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Institutional Investors, Financial Market Efficiency and
Financial Stability

E Philip Davis


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:

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.