08 May 2006

Speech Smaghi: The Growth of Pension Funds and Financial Markets

On the occasion of the IMCB conference on “Dealing with the New Giants” in Geneva, Mr Smaghi, ECB executive board member pointed out some of the risks the growing pension funds may have on the structure and functioning of financial markets.

“For pension funds, in particular, the shortening of the time horizon associated with the progressive aging of society might create incentives for asset managers to be myopic”, Mr Smaghi said. “If benchmarks play a key role in portfolio management, a natural tendency to herd may emerge among institutional investors. As is well known, herding can be a recipe for asset misalignments, in particular over the short term, and for the emergence of self-fulfilling price setting” he continued.

He undlined that “40 per cent of outstanding Government bonds are held by pension funds. Concentration may reduce the efficiency of the market and increase its fragility, in particular in the face of contagion.”

“The combination of the two risks mentioned above - myopic behaviour and market concentration - might further fuel the risk of herding behaviour. The fewer the portfolio managers, the easier it may be for them to “coordinate” their expectation and their market positions, independently of underlying economic fundamentals.“

“If the fixed income market is dominated by few institutional investors seeking to beat a benchmark, there is a risk that asset prices might reveal little about fundamentals.”

“A second question of interest for central banks is whether the emergence of large pension funds affects the transmission of monetary policy on output and inflation.

“If asset prices are set on the basis of short-term benchmarking, the relationship between the policy rate and households’ and firms’ behaviour may become non-linear and unpredictable.

“The emergence of pension funds may in fact itself contribute to an environment of low interest rates, especially at the long end of the curve, reflecting the increasing demand for fixed income assets. This may create phenomenon like “conundrum”, in which long term rates behave in a way not fully consistent with movements in short term rates.

“The rising importance of institutional investors and the associated changes in the financial structure has an impact on monetary analysis. On the one hand their liquidity and asset allocation may significantly differ from those of households and firms whose funds they often manage. On the other hand, institutional investors also directly engage in lending to households and firms and their activity may thus substitute for bank lending. This makes it more difficult to detect whether an increase in some parts of household liabilities, for instance bank credit, is motivated by consumption behaviour or by asset-liability management.

“In the euro area, theses developments are still at their infancy. However, if a trend towards a US model emerges, we can expect substantial changes in the financial structure of the household sector and in the way financial instruments are used.

“Going forward, the information provided by monetary financial institutions might have to be complemented with timely balance sheet information on institutional investors.

Full speech

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