus helping to coordinate decentralized decision making in various sectors of the economy The provision of ways to deal with incentive problems when one party to a financial transaction has information the other does not, or when one is agent of the other, and when control and enforcement of contracts is costly Our main focus is on pooling, transfer of resources and incentive problems, although the other functions are also touched upon . We begin by providing details on the current size and likely future trends in institutional investment. Then we assess successively the extent to which insurance companies, pension funds and mutual funds differ in ways that may be relevant to their impact on financial markets. We examine whether institutional investors can raise the saving and investment rate of the economy, the impact on corporate governance and other aspects of financial structure. Proceeding from efficiency to stability aspects, we look at the impact on market dynamics of the investment techniques, asset pricing models and risk management approaches adopted by institutional investors. We consider the systemic consequences of the conduct and regulation of institutional investors, we outline some specific issues linked to life insurance companies; and assess the implications of growing institutional investor sectors for prudential regulatory policy.