Enlarging the Investor Base developing institutional investors

1
Enlarging the Investor Base developing
institutional investors

• September 25-26
• Shanghai, China
• Noritaka Akamatsu
• The World Bank

2
Issues

• In emerging markets, the domestic institutional
  investor sector tends to be small compared to
• that in developed countries, or
• their own banking sector.
• Its ability to mobilize domestic long-term
  resources is limited, and so is the domestic
  demand for bonds.
• Excess liquidity in the global market brings
  portfolio investment flows into emerging markets
  which can cause overheating of the stock market
  (when flowing in) and a crash of the market and
  currency value (when flowing out).
• Need to develop the domestic institutional
  investor sector as well as the bond market to
• mobilize resources to finance investment, and
• stabilize the equity market.

3
Institutional investors

• Insurance companies
• Life and non-life
• Social security and pension funds
• Public PAYG social security fund (1st pillar)
• Compulsory, competitively managed pension funds
  (2nd pillar)
• Voluntary private pension funds (3rd pillar)
• Investment funds
• Foreign and domestic funds
• Different legal forms (e.g., contractual,
  corporate, etc).
• Income funds, growth funds, mixed funds
• Banks
• Corporate treasuries

4
Causes of their business

• Except investment funds, they all have reasons to
  exist other than mobilizing investable funds.
• Insurance companies are there to provide life and
  non-life insurance services while social security
  and pension funds are to provide health insurance
  and old age financial security.
• Banks mobilize deposits and extend credits while
  corporate treasuries finance the companies.
• Mobilization of investable funds is only the
  secondary reason.
• Unless the policy/business environment is
  supportive for their primary (liability side)
  business, they will not grow.
• E.g., insurance companies will not grow unless
  there is demand for insurance services.
• They compete in some aspects while supporting
  each other in some other aspects. Thus, their
  development depends on each other to some degree.

5
Banks

• The largest and best established financial
  institutions in most start-up / emerging markets
  in Asia. Thus,
• They tend to have a large capacity to invest (and
  trade) bonds despite their short-term
  liabilities, thus strongly driving the
  development of the emerging fixed income market.
• Prudential requirements matter in motivating
  their investment in and trading of bonds. E.g.,
  capital requirements for
• risky assets (preference for Government bonds
  over corporate debt unless the yield spread
  justifies.)
• Liquidity risk, interest rate risk, maturity
  mismatch / duration gap.
• The possibility of repo / reverse is critical to
  allowing their sound management of fixed income
  portfolio (including market making for bonds),
  thus affecting their demand for bonds.

6
Banks continued

• Banks also provide custody services for other
  institutional investors although their corporate
  lending business is a close substitute of
  corporate bond investment and, therefore, compete
  with other institutional investors.
• Banks increasingly understand the need to
  diversify their income base by developing fee
  income sources so as not to rely excessively on
  interest income.
• Custody services, asset management services, etc.
  even for money market / fixed income funds.
• Market making to provide liquidity for bonds to
  facilitate other institutional investors to
  invest in them.
• Critical to have banks capable of providing
  competent account management services for other
  institutional investors.
• Sound electronic data processing capacity is
  required.

7
Investment funds

• Unlike other institutional investors, they are
  purely a vehicle to mobilize funds for
  investment.
• Income funds / money market funds are a deposit
  substitute and compete with bank deposits.
• Fund managers owned/controlled by banks may not
  be encouraged to develop income or money market
  funds.
• Independent fund management companies can promote
  competition (e.g., foreign or state-owned)
• However, they enable small investors to benefit
  from professional investment management at
  reasonable cost.
• Higher brokerage fees for small investors can
  encourage their migration to professionally
  managed funds instead of having own brokerage
  accounts.
• Insurance companies and pension funds often
  outsource their asset management to an investment
  management company

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Investment funds continued

• Open end funds (as opposed to closed end funds)
  allow investors to readily redeem / liquidate the
  investment at market value, thus considered to
  offer better protection for investors.
• However, open end funds can be subject to a run.
• An interest rate rise depresses the net asset
  value (NAV) of a fixed income fund and can cause
  redemption panic by investors.
• Illiquid market can worsen the run by not
  allowing the funds to meet redemption demand (can
  trigger a market crash or high volatility).
• Illiquid market makes valuation difficult and
  could allow manipulation of NAV unless the market
  is equipped with sound pricing rules / practice.
• Closed end or interval funds may be more suitable
  for volatile, illiquid, thin market.
• Avoid multiple taxation of their income, and
  provide for effective regulation of investment
  managers
• provide for comprehensive regulation for all
  institutional investors.

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Insurance companies

• Life insurance companies tend to have longer term
  liabilities than non-lifes, thus able to invest
  in longer term debt and equity.
• Certain non-life insurance is often made
  mandatory (i.e., auto insurance, housing mortgage
  indemnity insurance, etc.), thus providing for
  steady growth of the insurance business.
• If the environment is supportive, the insurance
  premium income can grow 2-3 times the real growth
  rate of the economy in an emerging market.
• Life insurers can often provide annuity for
  pensioners by managing a portion of retirement
  fund on behalf of the pensioner, thus growing
  further.
• There need to be pension / provident funds to
  provide a lump sum retirement allowance for
  retiring workers.

10
Social security and pension funds

• Public PAYG social security fund (1st pillar)
• provides minimum old-age financial security
  (typically with some degree of defined benefit).
• Pensioners rely on contribution by younger
  working class.
• Demographic change (e.g., aging of the
  population) can make a PAYG scheme unsustainable,
  thus forcing a shift to a funded scheme (with
  defined contribution).
• Shift from PAYG scheme to funded schemes with
  defined contribution (2nd pillar).
• Can accumulate a significant investable funds
  (e.g., 30-40 of GDP). Fund accumulation
  continues many years (e.g., 30-40 years).
• The shift tends to generate a big impact on the
  demand for investable assets including bonds.

11
Illustrative accumulation by 2nd pillar
schemes (projections for the case of Russia)
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Implications

• If 2nd pillar pension schemes should be
  introduced, it should be carried out in parallel
  with the implementation of aggressive capital
  market development measures. Otherwise
• The fund accumulation can overpace the generation
  of pension investable assets, and therefore, the
  pension funds may be forced to invest overseas.
• During the rapid accumulation phase, the funds
  tend to buy and hold the assets with little
  trading, thus constraining the bond market
  liquidity.
• The funds should be diversified into different
  types (e.g., income, growth and mixed) to suit
  the investment needs of different generations.
  Otherwise, the funds tend to show herding
  behavior, amplifying the market volatility.
• The management of the funds should be made
  competitive (by private fund managers).

13
Foreign institutional investors

• All the above from overseas.
• Investment funds, insurance companies, pension
  funds and banks.
• Look for high yield while demanding transparency.
• Avoid withholding tax as they are taxed in their
  home countries.
• Both long-term funds and short-term speculators
  (e.g., hedge funds) come to emerging markets.
• The latter has demanding clients behind and are
  under pressure to invest the money quickly and
  show results in short-term.
• Need sound / effective regulation and supervision
  of their activities to monitor capital flows
  across the national border.

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Conclusions

• Building of the domestic investor base will take
  time while the foreign portfolio investment needs
  to be well monitored.
• Domestic institutional investors support as well
  as compete with each other.
• The development of contractual savings
  institutions (i.e., pension funds and insurance
  companies) is driven by the demand for their
  liability side of business, which is in turn
  driven by welfare policy.
• Systematic promotion of certain institutional
  investors (e.g., introduction of 2nd pillar
  pension funds) must be done in parallel with the
  implementation of aggressive capital / bond
  market development plan.
• Provide sound regulatory framework for investment
  / asset managers for all institutional investors.

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Thank you.