Role of Institutional Investors in Financial Markets - Essay Example

?The Role of al Investors in Financial Markets In many financial markets, particularly in developed economies (with the exception of countries like Japan), institutional investors have grown by leaps and bounds. For example, in the United Kingdom, 75% of the market valuation of all stock is held through institutional investment. In the United States, the trend is the same: over 60 percent of stocks are controlled by this type of investor (Burton and Brown, pp.223). The OECD also reported that in its member economies, institutional investors are growing on average of 9 percent per year since the 1990s (OECD, 2000, pp.195). This development has shifted the attention to the role and importance of institutional investors to financial markets. What this means is that these entities came to dominate and dictate the trajectory and the pattern of investment choices, affecting the dynamics of financial markets in the process. This paper will explore this theme. This objective will be undertaken in the context of financial markets with high institutional investors. Institutional Investors: A Background There is no standard definition or precise concept explaining the dynamics of institutional investors. But Lumpkin (2000) offered a general view, which will effectively serve the purpose of this paper. He explained that institutional investors are those financial institutions that invest savings of individuals and non-financial companies in the financial market (pp.195). The breadth and diversity of this definition can be tempered by a key requirement: That, money is being managed by institutions as distinguished by those administered by retail investors. Based on this definition seven principal categories of institutional investors exist: private pension funds; state and local retirement funds; mutual funds; life insurance companies; property and casualty insurance companies; non-pension fund money managed by banks; and foundation and endowment funds (Baums and Buxbaum, 1994, pp.667). This classification highlights a diversity which means that institutional investors are driven and influenced by different factors. There are however commonalities. For example the sector operates on the basis of well-defined risk-return criteria and employs sophisticated investment strategies and methods (Blommestein and Funke, 1998, pp.69). Furthermore, the OECD identified the common factors that drive the growth of this sector: There is a rising demand for retirement “products” such as mutual funds and guaranteed-equity plans, among others, due to the increase of ageing population in developed economies; The technological development especially in communications, computing and information fields lead to the enhanced capabilities of institutional investors to provide intermediation and services that entail minimal risks, with all these transpiring at very high speed but at a cheaper cost; There is the deregulation of the banking and securities industries since 1980s, which intensified competition among financial institutions, further encouraged by easing of restrictions on cross-border capital flows (Lumpkin, pp.198). All in all, the theoretical underpinning for institutional investment is intermediation. Wealth is not directly funneled to the market. Instead, money is delegated by investors to managers who will manage it in turn. This is fundamentally different from investments by individual agents or by the manner by which corporate entities own and manage their stocks. The business model works because the operational landscape is conducive and the outlook is very favorable as demonstrated by current statistics, trends as well as projections by experts and agencies like the OECD. The Role of Institutional Investment There is the claim that institutional investment is critical in the modernization of financial markets. To put it another way, its emergence has supposedly brought about reforms that led to the efficiency in financial market. This argument appears to be valid because institutional investors are linked to stock market growth, the emergence of best practices standards such as in the area of corporate governance and so forth. A study by the OECD released in 2012 demonstrated this in the experience of Chile’s financial market. It reported that institutional investment has had positive effects on: 1) the number of independent board members; 2) the decrease of monitoring costs as a result of improved quality of public information; 3) an enhancement of the supervision of companies where institutional investors have invested; and, 4) an improvement of bondholder’s protection (OECD, 2012, pp. 90-91). The case of Chile, its financial market and institutional investors demonstrated just few dimensions of the role and importance of institutional investors. There are numerous others. And some of the overarching variables will be cited. Institutional Framework Institutional investors are crucial in financial market development because they create an institutional framework necessary in long-term capital accumulation. This is supported by the work of Impavido et al. (2003), which revealed that the depth of stock and bond markets are significantly enhanced by the rise of the assets of institutional investors. Their theory is that institutional investors “have a natural advantage over open-ended investment companies in financing long-term investment projects and their investment strategies will be more biased towards long-term bonds and the equity markets.” This is supported by numerous empirical studies. For example, the investment activities of insurance companies was reported by Outreville (1990, 1993) to be crucial in the positive performance of financial markets to the extent that it impacts a country’s economic growth. Ward and Zurbruegg (2000) built on Outreville’s works and found how this institutional investor can affect a structural change in the economy using a time series vector correction model (VECM). The investigations of Catalan et al. (2000, pp.20) also confirmed this because “the implementation of some active and sophisticated financial strategies require very frequent trading and given the large volume of funds managed by pension funds, the price volatility implied by these strategies would be too high if the stock market is not liquid enough.” All in all, Balling, Hennessy and O’Brien (1997) concluded that institutional investors are preconditions for the development of liquid securities markets with sophisticated financial vehicles. The ideal paradigm, hence, is that in order for a financial market to become stable and sustainable in the long-term, it must cultivate and maintain a solid investor base. This requirement is satisfied by institutional investors because this sector constantly seeks long-term financial instruments. Based on studies conducted in this theme, a viable institutional framework can only be developed by encouraging institutional investments. Contributing to Efficiency The increase in competition brought about by the diversity in the types of investors as well as the increase in cross-border capital flows has made financial markets more efficient. Institutional investors, particularly those within the contractual savings institution category, have forced other players such as banks to innovate and reform practices, contributing to a more efficient trading system. To illustrate this, there is the case of the development of asset-guaranteed securities in the United States as well as structured finance, the emergence of index-tracking funds and the financial products that feature the minimization of risks for investors especially against market volatility (Elliott, Karacadag and Sundararajah, 2003, pp.18). These innovations are modernizing the market and benefitting investors in the process. There are experts who believe that part of the reason why institutional investors play critical roles in the achievement of market efficiency is information advantage. Prior studies on this subject reveal how institutions can purchase positive cash flows according to news and information available. There is the case of Irvine, Lipson and Puckett’s (2007) findings, for example, which revealed how institutions have access to financial data especially those generated by analysts even before they are released for public perusal. Such advantage, including other resources, enables institutional investors to compete successfully with commercial banks. The existence of competition alone is enough to drive the engine of efficiency. Also, information advantage is crucial, because it empowers investors to act as “rational arbitrageurs”, dictate fair trading practices, transparency and improve price efficiency, among others (Shu, 2007, pp.1). This area highlights how an effective clearing and settlement facilities are established in line with the institutional investors influence given its dominant position in the market. They exert pressure not just on all investors in the spirit of competition but also the system so that excellent mechanisms like block trading, the abolition of minimum commissions and the automation of trading facilities became possible (Elliott, Karacadag and Sundararajah, pp.18). Moreover, it leads the market in the development of strong regulatory and supervisory landscape, critical in ensuring risk minimization. On Corporate Governance Institutional investors have the capacity to own (as holders of equity) and to monitor firms. This is the reason why it is also crucial in building best practices among organizations in an economy. This is especially true in the manner by which it can meaningfully contribute in the development of corporate governance. There is a capability – financially, structurally and ethically – to modernize the market. For example, it has the capacity to stimulate innovation or demanding for greater information disclosure, among other best practices standards. Such stimulation may come in the form of incentive or market pressure. One need only look at financial markets that do not have strong institutional investor base to highlight this area. The Russian financial market, which is typified by a small percentage of institutional investors has small capital market and is widely attacked for its poor corporate governance standards (Elliott, Karacadag, and Sundararahaj, pp.18). In Chile, where institutional investment is robust, corporate governance becomes a norm as institutional investors influence organization, leading to important development in three areas: 1) the launch of legal reforms, particularly in terms of regulation, oversight and efficiency by which firms must operate; 2) the development of greater liquidity in capital markets due to growth in funding and trade; 3) the professionalism of the system and the adoption of advanced and efficient practices (OECD, pp.91). Conclusion The increase in institutional investors is a positive development in financial markets. First, it can provide a coherent and viable framework that can ensure the sustainability of specific financial market in the long-term. Secondly, as the institutional investors compete with other investors such as commercial banks, it drives the market to reform, innovate and modernize, driving efficiency in the process. Finally, the market dominance of institutional investors put them in the position to provide incentives or pressure so that competitors, firms and the system operates according to best practices and standards such as corporate governance, transparency and fair trading practices. The extant literature on this theme supports this argument. Furthermore, there are theorists that stress how institutional investors are preconditions to efficient financial markets. This point is legitimate and backed by empirical evidence. Indeed, from the experiences of financial markets not just of wealthy countries like the US or the UK, but more importantly of some developing economies such as Chile, institutional investors can contribute to the growth of a market and, henceforth, to the overall economy it operates in. References Balling, M., Hennessey, E. & O'Brien, R., 1997. Corporate Governance, Financial Markets and Global Convergence. Berlin: Springer. Baums, T., & Bubaum, R., 1994. Institutional Investors and Corporate Governance. Berlin: Walter de Gruyter. Blommestein, H., & Funke, N., 1998. Institutional Investors in the New Financial Landscape. Paris: OECD Publishing. Burton, M. & Brown, B., 2009. The Financial System and the Economy: Principles of Money and Banking. New York: M.E. Sharpe. Catalan, M., Impavido, G., & Musalem, A., 2000. Contractual Savings or Market Development: Which Leads? Journal of Applied Science Studies, 120(3), p.445-487. Elliott, J., Karacadag, C., & Sundararajah, V., 2003. Managing Risks in Financial Market Development: The Role of Sequencing, Issues 2003-2116. Washington, D.C.: International Monetary Fund. Impavido, G., Musalem, A., & Tressel, T., 2003. Contractual Savings, Stock and Asset Market. World Bank Policy Research Paper 2490. Irvine, P., Lipson, M., & Puckett, A., 2007. Tipping. The Review of Financial Studies, 20, p.741-768. Lumpkin, S., 2000. Overview of Institutional Investors in OECD Countries. 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