INSTITUTIONAL SAVINGS AND FINANCIAL MARKETS:

THE ROLE OF CONTRACTUAL SAVINGS INSTITUTIONS

Alberto R. Musalem and Thierry Tressel†

Introduction

Contractual savings (the assets of pension funds and life insurance companies) have been
growing at much faster rates than GDP in many OECD (e.g., the Netherlands, the United
Kingdom, the United States, Switzerland) and non OECD countries (e.g., Chile,
Malaysia, Singapore, South Africa) over the past 20-30 years (see Table 1). The
institutionalization of savings by pension funds and life insurance companies is bound to
further develop in the future as demographic trends push for reforming pension systems
in many countries in order to increase the funding ratio of mandatory pension systems
and to encourage voluntary long term saving plans through private pension funds and life
insurance instruments.1
Although the primary function of these institutions is to provide sufficient, sustainable
and affordable retirement income and survivors benefits, recent work suggests that the
spillovers on the financial system are significant by changing the composition of financial
flows in favor of securities markets (Impavido, Musalem and Tressel, 2003), thus
modifying firms’ and banks’ financing patterns (Impavido, Musalem and Tressel, 2002a
and 2002b) by increasing the maturity of their liabilities and reducing leverage. Recent
evidence shows domestic securities markets are increasingly important sources of
funding for the corporate sector as well as for the public sector.2 This suggests that the
development of contractual savings institutions can be a “pull” as well as a “push” factor
of financial globalization.
These papers also show that the impact of contractual savings institutions depends on the
characteristics of the financial system as well as on the transparency and regulations of
securities markets. This implies that government aiming at encouraging these savings
plans should take into account these factors when providing incentives to invest in
equities or bonds. Specifically, contractual savings should be encouraged to invest in
equities when disclosure rules are adequate; generally regulations of securities markets
are crucial. In the context of a financially integrated world economy, domestic
governance, transparency and the degree of domestic financial development are indeed
crucial for emerging economies to benefit from financial globalization.3

1
Poterba and Samwick (1995) provide empirical evidence of institutionalization of savings in the US.
They notice how the principal postwar trend in ownership has been a decline in stock owned by households
directly and an increase in ownership through various financial intermediaries.
2
The Global Financial Stability Report of the IMF (2003) shows that there has been a surge of local
corporate bond issuance in Asia and Latin America, particularly in 2000-01. Moreover local bond markets
have been the dominant source of funding for the public sector in all regions.
3
Prasad et al. (2003) provide evidence that the quality of domestic institutions plays a role in the ability of
a country to increase the benefits and control the risks of financial globalization.
† Alberto R. Musalem is Lead Economist in the MENA Region of the World Bank
([email protected]), and Thierry Tressel is Economist in the Research Department of the
International Monetary Fund ([email protected]). This paper reflects the view of its authors, not necessarily
those of the affiliated institutions. We are grateful to Robert Litan and Jorge Roldos for valuable comments.
The aim of this paper is to integrate the results so far obtained from the above mentioned
research in order to understand the different channels through which the
institutionalization of savings in the form of contractual savings contributes to financial
markets development, build an economy which is more resilient to interest rates and
demand shocks, and therefore stimulate economic growth.
This paper has five sections. The first section analyzes the impact of contractual savings
on the national savings rate. Section two discusses how the development of contractual
savings stimulates the development of securities markets. Section three discusses how
contractual savings contribute to improving risk management of firms while Section four
deals with the impact on banks. The discussion is based on the results obtained in the
papers written by Impavido, Musalem, and Tressel (2002a, 2002b, and 2003) in a sample
of developed and emerging economies. Not only does each of these papers generate
robust empirical evidences, but the results are also consistent across the sectors covered
in the papers, which provide further support for our conclusions. Section five is devoted
to policy recommendations and concludes.

1. Contractual Savings and National Saving

A key channel through which the development of contractual savings might contribute to
improved economic performance and higher economic growth is through the
encouragement of a higher rate of national saving. It is well accepted in the literature that
higher aggregate saving leads to higher growth, by establishing a greater pool of
resources available for productive investment (Schmidt-Hebbel and Serven, 1999). What
is less clear is whether changes in contractual savings translate into changes in aggregate
saving.

The theoretical literature on the question is ambiguous. On the one hand, pension
reforms that simply replace one form of voluntary saving with another are unlikely to
affect households’ saving, since households will simply substitute one form of saving for
another one. Moreover, even if pension funds offer greater (long-term) returns than other
saving instruments, it is well-known that the effect of a higher real return on saving is
ambiguous as the income effect might offset the substitution effect. But there are also
other reasons for supposing that the development of pension funds might stimulate
households’ saving. To the extent that participation in retirement plans is mandatory,
individuals will save more than they would otherwise (Bailliu and Reisen, 2000). This is
particularly true of those on low incomes, who may face binding borrowing constraints
and may therefore be unable to offset the impact of additional forced saving on
consumption. Furthermore, even if participation is voluntary, the development of funded
pension schemes may well raise awareness among the general population of the need to
save for retirement, leading to a 'recognition effect' that could stimulate households’
saving.

2
 Table 1: Assets of Contractual Savings Institutions
as Percentage of GDP in Selected Countries
Countries 1970 1980 1990 2000
Chile 1.1 29.94 67.49
Life 5.59 16.58
Pension 1.1 24.35 50.91
Malaysia* 18 20.12 44.29 64.18
Life 3.07 5.97 11.14
Pension 17.05 38.32 53.04
Singapore* 17 41.15 117.86 78.11
Life 2.81 6.16 11.17 21.64
Pension 14.19 34.99 106.69 56.47
South Africa 40 39.27 78.13 134.92
Life 17.2 43.94 79.63
Pension 22.07 34.19 55.29
Netherlands 45 66.9 108.11 182.82
Life 21.13 36.06 67.62
Pension 45.77 72.05 115.2
United Kingdom 43 38.81 86.91 176.57
Life 17.77 36.87 91.57
Pension 21.04 50.04 85
United States 40 43.31 69.2 99.79
Life 17.72 25.85 29.89
Pension 25.59 43.35 69.9
Switzerland 51 70 88.51 162.74
Life 32.29 60.74
Pension 56.22 102
Notes : * Prior to 1990, the data do not include the funds invested directly by
individual workers in housing and other approved assets. 1970 data from Davis
(1995).
Source :Chile:Superintendencias de Administradoras de Fondos de
Pensiones;Superintendencias de Valores y Seguros, 2002.
Malaysia:Employees Provident Fund;Life and General Insurance Funds,2002.
Singapore:Employees Provident Fund;Monetary Authority of
Singapore,2002.South Africa:South Africa Reserve Bank, 2002.OECD:Inst. Inv.
StatisticalYear Book 2001;Ins.StatisticsYear Book

The short-run impact of pension fund development on aggregate saving depends

primarily on government policy and in particular, on how the government decides to
finance the transition from a pay-as-you-go pension system to a partially or fully funded
system.4 If current un-funded liabilities are financed through debt, the short-run impact
will be neutral, as the implicit debt of the pay-as-you-go system is transformed into an
explicit liability. If on the other hand, this transitional cost is financed via adjustments in
the non-pension budget – either through increases in taxation or reductions in other
expenditures – then there may be an increase in national saving. In particular, in the
presence of credit constraints,5 or if prior saving were motivated by precautionary rather

4
See for instance Holzmann (1997)
5
See for instance Cifuentes and Valdes-Prieto (1996).

3
than lifecycle reasons,6 agents will be unwilling to reduce their saving in response to a
transition tax.
Furthermore, in the case that the government decides to encourage voluntary contractual
savings plans through income tax incentives, the results on national saving would depend
primarily on the government fiscal stance. A positive effect on aggregate saving would
require that the reduction in income tax revenue be compensated either through increases
in other tax revenues or reduction in expenditures.
Several empirical studies attempted to assess more directly the impact of different types
of pension systems on private saving, among them Dayal-Gulati and Thimann (1997).
They conclude from a study of a sample of South East Asian and Latin American
countries over the period 1975-95 that fully funded systems can be expected to increase
saving provided that early withdrawals are prohibited. Similarly, Samwick (1998b) finds
that developing countries that shift from a pay-as-you-go to a funded system tend, over
time, to experience an increase in saving even though the initial impact of such reforms
may be negative. He also finds that countries that operate un-funded, pay-as-you-go
systems tend to have lower saving rates, with the magnitude of the effect increasing with
the degree of coverage of the system.7 8

Bailliu and Reisen (2000) use panel data, covering ten countries over the period 1982-
1993, to measure the effect of pension funds assets on saving. They find a statistically
significant effect among non-OECD countries but none among OECD countries.
However, the positive relationship between pension funds and the national saving rate is
weakly robust.

Finally, the development of contractual savings institutions is not likely to affect the
national saving via financial deepening. Indeed, as shown by Loayza et al. (2000),
private saving rate are highly autocorrelated, and are not significantly associated with
financial deepening.

2. Contractual Savings and Securities Markets

There is also a rapidly expanding literature on the role of contractual savings in
promoting financial markets development.9 A more detailed discussion of this topic can

6
Samwick (1998a).
7
With a larger sample that includes developed countries as well, Samwick (2000) finds that there is little
evidence that countries that implement defined-contribution reforms have higher trends in saving rates after
the reform. However, cross-sectionally, countries with pay-as-you-go systems tend to have lower saving
rates, and this effect increases with the coverage rate of the system.
8
Recent additional single-case studies include those of Coronado (2002) on Chile, Loayza and Shankar
(1998) on India and Burnside (1998) on Mexico.
9
This suggests that the development of contractual savings institutions may have an indirect positive effect
on growth. Indeed, there is a substantial literature on the relationship between financial market
development and economic growth. It is now accepted that capital market development exerts a strong and
independent influence on growth by raising capital accumulation and productivity (Demirguc-Kunt and
Levine 1996; Levine and Zervos 1996; Neusser and Kugler 1998).

4
be found in Catalan, Impavido and Musalem (2000), Blommestein (2001), Blommestein
and Funke (1998), Davis and Steil (2001), Impavido, Musalem and Tressel (2002a,
2002b and 2003), Reisen (2000), and Vittas (1999). As seen on Figure 1, contractual
savings financial assets are larger than money plus quasi-money (M2) in about half of the
sample, including South Africa and Chile.

Figure 1: Relative Shares of Contractual Savings Financial Assets and M210 (2000)

100%

90%

80%

70%

60%
M2%
50%
CTR%
40%

30%

20%

10%

0%
New Zealand
Netherlands

Hungary
Switzerland

Thailand
Italy

Norway

Turkey
Iceland

Finland

Belgium
United States
South Africa

Malaysia

Germany
Sweden

United
Chile
Australia

Portugal
Korea, Rep.
Denmark

Canada

France
Singapore

Japan

Spain
Austria

Greece

Contractual savings institutions affect securities markets through different channels.

First, the development of contractual savings institutions provides an institutional
framework favoring the accumulation of long-term capital. For instance, the existence of
transaction costs in capital markets, the ability to diversify risk, and the long-term
commitments of contractual savings institutions explain why they may be more willing to
hold long-term securities than individual investors, and require lower risk and liquidity
premiums.11 By increasing the demand for long-term financial assets, contractual savings
could thus promote the development of securities markets.12

10
The figure plots contractual savings financial assets and M2, relative to total contractual savings financial
assets plus M2. Note that, since contractual savings financial assets include deposits, one should in
principle substract these deposits from M2. This correction would increase the relative share of contractual
savings financial assets, and decrease the other component.
11
Contrary to contractual savings institutions, mutual funds and other investment funds have a preference
for liquid financial assets.
12
Allen and Santomero (1998) argue that the institutionalization of saving is strongly associated to the
development of capital markets over the past 20 years.

5
Next, whether contractual savings development stimulates further the demand for
securities – and in turn stimulate the supply by lowering issuance costs – will depend on
the supervisory and regulatory mechanisms, fostered by transparent accounting practices,
among other factors. Moreover, contractual savings institutions, because of their size,
have the potential to enhance market discipline and promote the interests of minority
shareholders of the firms in which they invest.
Finally, the development of contractual savings institutions may have an indirect impact
on domestic financial markets. For instance it may signal a sound and stable domestic
financial system to foreign investors, hence leading to significant cross-border
transactions of securities.13 On the contrary, the development of domestic financial
markets is less stimulated when contractual savings invest a larger proportion of their
funds abroad.14
The development of securities markets would also be stimulated if the additional demand
of contractual savings institutions is matched by additional supply of government debt.
Indeed the development of contractual savings creates a demand for long-term public
debt – which is matched by issuance of bonds - instead of short-term instruments - which
provides a benchmark for setting interest rates and eventually helps to build the yield
curve. Of course, the issuance of public debt may come at the expense of the equity and
corporate bond markets.
The development of securities markets may in turn affect the access of small and medium
size enterprises (SME) to financial services. In developed financial systems, debt finance
is a specialized activity performed almost entirely by banks, and SMEs have full access
to bank credit in great part due to well developed accounting rules, and legal and
judiciary systems. In these markets, SMEs also have access to financial services through
factoring, leasing, and venture capital companies. However, in less developed financial
systems, primarily in developing countries, SMEs have either restricted or no access to
bank credit and other financial services due to lower legal and accounting standards, less
supportive judiciary systems, and higher transaction and monitoring costs (see Beck,
Demirguc-Kunt, and Maksimovic (2002); Berger, Klapper, and Udell, (2001)). As a
consequence, it is possible to observe that SMEs in developing countries have access to
credit from the corporate sector, either exclusively or complementary to institutionalized
financial services. This is particularly the case of industrial structures where large
corporations operate in collaboration to a large number of SME and the linkages between
them are quite strong, involving supply of inputs, purchase of output, quality control,
technology transfer and financing.
Overall, there is a variety of reasons why one would expect to observe substantial
heterogeneity across countries’ experiences, as indeed it is observed.
This may have implications for the macroeconomic impact of contractual savings
development, specifically its impact on economic growth. As the development of

13
For instance, pension funds hardly invest in stocks in Switzerland, Malaysia and Singapore, all countries
with large contractual savings and stock markets.
14
However restricting the foreign investments of contractual savings for the sole purpose of stimulating the
domestic financial system is likely to be counter-productive: see Impavido, Musalem and Vittas (2002) for
a discussion.

6
contractual savings shifts financial intermediation from banks to capital markets, one
could argue that it would imply shifting resources from higher to lower return activities
(from SME to corporate sector projects, if SME have indeed greater returns), hence the
impact on growth would be negative. However, this argument could be weakened
because in developing countries there are strong financial linkages between SMEs and
the corporate sector. Furthermore, in competitive financial systems, banks, factoring,
leasing and venture capital companies would be able to capture funds in the capital
market through the issuance of bonds or by offering attractive deposit rates to contractual
savings institutions. This would enable them to maintain the flow of finance to SMEs.
Furthermore, to the extent that contractual savings development would increase the
availability of long term funds to financial intermediaries, they, in turn, would be able to
allocate a higher proportion of their loan portfolio in long term credit to the enterprise
sector without themselves undertaking excessive term transformation risks. In fact, the
analysis conducted by Impavido, Musalem, and Tressel (2002a) shows that the share of
short term loans in banks’ loan portfolios decreases when contractual savings institutions
develop. Furthermore, Impavido, Musalem, and Tressel (2002b) show that in bank based
systems, the share of long term debt to total debt in the corporate sector increases when
contractual savings institutions develop. Finally, the lengthening maturity of debt is
likely to imply shifting resources from low return short term to higher return long term
projects, thus fostering growth.15
Empirical Results
The most recent and robust analysis of the impact of contractual savings on securities
markets are derived from the latest work of Impavido, Musalem, and Tressel (2003). It is
based on panel data and focuses on the short-term dynamics of stock market depth,
liquidity, and bond market depth.16 The main results are:
• Controlling for several sources of bias that may affect the correlation between
financial market variables and the development of contractual savings,17 the
institutionalization of savings leads to the deepening of stock and bond markets.
• There is evidence of substantial heterogeneity across countries. First, the
development of contractual savings is associated with an increase in stock
market depth in countries that structurally rely more on stock market finance;18
it is associated with an increase in bond market depth in countries that
structurally rely more on bank finance. Second, contractual savings
development leads to an increase in stock market depth and stock market
liquidity in countries in which pension contributions are mandatory, while these
two effects are less clear in countries in which pension contributions are

15
If more productive projects are less liquid, an increase in the availability of long-term capital should, on
average, increase the returns of projects.
16
Markets depth and liquidity are defined as market capitalization and value traded relative to GDP,
respectively. Bond market capitalization is the value of bonds outstanding (the aggregate of public and
private bonds).
17
In particular we control for the level of development, measured with income per capita.
18
Using macroeconomic indicators of financial development, Demirgüç-Kunt and Levine (1999) classify
countries in two sub-groups: (i) economies with bank-based financial structures; and (ii) economies with
market-based financial structures. Our results are based on their classification.

7
 voluntary. Third, the impact on stock market depth is significant when cross-
border transactions in securities are not too large. Finally, structural features of
the securities market, such as transparency also matter: the impact of
contractual savings is greater in countries with better accounting standards.
• The impact of contractual savings on the short-term dynamics of securities
markets is not explained by other structural characteristics of the economies,
such as the overall level of development, openness to trade, the legal
environment and the demographic structure. This result can be interpreted as
evidence that policy decisions that shape the evolution of contractual savings
institutions do matter and that the impact of contractual savings on securities
markets is not due solely to slow-moving country characteristics.
Accordingly, we conclude that contractual savings institutions have an independent and
positive impact on securities market development, which may have indirect positive
effects on economic growth. However, even in bank based financial systems, contractual
savings institutions may have a positive impact on growth by: i) lengthening debt
maturities and flattening the yield curve which enable the undertaking of higher return
long term projects; and ii) developing the bond market and the yield curve which is key
for financial sector innovation and development.

3. Contractual Savings Institutions and the Mitigation of Firms’

Financial Risks
This section focuses on the channels through which contractual savings institutions
contribute to mitigating firms’ financial risks. Assessing whether the development of
institutional investors reduces firms’vulnerability to various shocks has important
implications because the resulting reduction in the cost of capital is likely to foster
investment and growth.
In the recent context of currency and financial crisis associated with asset-liability
mismatch in the balance sheets of banks and firms, and excess reliance on (foreign
currency denominated) short-term debt,19 there is a growing consensus about the
importance to evaluate whether the presence of domestic institutional investors tends to
reduce banks’, firms’, and other economic agents’ vulnerability to interest rate variations
and other shocks. In a more general context, Caprio and Demirgüç-Kunt (1997) show
that the lack of long term finance in emerging economies is not totally explained by
banks’ and firms’ characteristics. The institutional environment and macroeconomic
factors affect significantly the supply of long-term finance.

19
See for instance Rodrik and Velasco (1999), Aghion, Benarjee, and Piketty (1999), and Aghion,
Bacchetta and Banerjee (2000) for theoretical models of monetary policies in such a context.

8
Determinants of Firm’s Financing Patterns
In a world of asymmetric information, the financial institutions and the legal
environment20 will shape the capital structures21 of firms, leading to systematic
differences across countries. To the extent that contractual savings institutions may
modify the information set available to all investors, push for compliance with
transparency rules and legal rights, or simply modify the relative supply of different
securities, one should indeed expect to observe significant cross-country differences
associated with contractual savings’ characteristics. In particular, the effects would be
minimal if contractual savings invest primarily in government debt.
The paper by Impavido, Musalem and Tressel (2002b) emphasizes informational issues22
and refinancing risks. It provides a simple framework in which firms choose the debt
maturity and can also issue equity. It discusses the potential benefits associated with the
development of stock markets, and the nature of investors, in a framework in which
banks may be subject to term transformation risks. In particular, the model suggests that
the development of contractual savings institutions may affect firms’ financing choices if
it: (i) leads to an increase in the supply of long-term debt; (ii) reduces equity rationing;
and (iii) fosters information disclosure and better corporate governance mechanisms on
the stock market. More generally, the framework predicts that the equilibrium capital
structures of firms will be a function of: (i) their characteristics (maturity of assets,
profitability, risks, asymmetry of information, etc.); (ii) the efficiency of the financial
system (for instance in generating – ex-ante and interim – private and public
information); and (iii) the supply of funds to capital markets, that depend on the nature of
investors.
The empirical analysis assesses the impact of contractual savings institutions
development on firms’ capital structures. It focuses on: (i) the choice between debt and
equity; and (ii) the maturity structure of debt. Three sets of explanatory variables explain
firms’ financing patterns: (i) firms’ characteristics; (ii) macroeconomic factors; and (iii)
financial system characteristics. Hence we have:
Capital structure = F(firms’ characteristics; macroeconomic factors;
financial system characteristics)

Firms’ characteristics
The following firm’s characteristics are controlled for: (1) the market to book ratio, as a
proxy for Tobin’s Q,23 (2) the ratio of net fixed assets to total assets,24 (3) the ratio of net
sales to total assets,25 (4) size,26 (5) profitability27 and (6) firm level risk.28

20
Demirgüç-Kunt and Maksimovic (1996a, 1996b, 1999), Demirgüç-Kunt and Levine (1999) and La
Porta et al. (1998).
21
See Shleifer and Vishny (1997) for a survey on corporate governance, La Porta et al. (1998) for the
impact of the legal environment on external finance.
22
More specifically, Impavido, Musalem and Tressel (2002b) develop a model focusing on adverse
selection issues, and the role of private information in the credit relationship.
23
For instance, in accord with Myers’ theory of underinvestment (1977), Barclay and Smith (1995) have
shown that firms with more growth options in their investment opportunity sets have less long-term debt in
their capital structure. The reason is that stockholders have incentives to reject profitable investments when
they have to share their benefits with debt holders. Myers argues that, for a given indebtedness, this

9
Macroeconomic factors
Various macroeconomic factors may affect firms’ financing patterns. More developed
economies have in general more efficient institutions, a better compliance with the legal
system in general, and with investor rights, accounting standards and transparency rules
(on the stock market) in particular. The inflation rate is an indicator of the government’s
management of the economy and whether long-term contracting is likely to be
widespread.29 Two other control variables for asset markets conditions are: the real
interest rate and the cost of equity. Finally, the volatility of inflation is a proxy for
macroeconomic instability.

Financial system characteristics

The financing patterns of firms, especially their access to external finance,30 depend on
the characteristics of the financial system. This in turn affects the ability of firms to
reach a higher rate of growth than the one permitted by their internal resources.31 The
stock market and banking sector variables provide a control group guaranteeing that the
contractual savings variables are not simply a proxy for the level of development of the
financial system.32

incentive problem can be mitigated by shortening the maturity of debt. Moreover, Fama (1978) shows that
shortening the maturity of debt remains beneficial when stockholders can recapitalize the firm because the
price at which they may repurchase the debt will reflect more the value of the investment for short-term
debt than long-term debt.
24
Theories of lending under asymmetric information show that the debt capacity of a firm depends on the
availability of collateral. Moreover, Stohs and Mauer (1996) have shown that firms in the U.S. match the
maturity of assets and liabilities (as suggested by Hart and Moore (1994), but it is also the case if firms try
to limit the risks of illiquidity).
25
Third, as argued by Demirgüç-Kunt and Maksimovic (1999), a high ratio of net sales to total assets may
signal a need for short-term financing. To the extent that high sales (relative to total assets) imply high
short-term assets (relative to total assets), maturity matching will also lead to a high short-term
indebtedness.
26
Fourth, the size of the firm may be an important determinant of the firm indebtedness. A positive
correlation between leverage and size is expected if the size is a proxy for the public information and the
reputation of the firm. A similar correlation is expected with the debt maturity (Note that all firms in the
sample are publicly listed). Barclay and Smith (1995) find that large firms have more long-term debt in
their capital structure.
27
Fifth, several studies in the past (Rajan and Zingales (1995) for developed economies and Demirgüç-
Kunt and Maksimovic (1996a) for emerging countries) have found a negative correlation between
profitability and leverage. Although this correlation is not clearly explained, Impavido, Musalem and
Tressel (2002a) also use a profitability measure in their regressions.
28
Finally, risk considerations seem to be important determinants of corporate financing decisions (Graham
and Harvey (2001)). The risk control variable at the firm level is defined as the ratio of the standard
deviation of earnings and the average of earnings over the period (in absolute value).
29
It also characterizes the opportunity cost of holding money. Debt contracts may be specified in nominal
terms. So the authors expect a negative correlation between the rate of inflation and firms’ indebtedness, if
this supply effect dominates.
30
Demirgüç-Kunt and Maksimovic (1996, 1999), Rajan and Zingales (1998) and Carlin and Mayer (1999).
31
See Beck, Demirgüç-Kunt, Levine and Maksimovic (2000) for a synthetic approach.
32
First, the size of the stock market is measured by the stock market capitalization (in percentage of GDP).
The ability of the stock market to provide risk diversification opportunities and information also depends

10
Contractual savings institutions
The study measures the development and investment behavior of contractual savings
institutions by the size of contractual savings institutions relative to capital markets. It is
defined as the ratio of contractual savings financial assets to market capitalization plus
total bonds outstanding. There are two motivations for this variable: (i) it grasps,
although imperfectly, the relative importance of contractual savings as a provider of
finance relative to total supply of long-term finance; and (ii) it partially corrects for
movements in the price of shares that may introduce a spurious correlation between the
firm level variable and this explanatory variable.33

on its level of activity and liquidity (Levine and Zervos (1998)). Greater liquidity will encourage investors
to acquire stakes in risky firms (and make efficient restructuring decisions: see Maug (1998) for a
theoretical argument) and will enhance information acquisition by large investors (Holmstrom and Tirole
(1993)). Greater informational content of prices will increase the efficiency of capital allocation.
Moreover better public information may have a spillover effect on the long-term debt market by reducing
initial informational asymmetries. Activity on the stock market is measured by the turnover ratio, e.g. the
total value traded, in proportion of the stock market capitalization. Second, banks have a comparative
advantage in acquiring private information on borrowers and in monitoring their actions. A sound and
efficient banking sector is obviously essential for firms especially those that do not have access to capital
markets. The use of short-term debt reduces the scope for opportunistic behavior, thus reducing the cost of
monitoring. But the implication for the debt maturity of firms is not clear. A developed banking system
implies lower monitoring costs in general. This will lead to an increase in the supply of short-term debt,
but also in the supply in long-term debt in the sense that more projects will be able to be financed by long-
term debt. The overall impact may be negative or positive. Moreover, monitoring per se is not the only
issue. The market structure of the banking sector (i.e., the degree of competition among banks, and the
indirect competition from other financial institutions) will have an impact on the lending behavior of banks.
For instance, greater information disclosure on the stock market and in general easier outside options for
firms will impact the lending behavior of banks: their ex-post informational rent may be reduced, which
may reduce their ex-ante incentive to invest in information (see Stulz (2000)). On the contrary, greater
information disclosure and better accounting standards associated with capital market development are
likely to increase the supply of bank credit by limiting managerial slack. Finally, the development of non-
bank financial intermediaries will probably not be neutral. This may increase competitive pressures on
banks, leading them to specialize on their short-term debt comparative advantage. This competitive
pressure may be direct or indirect. Contractual savings development may however complement the activity
of the banking industry. This will be the case if these institutions act as suppliers of funds to the banking
industry, instead of lending directly to firms. As contractual savings do not face unexpected liquidity
needs, they will reduce the scope for bank runs, thus limiting the term transformation risk in the banking
industry. Such a mechanism would increase the incentive of banks to offer long-term loans. As a measure
of the activity of the banking sector, the authors use the total credit to the private sector, as a percentage of
GDP.
33
Consider for instance an exogenous rise in stock prices. Then the value of contractual savings assets
and the stock market capitalization will increase, implying a correlation that has no economic meaning.
Similarly, this may also introduce a negative correlation with firms’ debt equity ratio. This effect is likely
to be stronger when measuring firm equity by the market value of the firm. Still, in principle, a negative
correlation (but presumably weaker) may remain because firms are sensitive to their market value when
they decide to issue new shares. Pagano, Panetta and Zingales (1998) show for instance that IPOs are partly
motivated by stock overvaluation in the industry in which the firm operates. Finally, the behavior of
contractual savings institutions may significantly depend on their investments. For instance, they will have
greater incentive to be active investors in the stock market when they hold a large share of their assets in
stocks; conversely, explanations favoring corporate governance issues are less likely to be relevant in
countries in which contractual savings hardly invest in the stock market. It is likely that the incentive for
contractual savings institutions to be active minority shareholders is positively correlated to the proportion

11
The Empirical Analysis
Impavido, Musalem and Tressel (2002b) agree that endogeneity may be an issue in their
analysis. However, they argue that the simultaneity bias may be small given the variables
considered.34

Contractual savings and firms’ financing patterns

Impavido, Musalem and Tressel (2002b) obtain the following results.
• After controlling for firms’ characteristics, for macroeconomic factors, and for
financial system characteristics, the level of development of contractual savings
institutions is positively correlated with leverage and with the maturity of debt. The
mechanism seems to go through an increase in long-term debt relative to equity and
long term debt relative to short-term debt. These results tend to support the hypothesis
of an independent impact of contractual savings development on leverage. Moreover,
the development of contractual savings institutions seems to foster the use of long-
term debt.
• Furthermore, an increase in the proportion of financial assets invested in shares is
associated with a decrease in corporate leverage. It leads also to a decrease in short-
term debt relative to equity. This set of results is consistent with the claim that the
investment behavior of contractual savings institutions matters for corporate
financing patterns. Their investment decisions have a significant impact on firms’
capital structure: for instance, it implies that if Korean contractual savings institutions

of shares in the portfolio of contractual savings institutions. Therefore, this variable aims at capturing
cross-country and time-series differences in the behavior of these institutions.
34
The size and characteristics of the financial system may indeed evolve to respond to the aggregate
demand of capital by the corporate sector and the public sector. Although each firm takes the size and
activity of the banking sector and capital markets as given, the aggregate decisions of firms affect the size
of the financial institutions. Moreover, shocks affect the financial sector and the corporate sector
simultaneously. For instance, an unexpected good news on profit opportunities will increase the demand
for external finance by firms, and banks will also tend to offer more loans. Hence, it will increase
simultaneously the size of the banking sector and firms’ indebtedness. In the case of contractual savings,
however, it is less clear why their size is significantly affected by firms’ demand for capital, unless one is
willing to argue that pension contributions and insurance premia are significantly affected by the current
business environment. Endogeneity may arise because the value of contractual savings assets will move
with stock market capitalization of the firm. The authors provide three controls for this source of
simultaneity bias. First, firms’ net worth are measured at their book value; second, the variable contractual
savings financial assets to market capitalization ratio should in principle partially correct for price
movements; finally, the stock market capitalization variable should capture these effects. Portfolio
decisions will, of course, depend on the relative returns of the different assets; for this reason, the asset
allocation of pension funds may be endogenous. However, the authors expect this endogeneity problem to
be limited because: (i) price movements affecting the corporate financing patterns should be captured in the
stock market capitalization variable; (ii) investment regulations may be binding, especially in developing
countries (See for instance Srinivas and Yermo (1999)); and (iii) in many developed economies, implicit
limits or strong (conservative) asset management traditions may be as important as relative returns in
determining the allocation of assets when return differentials are not too large. (For instance, in the case of
Germany, it seems difficult to attribute the 2.77 percent of equity in total financial assets to low stock
returns relative to other assets.)

12
 had had the same investment behavior as in South Africa (where contractual savings
are investing 44 percent of their financial assets in shares on average over the period,
compared to 12 percent in Korea), the debt equity ratio of Korean firms would have
decreased from 4.9 to the 4.6-3.9 range.

Overall these results strongly suggests that: (i) any attempt to understand cross and within
country variations in corporate financing patterns needs to assess the role of non-bank
financial intermediaries such as institutional investors; and (ii) policy interventions that
remove binding constraints on portfolios may have sizeable effects on the corporate
sector financing patterns.

The results displayed in the next section shed light on the channels through which
contractual savings institutions affect corporate financing choices. They provide a basis
for better targeted policy interventions.

Macroeconomic financial channels

Impavido, Musalem and Tressel (2002b) used the classification of macroeconomic
financial structures developed by Demirgüç-Kunt and Levine (1999). Countries were
divided in two sub-groups: (i) economies with bank-based financial structures; and (ii)
economies with market-based financial structures. This classification has been
constructed by using a large set of indicators for size, activity, and efficiency of the
banking sector and the stock market. It provides a rough evaluation of whether savings
are channeled to productive activities mainly through the banking system or the stock
market.35 Therefore, this is a relevant classification for our purposes: in market-based
economies, for instance, the contractual savings industry accounts for 46.3 percent of
long-term capital markets size, equity investments are 30.7 percent of total financial
assets and 29 percent of stock market capitalization; in bank-based economies, the same
figures are respectively 22.3 percent, 12.3 percent and 12.2 percent. Therefore, the
contractual savings industry is less developed in bank-based countries than in market-
based countries. Moreover, pension funds and life insurance companies invest
significantly less on the stock market in bank-based economies than in market-based
economies.
This classification is used in order to disentangle different channels through which
contractual savings institutions affect firms’ capital structure, by identifying different
impacts on firms’ leverage and debt maturity. Although there was no information on the
maturity of debt instruments held by contractual savings institutions, the authors were
able to break their assets in two categories ((i) bills and bonds (BB); and (ii) loans (LL)),
for a significant number of countries. In market-based economies, BB represents 42.6
percent of total financial assets and LL only 13.9 percent. In bank-based economies, the
same figures are respectively 45 percent and 31.6 percent. It seems therefore that, on

35
Beck et al. (2000) show that the financial structure does not explain economic growth and the reliance on
external financing after controlling for the level of financial development. Note that our point is not
inconsistent with their claim: our result is not normative in the sense that we do not claim that one financial
structure dominates from a welfare point of view: we simply show that financial channels differ across
countries, and that this classification is useful for this purpose.

13
average, the lower equity investments in bank-based economies are mainly explained by
a higher proportion of loans in their portfolio.
The relative importance of pension funds and life insurance companies differs in the two
groups of countries. Pension funds account on average for 30 percent and 20.4 percent of
total contractual savings financial assets respectively in market-based and bank-based
economies. In particular, Anglo-saxon and continental Europe exhibit strongly different
contractual savings industries. Pension funds hold 70 percent, 54 percent and 50 percent
of contractual savings financial assets respectively in the United States, the United
Kingdom and Australia. In Germany, Italy and France the figures are 12 percent, 37
percent, and less than 1 percent.

The results are the following:

• In market-based economies, there is a strongly significant impact of contractual

savings portfolio choices on firms’ financing patterns: an increase in equity
investments by contractual savings leads to a decline in leverage, and its effect is
economically large. The impact of contractual savings development is somewhat
weaker, although it affects leverage in a similar way. Debt maturity is also negatively
correlated either to the level of development of contractual savings or the proportion
of share investments in the portfolios of contractual savings. These results are
consistent with intuition. As contractual savings are large in these countries on
average, it is likely that their marginal effect on firms’ financing patterns go through
their investment choices rather than through an increase in their size.36 As they
increase their equity holdings, firms tend to substitute equity finance for debt finance.
These results suggest that banks and institutional investors are indirect competitors.
The fall in the maturity of debt may be partly attributed to the fact that banks
concentrate on their core activity, which is short-term lending.

• In the case of bank-based economies, the channels through which firms’ capital
structures are affected are noticeably different. The dominant effect is the level of
development of the contractual savings industry, while the asset allocation hardly
affects firms’ capital structures. The no-correlation result with the portfolio variable
makes sense: as contractual savings investment in equity is no more than 12 percent
of stock market capitalization, a change in their behavior is very unlikely to affect
significantly the aggregate corporate financing choices. Hence, the level of
development of the contractual savings industry has a positive effect on leverage and
a positive effect on the maturity of debt. These results suggest that the channel
through which contractual savings affect the corporate financing patterns does not go
through the stock market. Indeed, contractual savings development is associated with
an increase in debt finance – and an increase in debt maturity. As explained above, it
is very unlikely that this can be explained by higher investments in bonds in bank-
based economies than in market-based economies. Rather the explanation is likely to

36
More precisely, it seems that the characteristics of contractual savings portfolios are more important than
the size of share holdings relative to stock market capitalization. This result favors a corporate governance
explanation.

14
 be related to loans: either (i) they lend directly to the productive sector; or (ii) they are
complementary to the banking sector. More specifically, by reducing the risk of
liquidity in the banking system, they may increase the incentive of banks to increase
long-term loans in proportion to total loans.

Summary
The development of contractual savings institutions, as well as their portfolio decisions,
are significantly associated with firms’ financing patterns across and within countries and
after controlling for firms’ characteristics and macroeconomic determinants. The
empirical results are consistent with contractual savings institutions having a comparative
advantage in supplying long-term finance to the corporate sector.
The study identified different channels through which contractual savings affects the
financing decisions of firms. In bank-based economies, the development of contractual
savings is associated with an increase in firms’ leverage and maturity of debt. In market-
based economies, instead, the asset allocation affects firms’ leverage: an increase in the
proportion of shares in the portfolio of contractual savings is associated with a decrease
in firms’ leverage. These results suggest that there might be an efficiency gain at the firm
level: an increase in the array of external financing possibilities is associated with
increased maturity of firms’ liabilities.
Increased maturity of the corporate sector liabilities should increase its resilience to
various shocks (such as refinancing risks and bankruptcy risks). The impact goes through
several possible channels; in market-based economies, the main effect seems to go
through the stock market and equity finance. In bank-based economies, it seems to go
through the supply of long term bank loans or through the bond market.
The results of this section and the analysis of Section 2 that describes the impact of
contractual savings on securities market have important policy implications. They show
that public intervention encouraging the development of contractual savings will be
beneficial to the corporate sector. However, both sets of results clearly imply that the
decision to encourage investments in equities (or bonds) depends on the financial
structure of the economy and the adequacy of information disclosure, accounting rules,
and generally regulation of securities markets. Equity investment should be encouraged,
relative to bonds, when security markets are more transparent; and conversely investment
in bonds may be more appropriate when securities market’s regulation is still
underdeveloped.

4. Contractual Savings Institutions and Banks’ Stability and

Efficiency
The broad movement of financial liberalization that started in the early eighties has
deeply modified the functioning of banking systems in many countries. Increased
competitive pressures may increase efficiency of the banking system, but may also
increase instability when proper regulation and supervision is not set. Surprisingly, few
studies have analyzed the efficiency, profitability and balance sheets of banks on a cross-

15
country basis.37 In particular, whereas financial liberalization was often associated with
competitive pressures from non-bank financial institutions, there has been, to date, no
attempt to analyze both empirically and theoretically the interaction between the banking
system and other financial institutions (except the stock market)38 in cross-country
regressions.
First, Impavido, Musalem and Tressel (2002a) assess the association between the
development of contractual savings institutions and the banking system, across countries
and over time. They evaluate the impact of contractual savings institutions on banks’
pricing and asset structure, after controlling for banks’ characteristics, financial sector
development, and the macroeconomic environment.
Contractual savings institutions act as competing suppliers of funds; hence competitive
pressure on the banking systems may increase, either indirectly or directly, when
contractual savings institutions develop. The development of contractual savings
institutions will indirectly increase competitive pressures on the banking system because
the development of contractual savings institutions is associated with the development
and increased liquidity of the capital markets (see Section 2 above). The cost of issuing
securities will decrease,39 hence reducing the market power of banks.40 Moreover,
contractual savings institutions may increase the supply of public information on capital
markets and have positive spillover effects on monitoring of borrowers by banks. In
addition, the development of contractual savings institutions directly increases
competitive pressures on the banking system. First, these institutions compete on the
saving side.41 Second, they compete on the lending side, either directly or indirectly, by
increasing the demand for securities on the primary markets. Hence, one should expect
to observe an impact on banks’ behavior. Competition, however, is likely to be two-
dimensional. First, competition will be in price, thus we should expect a decrease in
bank net interest margins as contractual savings institutions develop. Second, banks may
modify the maturity of their loans. As contractual savings institutions have a
comparative advantage in supplying long-term finance,42 banks may decrease the
maturity of their loans. Therefore, one might expect to observe a decrease in the maturity
of bank loans.
However, contractual savings institutions may also be complementary to banks. First, as
noticed by Demirguc-Kunt and Maksimovic (1996a), banks and stock markets may be
complementary.43 Information disclosure requirements and generally the increased

37
See, however, Demirguc-Kunt and Huizinga (1999a, 1999b), Davis and Tuori (2001) and Claessens,
Demirguc-Kunt and Huizinga (2001).
38
Allen and Santomero (1999) claim that the broad movement towards more market finance, that was
initiated in the 80s, has led to a greater importance of non-bank financial intermediation.
39
Underwriting costs may decrease, as argued by Vittas (1999) and the supply of funds will increase on
capital markets.
40
See Rajan (1992) who analyzes the welfare gains of increasing firms’ outside financial opportunities. See
also Petersen and Rajan (1995).
41
In France, the development of life insurance over the past 10 years has implied a significant reallocation
of savings from more “classic” banking savings instruments.
42
Contractual savings institutions have long-term liabilities.
43
Bank and market finance are complementary also because they finance different segments of the firm
population: see Diamond (1991), Bolton and Freixas (2000) among others.

16
transparency associated with capital market development may stimulate the monitoring
activity of banks,44 lowering the credit risk borne by the banking sector.45 An increase in
bank lending and total profitability may be observed as capital markets develop. Second,
contractual savings institutions may provide long-term resources to banks, thus reducing
the interest rate and liquidity risk in the banking system by limiting the term
transformation activity of banks.46 Therefore the maturity of bank loans may increase if
such complementarity effects dominate.
The development of contractual savings institutions may increase the stability of the
banking system, thus reducing systemic risks that may potentially lead to banking crisis.47
This is the case if the development of contractual savings institutions reduces the risks
borne by the banking sector. First, credit risk may be reduced if the development of
contractual savings institutions leads directly or indirectly to an increase in bank
monitoring. Second, the development of contractual savings institutions may reduce
interest rate risks and liquidity risks associated with the term transformation of assets
realized in the banking system. On the one hand, as noticed in the previous paragraph, if
contractual savings institutions are competitors to banks, the latter may indeed respond to
competitive pressures by concentrating on their core comparative advantage (associated
with narrow banking, that is their superior ability to monitor firms) and increase short-
term loans. Banks will therefore be able to avoid losses caused either by unexpected
increase in short-term interest rates or by sudden withdrawals. On the other hand, if
contractual savings institutions provide resources to the banking system (either in the
form of loans, deposits, or by buying securities issued by banks), banks will be less
subject to liquidity risks for a given level of long-term assets. They may therefore
increase the supply of long-term loans.48 Finally, the recent emerging economies’ crisis
have stressed the risks associated to short-term capital flows. Excessively volatile capital
movements have exacerbated the structural weaknesses of these economies, that were
magnified by fragile banking systems.49 This financial risk is associated with the
difficulty (or impossibility) for these economies to borrow abroad in their own
currencies, and long-term. One of the solution is to deepen the domestic financial system

44
However, the theoretical relation between stock market transparency, liquidity, and monitoring of firms
by claimants (banks or investors) is not clear-cut. See Holmstrom and Tirole (1993).
45
Davis (2001) stresses the “multiple avenues” of financial systems by comparing aggregate net flows of
bank loans and market debt finance.
46
Following Diamond and Dybvig (1983), systemic risk in the banking system has been identified as a
consequence of maturity transformation and the “sequential service” constraint on bank liabilities; in
addition, imperfect information and moral hazard increase this fragility of the banking system (Chen
(1999)). Freixas and Rochet (1997) provide a guidebook to microeconomic theories of banking.
47
Increased competitive pressures and financial stability are not incompatible. For a recent theoretical
analysis, see for instance Koskela and Stenbacka (2000) who show that loan market competition, which
leads to a reduction of lending rates and higher investments without increasing the equilibrium bankruptcy
risk of firms. In addition, whether a reduction in term transformation risk in the banking system leads to
more or less efficient lending decisions is an empirical question.
48
Impavido, Musalem and Tressel (2002a) results are consistent with this assertion.
49
See the recent literature, such as Aghion, Bachetta and, Banerjee (2000), Caballero and Krishnamurthy
(2000), Chang and Velasco (1999), Rodrik and Velasco (1999) and Deckle and Kletzer (2001). For
empirical analysis, see Demirguc-Kunt and Detriagache (1997, 1998, 2000) and Harwood et al. eds.
(1999).

17
in order to develop domestic sources of long-term finance (see for instance Caballero
(2001)), which is the comparative advantage of contractual savings.

Empirical strategy
Evidence on the impact of contractual savings institutions on the stability and efficiency
of the banking system, given adequate regulation and supervision,50 is limited. Impavido,
Musalem and Tressel (2001) make a first step in assessing this impact. More specifically,
they analyze: (i) profitability; (ii) the maturity structure of loans; (iii) credit risk; and (iv)
the structure of liabilities. They assess the association between contractual savings
institutions and the following variables: (i) the net interest margin (NIM), defined as the
accounting value of a bank’s net interest income over total assets; (ii) the profitability
(Profit), defined as profit before taxes over total assets;51 (iii) the loan maturity defined as
short-term loans (with maturity less than one year) over total loans; (iv) credit risk
proxied by loan loss provisions (over total assets, or over total loans); and (v) the
importance of short-term liabilities, proxied by customer plus short-term funding (over
total assets).
The first two variables describe the profitability of banks, hence proxy for their
efficiency. The NIM variable accounts for banking spreads; the objective is to assess
whether banks pricing behavior may be affected by the development of contractual
savings institutions. The NIM is also affected by the credit risk borne by the banks: it is
an ex-post measure taking into account the realized default rate. For these reasons,
Impavido, Musalem and Tressel (2002b) also use the Profit variable that accounts for all
sources of bank profits.
The third variable captures the maturity transformation activity realized in the banking
system; more specifically, they wanted to test whether the development of contractual
savings institutions has had an impact on the maturity of bank loans. In other words, do
banks increase or decrease long-term lending when contractual savings institutions
develop?
The fourth set of variables aim at describing the credit risk borne by the banks. They
used two measures: i) loan loss provisioning over total assets is the relevant variable to
understand the indirect impact of contractual savings on profitability via the reduction in
credit risk; and ii) loan loss provisions over total loans, roughly describes the risk of the
loan portfolio.
The authors used three sets of explanatory variables: (i) banks’ characteristics, (ii)
macroeconomic factors, and (iii) financial system characteristics.52 The latter two sets of
characteristics are the same as in the firms’ study discussed in section three.

50
See Barth et al. (2001) for an analysis of the prudential regulation of banks (see also Dewatripont and
Tirole (1994)). Generally, La Porta et al. (1997, 1998) claim that laws are important determinants of cross-
country differences in firms’ external finance choices.
51
See for instance Demirgüç-Kunt and Huizinga (1999a, 1999b).
52
In order to provide comparable results, Impavido, Musalem and Tressel (2002a) chose explanatory
variables similar to those used by Demirgüç-Kunt and Huizinga (1999a, 1999b).

18
Bank-specific characteristics
The first bank characteristic is the book value of equity divided by total assets. Recent
studies (see for instance Demirgüç-Kunt and Huizinga (1999a, 1999b) for cross-country
comparisons) show that there exists a positive relationship between bank profitability and
capitalization. High capitalization and profitability may indeed reflect a high franchise
value (Caprio and Summers (1993)). Moreover, well-capitalized banks may face lower
bankruptcy risks, thereby reducing their costs of funding. In addition, the authors wanted
to control that loan maturity is not explained by the structure of banks liabilities.
The second variable controlling for the structure of bank liabilities is customer and short-
term funding over total assets. It includes all short-term and long-term deposits plus
other non-deposit short term funding. Again, this variable controls that loan maturity is
not driven by the structure of liabilities. This is important in so far as we want to test
whether the development of contractual savings institutions has an independent impact on
bank loan maturity that is not driven by other bank-specific characteristics.
The study includes two variables describing the structure of bank activities. The first one
is total loans over total assets. The second one is non-interest earnings assets over total
assets. Non-interest earnings assets are mainly cash and non-interest earnings deposits at
other banks.
Finally, the study controls for overhead expenses, expressed as a percentage of total
assets. This implies that differences between net interest margin and profits before taxes
are explained by variations in non-interest income (or taxes and provisions for loan
losses).

Empirical results
The data shows some interesting dispersion. For example, credit risk seems to be
negatively correlated with the development of contractual savings institutions. There are
large cross-country differences: the top four countries in term of credit risk are Hungary
(2.36 percent), Argentina (1.56 percent), Thailand (1.18 percent) and Brazil (1.16
percent), while banks face the lowest credit risk in Germany (0.06 percent), Austria (0.10
percent), Belgium (0.21 percent) and Ireland (0.24 percent). In the former group,
contractual savings financial assets are 4.3 percent of GDP on average, and 29.6 percent
on average in the latter group. This suggests that development of contractual savings
institutions is likely to explain part of the variation of credit risks across countries.

The econometric analysis confirms that the correlation between banks’ profitability, loan
policy and the activity of institutional investors is not merely a function of banks’
characteristics and other macroeconomic factors. The main results are the following:

• There is a logarithmic relation between contractual savings development and net

interest margin; this suggests that the magnitude of the impact depends on the
initial development of contractual savings institutions. The impact is large at low
initial levels of contractual savings development, and it decreases as contractual
savings institutions develop. Therefore, the results are consistent with the initial
hypothesis that the development of contractual savings institutions is associated

19
 with increased competitive pressures in the banking system, leading banks to
reduce the spreads between loan and deposit rates.
• While banks tend to choose lower spreads when contractual savings institutions
are more developed, the total impact on profit is surprisingly positive, and the
impact is likely to go through a reduction in credit risk.
• The level of development of contractual savings institutions has a positive and
significant effect on loan maturity. This suggests that, even if banks seem to face
higher competitive pressures when contractual savings institutions develop (thus
reducing interest spreads), they do not reduce the maturity of loans (in other
words they do not seem to concentrate on their core activity). On the contrary,
there seems to be a complementarity between the two institutions when
concentrating on the loan maturity dimension.53
• There is a negative correlation between credit risk borne by the banking system
and the level of development of contractual savings institutions. It is worthwhile
underlining that this strong result does not reflect cross-country differences, for
instance the level of economic development. This result complements the
conclusions of the firms’ analysis above, showing that the corporate sector is
more resilient to various shocks when contractual savings institutions are more
developed or invest more on the stock exchange.
• The development of contractual savings implies a reduction in the short-term
liabilities of the banking sector. This result is also consistent with
complementarity between banks and contractual savings institutions.

The paper by Impavido, Musalem and Tressel (2002a) was a first attempt at assessing the
interaction between the banking system and contractual savings institutions. The results
are consistent with the view that the development of contractual saving is associated with
a more efficient banking system. Moreover, these results support the argument that the
banking system is more resilient to liquidity and credit risks when contractual savings
institutions are more developed. Furthermore, they are consistent with the conclusions
drawn by Impavido, Musalem and Tressel (2002b) concerning firms’ financing patterns.

5. Conclusions and Policy Recommendations

Our analysis is based on recent research on a topic that is not well explored. More
analysis is needed to identify the precise channels through which contractual savings
institutions interact with the financial system. In particular, country case studies may
provide useful insights.
In spite of these restrictions, there is scope for some policy recommendations. If
demographic, institutional and political preconditions for pension reforms (or reform of
the life insurance industry) are met, policy makers should bear in mind that development
of contractual savings instruments is a complex undertaking requiring the

53
For various aspects of the role of long-term finance, see the discussion in Impavido, Musalem and
Tressel (2002a).

20
synchronization of macroeconomic and financial sector policies. The commitment of the
government must be strong in these areas to minimize uncertainties.
First, only countries with sustainable macroeconomic policy frameworks, including low
expected inflation rates, will generate the enabling environment for the successful
development of long term saving instruments. This includes budget surpluses which
could be used to absorb the budgetary impact of policies promoting these instruments.
Second, particular attention should be paid to financial sector development policies that
enhance the efficiency of the contractual savings industry as a major provider of non
captive funds. The regulation, in particular of equity investments, may have a large
impact when portfolio limits affect actual investments. In general, investment regulations
should have as an objective the maximization of benefits to plan members. This is
achieved when it is based on the prudent person rule (maximization of investment returns
with due consideration to risks), rather than to be based on picking winners (regulating
quantitative portfolio allocations). In addition, policy intervention should be based on a
precise evaluation of the interaction between institutional investors and other components
of the financial system. For instance, one may want to assess the importance of
liberalizing the domestic banking system before the pension reform.
Moreover, adoption of internationally accepted standards on governance, accounting,
disclosure, and accountability through effective enforcement mechanisms would enhance
financial sector development, including contractual savings. Furthermore, sound
contractual savings plans require that funds be segregated as sole property of plan
members, to be independent from fund managers, and to be kept with reputable
custodians.
Next, regulations (on foreign investment) should assess the potential effects on the
external balance. On the one hand, if the return on foreign financial assets is imperfectly
correlated to the return on domestic financial assets, then plan members would benefit
from international diversification of portfolio. However, this should be traded-off against
potential macroeconomic risks for financing the current account. In a growing emerging
economy, one expects to observe a temporary current account deficit to be financed by
capital inflows. Hence, a careful assessment of the impact of substantial capital outflows
caused by pension funds investment may be necessary. In particular, since pension funds
usually adjust their portfolio on the margin (with new investment), the structural capacity
of the balance of payment to absorb capital outflows must be carefully evaluated.
Furthermore, currency risks should also be taken into account.
Finally, contractual saving plans deal with future claims on output. To the extent that
they promote growth, they would facilitate the distribution of future output between
active workers and beneficiaries. However, this does not mean that mandatory funded
plans should be supported without limit. Excessive mandatory contribution to funded
plans may be welfare reducing. The level of mandatory contribution to pension plans
should be such as to generate retirement income sufficient to avoid people falling into
poverty after retirement and not to pursue other objectives.

21
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