Changes in Financial Intermediation: The Role of Pension and Mutual Funds
Sellon, Gordon H., Jr., Economic Review - Federal Reserve Bank of Kansas City
Since the late 1970s, the U.S. financial system has undergone considerable stress. Many traditional intermediaries, such as thrifts, banks, life insurance companies, and investment banks, have suffered large losses and some have failed. Most analyses of these problems have focused on the difficulties of these institutions in adapting to the inflationary environment of the 1970s and 1980s.
Some of the problems of these traditional intermediaries have deeper roots, however. Over the postwar period, the rapid growth of pension and mutual funds has increased competition for household savings. While competition has opened up new business opportunities for some traditional intermediaries, it has undermined the profitability of others. As a result, many traditional intermediaries have been forced to adapt to new roles in the financial system.
This article examines the impact of pension and mutual funds on the postwar financial system. Recognizing their influence is important both for understanding the causes of recent financial problems and for deciding what regulatory changes might be appropriate to ensure the future health of the financial system.
The first section of the article describes the growth of pension and mutual funds over the postwar period and their increasing importance in the financial system. The second section examines how their success has undermined or enhanced the fortunes of traditional intermediaries. The third section describes how pension and mutual funds have affected the overall intermediation process and examines some of the implications for financial regulation.
THE RISE OF PENSION AND MUTUAL FUNDS
By offering greater portfolio diversification and professional investment management, pension and mutual funds have dramatically altered the investment options available to the individual investor. Their success is reflected in a shift away from traditional forms of intermediation and a significant restructuring of household balance sheets.
FEATURES OF PENSION AND MUTUAL FUNDS
In the early 195Os, individual investors faced very limited investment options. Most households placed their savings in deposits at banks and thrifts or in life insurance policies that combined insurance with low-interest savings. Wealthier individuals also bought corporate stocks and bonds. However, purchases of the stocks and bonds of individual companies required considerably sophistication by the investor or reliance on the research and investment advice of the investment banks providing brokerage services.
Pension and mutual funds substantially altered the investment landscape. By pooling funds from a large number of investors to purchase a diversified portfolio of assets, pension and mutual funds provide individual investors with a low-cost method of diversifying their asset portfolio. For example, pension funds combine employer and employee retirement contributions to purchase a large portfolio of stocks and bonds. Mutual funds allow individual investors to purchase shares of the fund that represent ownership interests in a large pool of assets selected by the fund. This proportional ownership allows investors with limited funds the opportunity to purchase assets that are available only in large denominations.
Another important feature of pension and mutual funds is professional management. Because the choice of individual assets in a fund is the responsibility of investment advisors or fund managers, individual investors can participate in a broad range of investments without the need for detailed knowledge of the individual companies issuing the stocks and bonds.
Despite these general similarities, pension and mutual funds have significant differences. Most importantly, pension plans have a fiduciary responsibility to deliver promised pension benefits and are subject to extensive federal and state regulation. These restrictions play a major role in guiding the investment decisions of pension plans. …