Pension Policy and the Financial System

This paper examines the effect of pension policy on the structure of financial systems around the world. In particular, I explore the hypothesis that policies that promote pension savings also promote the development of capital markets. I present a model that endogenizes the extent to which savings are intermediated through banks or capital markets, and derive implications for corporate finance, household finance, banking, and the size of the financial sector. I then present a number of facts that are broadly consistent with the theory and examine a variety of alternative explanations of my findings. ∗Harvard Business School and NBER. Presidential Address delivered to the American Finance Association, Philadelphia, January 6, 2018. I am very grateful to Will Diamond, Robin Greenwood, Sam Hanson, Gianluca Rinaldi, Jeremy Stein, and Adi Sunderam for many valuable discussions and for helpful comments on drafts of the paper. I also benefited from discussions with Hugo Bänziger, John Beshears, John Campbell, Garrett Curran, Sarah Feldman, Andrea Hamaui, Victoria Ivashina, Anil Kashyap, Divya Kirti, David Moss, Thomas Philippon, Jim Poterba, Tarun Ramadorai, Andrei Shleifer, Paul Tucker, Boris Vallée, Luis Viceira, the passengers of Carpe Diem V, and seminar participants at Yale Law School and the Chicago Booth Initiative on Global Markets. I thank Andi Wang for providing extraordinary research assistance throughout the project. I am also grateful to James Palano and Francesca Guiso for the help at various stages of the research. The Division of Research at Harvard Business School provided generous funding for this work. Disclosure: I am a director of M&T Bank Corporation, which offers banking, asset management and retirement products and services. Countries around the world have made vastly different choices about how to meet the retirement needs of their populations. Some have chosen to finance retirement incomes largely by taxing current workers, in so-called pay-as-you-go ("PAYGO") pension systems. Others have promoted private pension saving as a way to fund retirement benefits. For example, according to the OECD, in Italy and Denmark the average worker entering the labor force in 2014 could retire at age 67 and expect to have almost 70% of his or her pre-retirement income replaced by pension income (OECD (2015)). In Italy this pension income would be financed in large part by taxes on current workers, while in Denmark much of this income would be generated by the assets of private pension schemes. These different approaches are reflected in differences in pension assets across the two countries: in 2014 private pension assets were less than 10% of GDP in Italy, while in Denmark they were about 180% of GDP (OECD (2015)). Table I, described in greater detail in the next section, documents the remarkable variation in pension systems across the OECD. Countries also vary in the structure of their financial systems. They vary in bank dependence (Levine (2002)), corporate ownership structure (La Porta, Lopez-de-Silanes, and Shleifer (1999)), household assets and liabilities (Badarinza, Campbell and Ramadorai (2016)), the composition of bank balance sheets (Barth, Caprio, and Levine (2004)), and the size of the financial sector (Philippon and Reshef (2013)). In this paper, I connect the structure of financial systems in advanced economies to their pension policies. In particular, I explore the hypothesis that policies that promote the accumulation of pension savings also promote the development of capital markets, which in turn affects corporate finance, household finance, banking, and the size of the financial sector. The idea that pension saving stimulates capital market development has figured in pension reform proposals for both developed and emerging market economies (World Bank (1994)). However, the theoretical basis for this claim and the full set of implications of pension policy for financial systems are not well understood. Indeed, while an abundant academic literature studies the effect of pension policy on savings, there is little theory and evidence on how pension policy affects the way the financial system transforms savings into investment. I start my analysis with a model that links pension policy to the structure of the financial system. The theory I propose builds on William Diamond’s (2017) model of financial intermediation, which I use to derive implications for how pension policy affects the extent to which savings are intermediated through banks or capital markets. I then use the framework to link pension policy to risk-taking by firms, the composition of corporate and bank balance sheets, household assets and liabilities, and the size of the financial sector. Following Diamond (2017), in my model households choose to allocate their savings between safe bank deposits and securities. Banks want to issue safe deposits because households value the liquidity services that they provide and are thus willing to accept a low return on these investments. However, to offer safe deposits, banks will invest only in relatively safe assets and will issue equity as a buffer to protect depositors. By contrast, households will want to invest some of their savings in risky assets through the capital markets in addition to investing in the safe and liquid deposits that banks issue. This leads to a bifurcation in the allocation of risk between banks, which fund relatively safe projects, and capital markets, which fund relatively risky projects. I depart from Diamond (2017) in four important respects. To simplify the model, I assume that savings are exogenous and randomly distributed across households within an economy but that there are greater average household savings in economies that rely on prefunded private pensions (i.e., economies that are less dependent on PAYGO public pensions). Second, I model a production economy, which enables me to derive implications for the types of projects undertaken in the economy. Third, I assume that households incur fixed costs to invest in capital markets, implying that only households with a lot of pension savings invest in capital markets. Finally, in an extension of the model, I assume that households buy homes against which they can borrow to fund their purchases. This assumption allows me to incorporate the main asset of many households into the model. The above assumptions generate cross-sectional implications that link pension policy to key features of the financial system. Among the implications is that the financial systems of countries with PAYGO-oriented pension systems —– those with less pension savings —– are more bank-based and less capital-market intensive. Another implication is