Capital markets’ message to financial institutions: Differentiate or perish

When COVID-19 first surfaced in early 2020, the economic impact and potential risks to the global financial system were highly uncertain. Sixteen months in, after unprecedented simultaneous stimulus programs implemented by governments across the world, the financial system is stable. The pandemic is far from over; case counts and deaths continue to surge in some parts of the world, but in others, the worst of the crisis has passed. For banks and other financial institutions, the focus is now shifting to the pandemic’s effects on their business models.

To understand how those effects have influenced the value of the world’s leading financial institutions and what those shifts may mean for the sector’s future, we analyzed capital-markets performance of the 599 diversified global financial institutions in our database. We found that 56 players each gained at least $5 billion in market cap in the past 16 months, adding about $1.3 trillion in combined market value (Exhibit 1). 1 Our analysis covered the period from February 19, 2020 (a precrisis high for most stock markets), through July 31, 2021. Another 28 institutions each lost more than $5 billion in value. The vast majority of our sample, however, saw relatively little change, neither losing nor gaining much market value.

The massive gains made by the sector’s top performers, which account for less than 11 percent of the institutions in our sample, brought their share of the sector’s total market capitalization from 36 percent to an impressive 44 percent. As in other industries , the outperformers in financial services are pulling further ahead of the pack. Our analysis also suggests that investors are rewarding two models in particular: specialists and universal banks with strong domestic franchises and differentiated digital offerings.

The rise of financial specialists

Thirty-two of the 56 institutions that have gained the most value over the past 16 months have specialized business models focusing primarily on payments, financial market infrastructure, or investment banking (Exhibit 2). Collectively, specialists account for more than 70 percent of the $1.3 trillion in market cap added by the outperformers.

In the payments category, a variety of digital players—including platforms, card networks, processors, vertical specialists, and “buy-now, pay-later” companies—made the biggest gains, reaping the benefits of generally capital-light business models combined with soaring demand for digital payments during the pandemic. One leading platform player, for example, saw growth of its payment volumes more than double, from roughly 20 percent in the first quarter of 2020 to more than 45 percent in the same period in 2021. This single company represented more than 10 percent of the sector’s total value creation during the time frame we studied.

Some market-infrastructure providers such as financial exchanges also created disproportionate value for shareholders, thanks in part to stellar sales growth. One exchange grew its revenues by 46 percent in one year by significantly increasing average daily turnover and benefiting from strong momentum in the IPO market. Investors are also embracing infrastructure firms that have pushed into adjacent businesses, such as data and technology services, to diversify revenues and those that added new products.

Additionally, record deal volumes in recent months have raised the market values of several specialist investment banks in developed countries. A few specialist securities houses with differentiated business models in emerging economies surged ahead as well. For example, investors have flocked to a Brazilian investment bank and wealth manager after it dramatically grew its wealth assets under management last year.

Champions among universal banks

A second trend our analysis highlights is the emergence of an elite group of universal banks amid generally flat or declining performance among such institutions. Of the more than 420 banks in our database that provide comprehensive financial services, only 24 added value of more than $5 billion in the past 16 months. Most of these outperformers are based in emerging markets, including four banks in the Middle East, three each in China and India, and one each in Brazil, Russia, and Singapore.

Most of the big value gainers among universal banks are domestic leaders that are making significant investments in digital capabilities as a point of competitive differentiation. In a few instances, investors rewarded banks for boldly reshaping their portfolios. One US bank, for example, has completed more than 30 digital acquisitions so far in 2021 as part of a clear strategy to diversify sources of revenue beyond traditional banking services. This and other banks have used M&A to pursue consolidation to drive scale, to gain footholds outside their home markets, or to expand their business portfolios aggressively to diversify revenue streams.

Incumbent financial institutions are likely to face challenging times ahead, including potential losses in their credit portfolios as the pandemic’s impact on businesses and consumers continues to reverberate. As players shape their strategies for the postpandemic world, they should reflect deeply on the signals that investors are sending. Is the current universal banking model becoming obsolete? Does the future require significant horizontal expansion into new areas beyond traditional banking? Is a major consolidation in domestic banking markets inevitable? Our flagship Global Banking Annual Review will examine these and other questions in the coming months.

Joydeep Sengupta is a senior partner in McKinsey’s Singapore office, where Archana Seshadrinathan is an associate partner; Peter Stumpner is an associate partner in the New York office.

The authors wish to thank Chris Bradley for his contributions to this article.

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What Are Capital Markets?

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Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

article review on capital market

Capital markets are where savings and investments are channeled between suppliers and those in need. Suppliers are people or institutions with capital to lend or invest and typically include banks and investors . Those who seek capital in this market are businesses, governments, and individuals. Capital markets are composed of primary and secondary markets. The most common capital markets are the stock market and the bond market. They seek to improve transactional efficiencies by bringing suppliers together with those seeking capital and providing a place where they can exchange securities.

Key Takeaways

  • Capital markets refer to the venues where funds are exchanged between suppliers and those who seek capital for their own use.
  • Suppliers in capital markets are typically banks and investors while those who seek capital are businesses, governments, and individuals.
  • Capital markets are used to sell different financial instruments, including equities and debt securities.
  • These markets are divided into two categories: primary and secondary markets.
  • The best-known capital markets include the stock market and the bond markets.

Investopedia / Yurle Villegas

Understanding Capital Markets

The term capital market is a broad one that is used to describe the in-person and digital spaces in which various entities trade different types of financial instruments . These venues may include the stock market, the bond market, and the currency and foreign exchange (forex) markets. Most markets are concentrated in major financial centers such as New York, London, Singapore, and Hong Kong.

Capital markets are composed of the suppliers and users of funds. Suppliers include households (through the savings accounts they hold with banks) as well as institutions like pension and retirement funds, life insurance companies, charitable foundations, and non-financial companies that generate excess cash. The users of the funds distributed on capital markets include home and motor vehicle purchasers, non-financial companies, and governments financing infrastructure investment and operating expenses. 

Capital markets are used primarily to sell financial products such as equities and debt securities. Equities are stocks, which are ownership shares in a company. Debt securities , such as bonds, are interest-bearing IOUs.

These markets are divided into two different categories:

  • Primary markets where new equity stock and bond issues are sold to investors
  • Secondary markets , which trade existing securities

Capital markets are a crucial part of a functioning modern economy because they move money from the people who have it to those who need it for productive use.

Primary Market

When a company publicly sells new stocks or bonds for the first time, such as in an initial public offering (IPO), it does so in the primary capital market. This market is sometimes called the new issues market. When investors purchase securities on the primary capital market, the company that offers the securities hires an underwriting firm to review it and create a prospectus outlining the price and other details of the securities to be issued.

All issues on the primary market are subject to strict regulation. Companies must file statements with the Securities and Exchange Commission (SEC) and other securities agencies and must wait until their filings are approved before they can go public.

Small investors are often unable to buy securities on the primary market because the company and its investment bankers want to sell all of the available securities in a short period of time to meet the required volume, and they must focus on marketing the sale to large investors who can buy more securities at once. Marketing the sale to investors can often include a roadshow or  dog and pony show , in which investment bankers and the company's leadership travel to meet with potential investors and convince them of the value of the security being issued.

Secondary Market

The secondary market includes venues overseen by a regulatory body like the SEC where these previously issued securities are traded between investors. Issuing companies do not have a part in the secondary market. The New York Stock Exchange and Nasdaq are examples of secondary markets.

The secondary market has two different categories: the auction and the dealer markets . The auction market is home to the open outcry system where buyers and sellers congregate in one location and announce the prices at which they are willing to buy and sell their securities. The NYSE is one such example. In dealer markets, though, people trade through electronic networks. Most small investors trade through dealer markets.

Are Capital Markets the Same as Financial Markets?

While there is a great deal of overlap at times, there are some fundamental distinctions between these two terms. Financial markets encompass a broad range of venues where people and organizations exchange assets, securities, and contracts with one another, and are often secondary markets. Capital markets, on the other hand, are used primarily to raise funding, usually for a firm, to be used in operations, or for growth.

What Is a Primary vs. Secondary Market?

New capital is raised via stocks and bonds that are issued and sold to investors in the primary capital market, while traders and investors subsequently buy and sell those securities among one another on the secondary capital market but where no new capital is received by the firm.

Which Markets Do Firms Use to Raise Capital?

Companies that raise equity capital can seek private placements via angel or venture capital investors but are able to raise the largest amount through an initial public offering when shares list publicly on the stock market for the first time. Debt capital can be raised through bank loans or via securities issued in the bond market.

Capital markets are a very important part of the financial industry. They bring together suppliers of capital and those who seek it for their own purposes. This may include governments that want to fund infrastructure projects, businesses that want to expand, and even individuals who want to buy a home. They are divided into two different categories: the primary market where companies list new issues for the first time and the secondary market, which allows investors to purchase already-issued securities. The key benefit to these markets is that they allow money to move from those who have it to those who need it for their own purposes.

U.S. Securities and Exchange Commission. " Going Public ."

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Capital Market Equilibrium With Imperfect Competition: The Case of the ECB’s Asset Purchase Programme

  • Original Article
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  • Published: 27 May 2020
  • Volume 72 , pages 369–391, ( 2020 )

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  • Christian Koziol   ORCID: orcid.org/0000-0003-2999-1306 1 &
  • Werner Neus 2  

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We set up a multiperiod, CAPM-type model with imperfect competition between investors in case of an additional price-insensitive market participant. The motivation for this additional actor comes from the ECB’s announcement to buy a substantial amount of securities “whatever it takes” which reflects the willingness to trade in a entirely price-inelastic way. Our model explains the effects on demand functions, equilibrium prices, portfolio holdings and investors’ expected utility. The interaction of price-inelastic additional demand by the ECB, on the one hand, and imperfect competition, on the other hand, causes differentiated results regarding timing strategies, development of prices over time, and utility implications.

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1 Introduction

The asset purchase programme (APP) carried out by the European Central Bank (ECB) between March 2015 and December 2018 has gained widespread attention for two reasons: First, the total market volume of acquired bonds attributes to more than 2.5 trillion EUR and is, therefore, of a predominant magnitude. Related to the size of the total sovereign bond market, the ECB acquired almost 40% of the outstanding bond issuances within the eurozone.

Second, this extreme activity of the ECB has offset traditional market forces within the fixed income trading. In the first place, the bond prices have increased so that the yield to maturity of the corresponding bonds and likewise interest rates, in general, have significantly declined. More than that, the relation between prices and other asset classes has sharply changed due to the fundamentally different environment. As of November 2019, further buybacks with a monthly volume equal to 20 billion EUR have been announced. Given the Corona crisis, the amount has been substantially extended, again.

With this bond acquisition behavior, the ECB has become a major player at the capital market, acting in an unusual way relative to the other investors. While traditional equilibrium pricing models assume market participants to behave in accordance with their individual preferences, beliefs and endowments, the ECB is a fundamentally different player acting in a price-insensitive way according to a communicated schedule.

This observation of a new type of market participant trading large volumes regardless of the price is the motivation for our paper. Our aim is to analyze the effects of a suchlike price-insensitive market participant for an equilibrium asset pricing model. In particular, we can have the notion that this market participant is the ECB but does not need to be: Alternatively, investors following a frequent asset savings plan also exhibit these characteristics. Moreover, we can also think of companies carrying out a stock repurchase programme approved by the general meeting. For reasons of illustrative simplification, we will use the term ECB as a general abbreviation for all types of price-insensitive investors following a prespecified schedule and do not exclusively refer to the European Central Bank and their particular characteristics within our equilibrium.

In a theoretical model with perfect competition, the price effect of the ECB’s interventions is like that from a reduction of units held by the other investors. Therefore, only the intended volume of the ECB’s repurchases matters in order to impact asset prices rather than the point in time of trading.

However, if trading takes place under imperfect competition, e.g., if investors are strategically aware of the price impact of their trades, markets are not perfectly liquid so that prices might be additionally impacted by the ECB’s transactions beyond the pure reduction effect of outstanding bond volume. This characteristic is highly consistent with the bond market which is dominated by a limited number of large investors.

In order to understand the ECB’s impact on asset prices, we integrate a market participant representing the ECB who acts completely price-inelastic into a model of capital market equilibrium. Because of its well-known characteristics and implications, we choose the capital asset pricing model (CAPM) as the initial framework for our analysis. On this basis, we can identify the implications of a price-inelastic behavior on demand functions, equilibrium prices, optimal portfolios holdings and the expected utility of capital market investors. Footnote 1 In order to capture liquidity effects and the change of liquidity over time in our equilibrium asset pricing model, we assume strategic investors taking care of their price effect of their demand at two trading dates. Footnote 2

In particular, our theoretical model aims at answering the following questions:

How do trades by the ECB affect market prices?

Does the timing (early or late) of the ECB’s trades impact market prices? In other words, we want to distinguish whether the ECB’s announcement of a purchase programme or the execution of it has a more severe price effect.

How does the demand of other investors change when the ECB is present?

What do the ECB’s activities mean for the investors’ expected utility?

With these research questions, this paper provides insights for portfolio management and theoretical asset pricing in a new framework adjusted to recent challenges. Even though we address the ECB as an example, we do not aim at contributing either to central bank behavior nor to monetary economics.

Our model relies on a slightly modified version of the capital asset pricing model (CAPM). As it is well known, the Mossin ( 1973 ) representation of the ubiquitous CAPM is more suitable for theoretical analyses than the basic Sharpe ( 1964 ) model. We enrich the Mossin model by three additional features: First, there is a second trading round in order to capture timing effects driven by a change of market liquidity over time. Second, the market participants consider the price effects of their trading instead of acting as price-takers. Third, we introduce a market participant acting completely price-inelastic denoted as ECB.

In order to focus on these essentials, we remove some typical CAPM ingredients to keep the analysis concise: diversification of different types of risky securities, different degrees of risk aversion, and heterogenous expectations on the assets’ return parameters (the latter actually not being part of the basic CAPM).

Multiperiod capital market equilibria have been analyzed in a discrete time and a continuous time framework (see Stapleton and Subrahmanyam 1978 ; and Merton 1973 ; respectively). The consideration of two trading rounds allows us to capture both announcement effects (prior to ECB’s interventions) as well as price effects (subsequent to ECB’s trading).

Imperfect competition, most notably, has been analyzed by Lindenberg ( 1979 ). Footnote 3 He extends the Mossin-CAPM by including some price affectors in addition to the usual price takers. Solving the model, Lindenberg explicitly considers the influence one investor exerts on the other investors’ decisions (conjectural variations). He does not, however, come to an explicit solution for security prices and individual portfolios except for the case of a single price affector. We, therefore, employ the Nash equilibrium concept to reveal the unique equilibrium. To the best of our knowledge, there is virtually no example for an ECB-like price-inelastic behavior in the literature as analyzed in our framework.

As is well-known, CAPM prices are determined in a Walrasian auction. Another strand of literature focuses on alternative forms of market microstructure, for example, a market clearing by the inclusion of noise traders (Kyle 1989 ) or additionally introduced market makers (Kyle 1985 ; Subrahmanyam 1991 ; Spiegel and Subrahmanyam 1992 ). The main topics of these contributions are market liquidity and information aggregation via the pricing mechanism. Excluding the heterogeneous information topic and emphasizing the liquidity aspect, Heumann ( 2007 ) comes quite close to our analysis. Even if the two approaches referred to (CAPM-type modeling vs. market microstructure) considerably differ in their respective starting points, they end up with virtually the same results when adopted to comparable market conditions.

The main contribution of our paper is to extend the established models of imperfect competition by an ECB-like participant who demands a pre-specified schedule of assets at both trading dates. Beside a general analysis, we distinguish between the case with ECB trades taking place early (period 1) or only late (period 2). The investigation of this market structure reveals the following findings:

The ECB’s acquisitions of an asset increase its price more strongly than a pure reduction of the initial endowment (which was the price effect of the ECB for perfect competition).

Late purchases by the ECB imply a stronger price increase than early trades of the same size (as long as no information is revealed between trading dates).

Even though the investors’ period 1 demand functions are shifted upward due to the ECB’s purchases in period 2, their trading volume remains unaffected in equilibrium.

An additional demand by the ECB always causes utility losses on part of the investors.

The remainder of the paper is organized as follows. In Sect. 2, we present the two-period reference model with imperfect competition in the absence of the ECB’s purchases. In the next step, we extend this framework for an arbitrary, credible trading strategy of the ECB in Sect. 3. Sect. 4 analyzes the ECB’s timing effects on equilibrium prices, demand, trading volume and investors’ utility. In Sect. 5, we discuss a generalization of our model incorporating additional information at the end of period 1. Sect. 6 concludes. All technical developments are shown in the appendix.

2 The Reference Model

2.1 the setting.

For our analysis, we consider an equilibrium pricing model with imperfect competition. The analytical framework rests on Mossin ( 1973 ) and extends his approach by imperfect competition, to be more precise a Cournot-Nash behavior of the investors.

We analyze a capital market with \(n\) investors. In the market, two assets are traded, a riskless asset whose return is normalized to zero and a risky security. There are two trading periods. Thus, the investors can adjust their initial individual portfolios in two steps considering the activities of all involved market participants. The risky asset’s terminal value \(\tilde{v}\) at the end of the second period is normally distributed with mean \(\mu\) and variance \(\sigma ^{2}\) . These parameters are common knowledge. The investors’ utility function is exponential, \(u\left(\tilde{w}_{i2}\right)=-\exp \left\{-\theta \tilde{w}_{i2}\right\}\) , where \(\theta >0\) is the (constant) Pratt-Arrow coefficient of absolute risk aversion and \(\tilde{w}_{i2}\) is investor \(i\) ’s terminal wealth. Given the normally distributed asset value \(\tilde{v}\) , the investors maximize the mean-variance certainty equivalent \(\varphi _{i}=\mathrm{E}\left\{\tilde{w}_{i2}\right\}-\frac{1}{2}\theta \mathrm{Var}\left\{\tilde{w}_{i2}\right\}\) . Each investor is endowed with an individual legacy portfolio, i.e. a certain number of the risky asset and the riskless security ( \(\overline{x}_{i0}\) and \(\overline{y}_{i0}\) , respectively). There are no short-selling restrictions, and the securities are perfectly divisible. Finally, we normalize the number of risky securities outstanding to one.

As special features, we have (1) two trading rounds rather than one and (2) investors not acting as price takers but considering the price impact of their demand. Overall, the approach is compatible with the previously discussed related literature, most of all Lindenberg ( 1979 ).

It is essential for our purposes that investors have an incentive to revise their portfolios. Given the same degree of risk aversion on the part of the different investors, the optimal target portfolios consist of the same share, \(\frac{1}{n}\) , in the risky asset’s free float. Footnote 4 Footnote 5 The trading motive is, therefore, introduced by some deviation in the legacy portfolio. Later on, we will refer to investors as sellers or buyers if \(\overline{x}_{i0}>\frac{1}{n}\) or \(\overline{x}_{i0}<\frac{1}{n}\) , respectively. This exposition reveals the distortion caused by imperfect competition and the ECB in the easiest and most transparent way. In the following, we are mostly interested in the investors’ equilibrium portfolios \(x_{it}^{*}\) and prices \(p_{t}^{*}\) \(\left(i=1,\ldots ,n;t=1,2\right)\) .

The initial wealth of investor \(i\) is represented by the value of her initial endowment: Footnote 6

Her terminal wealth consists of her share in the risky asset and her holding of the riskless asset:

Substituting the period-specific budget constraints

for the riskless asset, we obtain for the investor \(i\) ’s terminal wealth

An increase in wealth is caused by the respective holdings in the two periods and positive price changes or favorable realizations of the risky asset’s terminal value.

Each investor maximizes her certainty equivalent

2.2 Intertemporal Equilibrium

We solve the two-period model by backward induction. At the beginning of the second period, the price \(p_{1}\) and the portfolios \(x_{i1}\) are given. Investor \(i\) ’s first-order condition reads

A crucial term for the further derivation of the equilibrium is the impact of a marginally increased demand on the price. Obviously, under perfect competition the effect equals zero. With imperfect competition, we expect a positive derivative. Lindenberg ( 1979 ) as the most similar approach to ours uses the total derivative as starting point:

and solves for different equilibrium outcomes depending on the investors’ “conjectural behavior”. In a Nash equilibrium, however, by construction there is no effect of one investor’s demand on the other investors’ demand because one-sided deviations from equilibrium must not pay off. The remaining partial derivative may be constant, increasing or decreasing. In what follows, we refrain from analyzing a non-linear form of the function \(p_{2}\left(x_{i2}\right)\) . Restricting ourselves to equilibria with a linear price-quantity schedule, we will show there is a unique Cournot-Nash equilibrium within this class of demand functions. Footnote 7 We do not make any statement on the possible existence of other equilibria with a non-linear demand. Neither within the CAPM-type approach (see, e.g., Hirth and Walther 2018 ) nor within the microstructure literature (see, e.g., Kyle 1985 ) there is any paper dealing with properties of an eventual non-linear equilibrium. A forteriori , it is quite unclear whether there exist other equilibria at all.

Given linear inverse demand functions, \(p_{t}=\gamma _{t}+\beta _{t}\sum _{i}x_{it}\) , we always have \(\frac{\partial p_{2}}{\partial x_{i2}}=\beta _{2}\) and can solve the first-order condition for the optimal individual demand

where \(R\equiv \theta \sigma ^{2}\) comprises the effects of risk and risk aversion. Solving for the equilibrium value of \(\beta _{2}\) (cf. Appendix 1) yields Footnote 8

\(\beta _{2}\) can be seen as an inverse measure for market liquidity in period 2. The higher \(\beta _{2}\) , the stronger is the price impact of demand, and the lower is market liquidity. In equilibrium, (quite naturally) liquidity increases with the number of investors. Increasing risk or increasing risk aversion, instead, implies decreasing liquidity. A strong preference for coming close to the optimal risk sharing leads to a less price sensitive demand. In liquid markets, prices hardly react to changes in demand or supply. In turn, demand shows a high price elasticity. In case of high risk or high-risk aversion, however, demand is mainly driven by risk considerations and not by price effects. In other words, the market is rather illiquid. Inversely, if there was no risk, the market would be perfectly liquid even in the presence of scarce competition.

Next, we solve for the equilibrium price of the risky asset. Summing up the investors’ first-order conditions

and using the market clearing conditions as depicted by the curly brackets we can solve for the equilibrium price

Here, \(p_{2}^{*}\) fully corresponds to the standard CAPM with perfect competition, i.e. price-taking investors. Remarkably, the price sensitivity reflected by \(\beta _{2}\) does not have any impact on the second-period equilibrium price. (This result will no longer hold when we add the ECB’s APP to the model. Cf. Sects. 3 and 4).

Finally, we are interested in the investors’ equilibrium portfolios \(x_{i2}^{*}\) . Inserting the equilibrium price \((3)\) into individual demand function ( 2 ), we obtain

where \(q_{2}\equiv \frac{\partial x_{i2}}{\partial x_{i1}}=\frac{\beta _{2}}{R+\beta _{2}}=\frac{1}{n-1}\) (cf. appendix 1). The optimal holding can be described as the weighted average of the second-period initial holding \(x_{i1}\) and the optimal risk-sharing rule \(\frac{1}{n}\) . The deviation from optimal risk sharing \(\left(q_{2}\right)\) increases if market liquidity decreases because the cost to arrive at the optimal risk sharing increases. In equilibrium, however, the extent to which this effect is present does not depend on the risk itself.

The first-period calculus is basically the same as for period 2. In maximizing the certainty equivalent \((1)\) , however, the second-period price \(p_{2}^{*}\) and the optimal portfolio adjustment rule \(x_{i2}^{*}\left(x_{i1}\right)\) will be anticipated. When choosing \(x_{i1}\) , investor \(i\) considers the impact on her future portfolio choice.

Starting from the first-order condition

and using \(q_{2}\) as defined above as well as \(\beta _{1}\equiv \frac{\partial p_{1}}{\partial x_{i1}}\) , we obtain the demand schedule

In equilibrium, \(\beta _{1}\) takes the value (cf. Appendix 1)

Notice that the price sensitivity for individual trades at time \(t=1\) , \(\beta _{1}\) , is below that at time \(t=2\) , \(\beta _{1}<\beta _{2}\) , i.e. in period 1 the market is more liquid than in period 2. Intuitively, the liquidity at time \(t=1\) is supposed to be higher because there is still a further trading opportunity at the later date \(t=2\) . Moreover, there is no risk to be revealed in period 1 and the second-period risk enters liquidity only via anticipation of the second-period trades.

Using the first-period market clearing conditions, the equilibrium price is

No price change over time can be observed.

Finally, using the equilibrium price, the optimal first-period security holding is

where \(q_{1}\equiv \frac{\partial x_{i1}}{\partial \overline{x}_{i0}}=\frac{1}{n-1}=q_{2}=q\) (cf. Appendix 1). The portfolio adjustment rule is the same as in period 2. Again, we have a weighted average between the beginning-of-period holding and the optimal risk sharing with the same weights as in period 2.

The main driver of the results is the investors’ need to adjust their individual portfolios caused by the imbalance of the endowment and optimal risk sharing. Restating eqs. \((4)\) and \((7)\) reveals

where \(\xi _{i}\equiv \frac{1}{n}-\overline{x}_{i0}\) is a measure for the initial imbalance, i.e. the need to adjust the initial portfolio. A certain share \(1-q\) of this imbalance will be captured in the first period. The same share of the remaining imbalance is settled in the second period. A steady increase of the number of trading periods implies a convergence of the final portfolio to optimal risk sharing. Footnote 9

A final interesting remark is about the investors’ expected utility. We have

where \(\lambda _{i}\equiv n\xi _{i}q^{2}\) measures the overall distortion caused by the initial imbalance and the reluctant adjustment of the portfolio. In case there is no initial imbalance of the endowment \(\left(\xi _{i}=0\right)\) or there is perfect competition between investors \(\left(q=0\right)\) we arrive at the well-known Pareto-optimal risk sharing and a maximum individual utility. Notably, the sign of the initial imbalance does not matter.

Up to here, the questions of interest have been the deviations that imperfect competition causes compared to the standard CAPM. There is no impact on the equilibrium prices, which are constant over the two periods. The differences are actually driven by the price affecting the behavior of the investors. The individual portfolios are not adjusted the way they should be because the investors do not want to affect prices in an unfavorable way. At the end, imperfect competition is some kind of built-in “brake” to trading activities (Hirth 1997 ).

3 Introducing the ECB—General Model

Starting with this section, we introduce an additional market participant, the ECB. This investor buys a certain amount \(\left(\Updelta _{t}>0\right)\) of the risky asset within the respective periods \(t=1\) and \(t=2\) whatever it takes. We can address the matter of timing, i.e. the different effects of the ECB buying “early” (within period 1) or “late” (within period 2) or both.

Here, some remarks on the institutional background of the ECB’s APP seem to be appropriate. On the one hand, the ECB’s decisions refer to a limited investment measured in money units in a wider class of assets (public sector purchase programme, corporate sector purchase programme, …). On the other hand, referring to a single issue, there are purchase limits measured in issue shares. We, therefore, define our \(\Updelta _{t}\) ’s as shares of the securities outstanding amount instead of some fixed money value. Furthermore, due to a strictly monotonous and continuous relationship between trading volume \(p\Updelta\) and traded units \(\Updelta\) , the variables could be translated into one another—however at the costs of implicit instead of explicit solutions.

Regarding the ECB’s trading strategies, it is important that its activities are publicly known. As credibility is a crucial matter for any central bank, there is no need of questioning the execution of an announced purchase program. Therefore, problems regarding both time-inconsistent central bank behavior such as those in Klein ( 2018 ) and the effectiveness of communication as discussed by Blinder et al. ( 2008 ) are ruled out in our theoretical framework.

The results of the model can be derived analogously to the reference model. Therefore, we omit the calculations. Instead, we solely present the resulting effects on the first- and second-period demand functions, prices, optimal portfolios as well as on investors’ expected utility. Footnote 10 Furthermore, we only give some preliminary comments on the general results while we will discuss the solutions for two examples in-depth within Sect. 4.

3.1 Demand Functions

The demand functions allow to state some important interim results:

Lemma 1 (The ECB, Liquidity and Individual Portfolio Restructuring)

The ECB’s activities do not have any impact on the relation between the prices and the other investor’s demand, i.e. market liquidity \(\left(\frac{\partial \beta _{t}}{\partial \Updelta _{s}}=0,\mathrm{for} s,t=1,2\right)\) . Furthermore, the relation between beginning-of-period holdings and individual demand does not change \(\left(\partial \left(\frac{\partial x_{it}}{\partial x_{it-1}}\right)/\partial \Updelta _{s}=0 \mathrm{for} s,t=1,2\right)\) . I.e., the relation \(q_{2}=q_{1}=q\) continues to hold. Furthermore, the ECB’s additional demand just causes an upward shift of the other investors’ demand functions in \(t=1\) and no change at all in \(t=2\) .

Interestingly, the second-period demand functions do not at all depend on the ECB’s activities, even including late trades. But, of course, in equilibrium the function is evaluated at a different point because the second-period price is affected. Different from period 2, the ECB’s activities have an impact on the first-period demand function. The investors anticipate the influence of the ECB’s purchases \(\left(\Updelta _{t}\right)\) which enter the demand function via the second-period price and the effect of the first-period demand on the second-period demand. Quite remarkably, the impact of \(\Updelta _{2}\) on \(x_{i1}\) is even stronger than the impact of \(\Updelta _{1}\) : \(\frac{\partial x_{i1}}{\partial \Updelta _{2}}>\frac{\partial x_{i1}}{\partial \Updelta _{1}}\) .

3.2 Equilibrium Prices

The equilibrium prices can be written in a general form using certain pricing coefficients for the ECB’s purchase variables:

Defining \(\delta _{st}\equiv n\frac{\partial p_{t}^{*}}{\partial \Updelta _{s}}\) as marginal impact of \(\Updelta _{s}\) on price \(p_{t}^{*} \left(s,t=1,2\right)\) , we have

Inserting for the equilibrium values of q and \(\beta _{t}\) shows

generally holds true. In line with intuition (and in line with the ECB’s intention), the positive coefficients indicate that an additional demand by the ECB always causes a higher price level. While \(\Updelta _{2}\) affects \(p_{2}^{*}\) more than \(p_{1}^{*}\) , the reverse holds true for \(\Updelta _{1}\) . I.e., the additional demand affects the current equilibrium price more than the previous or future price, respectively.

Quite remarkably, all except for one pricing coefficients exceed the value of \(R\) . Therefore, the price increase is higher if the ECB announces a future extraction of securities from the market compared to the case where the same amount of securities \(\Updelta =\Updelta _{1}+\Updelta _{2}\) is withdrawn before trading starts.

Another interesting question is the price development over time. We have

Result 1 (ECB Trade and Price Paths)

“Late” purchases by the ECB imply increasing prices \(\left(\delta _{22}>\delta _{21}\right)\) while an “early” demand comes along with decreasing prices \(\left(\delta _{12}<\delta _{11}\right)\) .

A striking and maybe even puzzling effect is the generally stronger price effect of a late purchase compared to an early purchase. A first intuition might be that the purchase timing should not matter at all because there is not so much change in the investors’ portfolio decisions: no change in information, no change in preferences, no change in the outstanding free float at the end of period 2. So why does the timing matter? The answer is derived from Lemma 1 above: The portfolio adjustment rule and the market liquidity are not affected by the ECB’s purchases. The decrease in liquidity is caused by imperfect competition and the optimal adjustment process in the investors’ portfolios following some exogenous shock (in our model: the imbalanced legacy portfolio). The strategic interaction induced by imperfect competition causes the liquidity to decrease over time which in turn implies a stronger price effect of late trades by the ECB. In Sect. 5, we discuss a generalization of our model incorporating additional information at the end of period 1 and address the question if this effect alters some of the relations.

One might further ask why an anticipated deterministic price change can take place at all and does not allow for arbitrage opportunities. Different from arbitrage transactions in perfectly competitive markets, the investors specified in our economy cannot carry out isolated marginal transactions at given prices. Instead, the price impact of a proposed arbitrage transaction also affects the price of the other traded units unfavorably.

We can formally illustrate this for an ECB strategy acquiring a share \(\Updelta\) of the asset at time \(t=2\) only and one particular investor initially holding \(1/n\) of the assets. Hence, she will optimally sell \(\Updelta /n\) units at time \(t=2\) at a price \(p_{2}^{*}\) and not trade at the equilibrium price \(p_{1}^{*}\) in \(t=1\) at all. Comparing the equilibrium prices at time \(t=1\) and \(t=2\) , we obtain a deterministic price increase over time equal to \(p_{2}^{*}-p_{1}^{*}=\frac{q\beta _{2}}{n}\Updelta\) . For this reason, we allow the investor to buy \(x\geq 0\) units at time \(t=1\) and to sell \(x+\Updelta /n\) units at time \(t=2\) rather than \(\Updelta /n\) units. The deterministic net payment at time \(t=2\) from trading at both trading dates is then:

Due to the additional trading volume \(x\) at time \(t=1\) , the price for the investor increases by \(\beta _{1}\) per additional unit, while at time \(t=2\) the additional selling volume reduces the price by \(\beta _{2}\) per each of the \(x\) additional units. Plugging in the corresponding values for equilibrium prices at both dates and the price sensitivities \(\beta _{1}\) and \(\beta _{2}\) , we obtain:

Since the difference takes its maximum value for \(x=0\) , it is optimal not to conduct any “arbitrage transaction” with \(x>0\) at all. As a result, the market is arbitrage-free, as no investor has an incentive to deviate from the equilibrium holdings despite deterministic price changes.

3.3 Equilibrium Portfolios

Inserting the equilibrium prices into the demand functions yields the following relations for optimum portfolios:

Obviously, the ECB’s additional demand just adds another component to the transparent and plausible structure of equilibrium holdings: The additional demand is compensated for by an equally divided reduction of holdings by the investors. The other component, i.e. the weighted average between beginning-of-period holding and optimal risk sharing has already been discussed in Sect. 3. Again, it is the limited liquidity caused by imperfect competition which prevents the investors from ending up with optimal risk sharing. Another observation deserves to be pointed out: Depending on the degree of the initial imbalance and the extent of the ECB’s transaction in the different periods, possibly some investors buy in the first period and sell afterward or vice versa.

Overall, we see a twofold effect of the ECB’s late \(\Updelta _{2}\) on the investor’s first-period demand. First, eq. \((8)\) indicates that the investor \(i\) ’s demand function \(x_{i1}\left(p_{1},\overline{x}_{i0}\right)\) is shifted upward for some given price \(p_{1}\) . Second, the announcement of \(\Updelta _{2}\) causes an increase in the first-period price \(p_{1}^{*}\) . In equilibrium, the demand function effect and the price effect just cancel out so that the equilibrium holdings \(x_{i1}^{*}\) are not affected by the ECB’s later demand. Fig.  1 illustrates these relations.

figure 1

Impact of \(\Updelta _{2}\) on \(x_{i1}\)

Similarly, the ECB’s first-period demand \(\Updelta _{1}\) does not impact the equilibrium adjustments of the investors’ portfolios \(\Updelta x_{i2}^{*}=x_{i2}^{*}-x_{i1}^{*}\) in period 2.

3.4 Investors’ Expected Utility

Even though it is a bit cumbersome, we present the general solution for the investors’ utility: Footnote 11

If investors do not act as price takers, there will always be some utility decreasing distortion in risk taking. Investors with a stronger initial imbalance \(\left| \xi _{i}\right|\) suffer more heavily than investors whose initial portfolios are already close to optimal risk sharing. Without the ECB’s purchases, the loss in utility is the same for buyers and sellers, i.e. the sign of the distortion does not matter.

The curly bracket reveals the additional utility loss induced by the ECB’s demand. The additional loss is strictly positive. Footnote 12 Furthermore, the effects of the ECB’s purchases are neither symmetric with respect to sellers or buyers nor to the timing.

In addition to the results for a neutral investor with \(\lambda _{i}=0\) , a further effect comes into place if there is an initial imbalance as represented by \(\lambda _{i}.\) Obviously, investors with \(\lambda _{i}>0\) , i.e. the buyers, suffer a higher loss than the sellers who are characterized by \(\lambda _{i}<0\) . This can be traced back to the price change between the periods. Early trades by the ECB imply a price decrease between the periods. Because of the portfolio adjustment rule, the investors’ first-period transactions tend to be higher than the second-period transactions. Therefore, decreasing prices hurt buyers in an additional way. This relationship can be most easily seen for “strong buyers” (with \(\xi _{i}>\frac{\Updelta _{1}}{n}\) ) who buy in the first period and sell in period 2. Nevertheless, even “weak buyers” (with \(0<\xi _{i}<\frac{\Updelta _{1}}{n}\) ) suffer from buying more at the high price and buying less at the low price. The opposite is true for sellers.

Result 2 (Redistribution)

Early trading by the ECB implies some (relative) redistribution from buyers to sellers compared to the case of late trading.

4 Price Impact of Different Timing Strategies by the ECB

Now we discuss the impact of the ECB’s timing strategy on the different endogenous variables. The effects on the investors’ equilibrium portfolios have already been discussed in Sect. 3. Therefore, in the following, we focus on equilibrium prices. We compare the results for the two extreme timing strategies, given a fixed total \(\Updelta\) of additional demand:

“Late”: The ECB only buys in period 2 so that \(\Updelta _{2}=\Updelta\) and \(\Updelta _{1}=0.\)

“Early”: The ECB only purchases in period 1 so that \(\Updelta _{1}=\Updelta\) and \(\Updelta _{2}=0.\)

As has been explained in the introduction, this elementary distinction allows for analyzing present pricing effects (impact of \(\Updelta _{1}\) on \(p_{1}\) and of \(\Updelta _{2}\) on \(p_{2}\) ), effects of former trading on present prices (impact of \(\Updelta _{1}\) on \(p_{2}\) ), as well as announcement effects (impact of \(\Updelta _{2}\) on \(p_{1}\) ).

For the considered cases we obtain the second-period equilibrium prices:

Whenever the ECB purchases a strictly positive net amount of risky assets, the equilibrium price \(p_{2}^{*}\) increases. This effect is plausible due to the shortage of available units for the investors. In case of an early trade by the ECB, the second-period price is only affected by the reduction of free float \(\left(\delta _{12}=R\right)\) . In case of a late trade, we see a stronger increase in \(p_{2}^{*}\) \(\left(\delta _{22}>\delta _{12}\right)\) . The investors actually have to be motivated to forgo earned risk premia by paying a higher price.

Result 3 (Impact on Second-Period Price)

A certain demand of the ECB has a stronger impact on the second-period price, when trades take place late.

At the end of period 1, we obtain the following equilibrium prices:

The driving force for the interpretation of these results is the relation \(\delta _{21}>\delta _{11}\) . A marginal unit traded by the ECB has a more severe effect on \(p_{1}^{*}\) when trading takes place late instead of early. The mere anticipation of trades in the less liquid second-period trading round has a stronger price impact than the actual early demand in period 1. This remarkable economic characteristic allows us to extend Result 3 to the prior trading period:

Result 4 (Impact on First-Period Price)

A credible announcement of the ECB to trade at a later date has a stronger price impact on the price \(p_{1}^{*}\) than an immediate trade.

The price changes \(p_{2}^{*}-p_{1}^{*}\) are as follows:

The inspection of the crucial differences between the pricing coefficients reveals a price increase over time if the ECB only trades in the second period \(\left(\delta _{22}>\delta _{21}\right)\) . However, an early demand by the ECB has an opposite effect on the price change and results in a price decline \(\left(\delta _{12}<\delta _{11}\right)\) . This is because the ECB’s early trade imposes an immediate price pressure which is relaxed in period 2. These relations confirm a corollary of results 2 and 3:

Corollary 1 (Price Change Over Time)

If the ECB only trades in the last period, the asset price will increase over time. If the ECB, however, only buys assets in the first trading period, the asset price will decline over time.

Fig.  2 summarizes the previously described price relationships. For a late demand of the ECB, the equilibrium asset prices in both periods are higher than the equilibrium prices resulting from early demand. This characteristic follows from the derived properties of the \(p_{t}^{*} \left(t=1,2\right)\) .

figure 2

Price changes in the respective cases

The different signs of the price effects of early and late trades raise the question if the two effects may counterbalance each other. Indeed, if the ECB splits its overall demand \(\Updelta\) over the two time periods accordingly into

the respective price effects cancel out and the price remains constant. To reach this effect, the ECB has to purchase more securities in the early stage than in the late stage because early trades have less impact on the price. Even though the price remains constant, it will be above the constant level that we could observe if the ECB was not present in the bond market (cf. eqs. \((9)\) ). This results from the fact that the ECB actually withdraws securities from the market.

Corollary 2 (No Price Change)

An appropriate division of the ECB’s overall demand prevents a price change over time.

5 A Generalization

Given a two-period model, we might imagine that investors receive a part of the information on the asset value at the end of period 1. Apparently, the liquidity (i.e. a lower \(\beta _{t}\) at trading date t) is a major driver of demand functions and equilibrium prices. While liquidity increases if there is a subsequent trading opportunity, it suffers from a higher uncertainty about the asset. As a consequence, the important relation \(\beta _{1}<\beta _{2}\) might no longer be valid when a major part of risk is reduced between the two trading dates so that there is (hardly) any risk left in the second period.

We introduce this idea to the model by assuming that the risky asset’s value evolves in two steps, i.e.

where the \(\tilde{\varepsilon }_{t}\) are uncorrelated noise variables \(N\sim \left(0;\sigma _{t}^{2}\right)\) revealed at the end of period \(t\) \(\left(t=1,2\right)\) . Predominantly and quite plausible, this approach has been included in the accounting literature (e.g., Christensen and Feltham 2003 , p. 243) and the literature on market microstructure with insider trading (e.g., Hirth 1997 ).

The observation of \(\varepsilon _{1}\) at \(t=1\) has two implications on second-period decision making: the conditional expectation on \(\tilde{v}\) is adjusted to the observable realization \(\mu +\varepsilon _{1}\) and some share \(\alpha\) of the overall ex-ante risk \(\mathrm{Var}\left\{\tilde{\varepsilon }_{1}+\tilde{\varepsilon }_{2}\right\}\) has already been eliminated. We parameterize the latter aspect using the notation \(\sigma _{1}^{2}=\alpha \sigma ^{2}\) and \(\sigma _{2}^{2}=\left(1-\alpha \right)\sigma ^{2}\) where \(\alpha\) reflects the share of overall risk being settled in period 1. Thus, the main part of the paper analyzes the special case of \(\alpha =0\) . We do not go through the derivations, again, but just report the results and comment on it.

The ECB’s additional demand \(\Updelta _{t}\) still causes just a vertical shift of the demand functions \(x_{it}\left(p_{t}\right)\) .

Neither the portfolio adjustment rule \(\left(q\right)\) nor the optimum equilibrium portfolios \(\left(x_{it}^{*}\right)\) depend on \(\alpha\) .

The market liquidity \(\beta _{t}\) is affected by the timing of the risk:

The early settlement of some part \(\alpha\) of the uncertainty has a different impact on the two period’s liquidity. While the second-period liquidity is enhanced \(\left(\hat{\beta }_{2}<\beta _{2}\right)\) , the first-period liquidity decreases \(\left({\hat{\beta }_{1}}>\beta _{1}\right)\) . Further, while liquidity is decreasing over time with \(\alpha =0\) , in the general approach there is some \(\alpha ^{*}=\frac{1-q^{2}}{2-q^{2}}\left(\frac{3}{7}<\alpha ^{*}<\frac{1}{2}\right)\) , such that \(\hat{\beta }_{1}>\hat{\beta }_{2}\) for all \(\alpha >\alpha ^{*}\) which reverses the evolution of the liquidity over time. The liquidity in a certain period most of all reflects the share of risk being settled within this period. The more risk is settled in a certain period ( \(\alpha\) in period 1, \(\left(1-\alpha \right)\) in period 2), the lower is market liquidity in this particular point in time. If, e.g., there were no residual risk in period 2 \(\left(\alpha =1\right)\) , the market would be perfectly liquid. The first period’s liquidity additionally but to a smaller extent reflects the anticipation of the second period’s trades \(\left(\left(1-\alpha \right)q^{2}\right)\) . As the relative liquidity in the two periods has been shown to be an important determinant of the ECB’s trading price impact, the observation may have consequences for the asset prices.

The pricing coefficients \(\delta _{st}\) of the ECB’s trades crucially depend on the timing of risk settling. We have

The relation of the equilibrium price sensitivities \(\delta _{\mathbf{22}}>\delta _{\mathbf{21}}>\delta _{\mathbf{12}}\) is not affected by the way uncertainty is resolved over time. The ordering of \(\delta _{\mathbf{11}}\) , however, may change. Now, \(\delta _{\mathbf{11}}\) may exceed \(\delta _{\mathbf{21}}\) and even \(\delta _{\mathbf{22}}\) . Looking at the different results, corollaries and lemmas from Sects. 3 and 4, only result 4 is affected to some extent: For a small part \(\boldsymbol{\alpha }\) of uncertainty being resolved early, late trades by the ECB still have a stronger impact on \(p_{\mathbf{1}}\) than early trades, while for a substantial part of uncertainty being resolved early, i.e. \(\boldsymbol{\alpha }\) close to one, the result is reversed.

6 Conclusion

If a market participant takes some units of an asset permanently from the market, the asset price increases due to the reduced number of assets held by other investors. This is the elementary logic behind the ECB’s asset purchase programme. In a perfect market, there is no further effect. Of course, investors as a whole bear less risk and participate to a reduced extent in the risk premium earned which on balance results in a reduced utility. Within the group of investors, there are no further distortions. Footnote 13

The story becomes more interesting if markets are not perfectly liquid. We, therefore, introduce an equilibrium asset pricing model with imperfect competition, preventing the investors to adjust their portfolios according to the optimal risk-allocation rule. The interplay of the ECB’s purchase programme and imperfect competition yields interesting results:

The ECB’s timing strategy gains importance. Compared to early trades, late trades lead to higher prices and a price increase over time.

Market liquidity decreases as time approaches the security’s maturity. As a remarkable implication of this effect, the anticipation of ECB-transactions in the second period has a stronger impact on the first-period price than the presence of first-period additional demand. Both relations require that no or only a minor part of the asset’s risk is settled between the trading dates. Otherwise, if a major part of the risk is revealed between the trading dates, the EBS’s impact on equilibrium prices for a late trade can be less pronounced than early trades.

Investors are affected differently, depending on their initial portfolios. While every investor incurs losses induced by the ECB’s additional demand, an early additional demand by the ECB comes along with higher losses for buyers than for sellers.

The price effect of the ECB’s transactions exceeds the mere unit effect.

Thus, we finally conclude that imperfect competition should regularly be included in capital market models. While imperfect competition is relevant per se, the explanatory power increases even more given some distortions stemming from whatever reason. Emphasizing this point is not just for presenting interesting results. Rather, it should be acknowledged that real markets are characterized by imperfect competition. This, a forteriori, holds true for bond markets dominated by a limited number of large institutional investors.

We use the term “investor” for all market participants except for the ECB-type participant.

Throughout the paper, “demand” characterizes the intended holdings, not the shifting of the portfolio. In a secondary market, the overall supply is identical to the set of outstanding securities.

Other papers, including Rudolph ( 1982 ) and Hirth ( 1997 ), discuss special cases of the general model. In addition, the latter integrates the effects of a second trading round.

Within later sections, the free float may differ from the number of outstanding securities by the ECB’s purchases.

The general rule for optimal risk sharing follows the share of the individual risk tolerance, i.e. the inverse of the absolute risk aversion, in the sum of the risk tolerances of all investors (cf. Wilson 1968 ). Because of homogenous risk preferences, risk should be equally shared between all investors.

Any equation indexed by \(i\) has to hold for every \(i\) -th investor. For ease of exposition, we skip this notation.

An alternative approach to solving for an equilibrium stands more in the tradition of the Kyle ( 1989 ) model of insider trading (which also has been employed by Heumann ( 2007 )). They model the capital market under imperfect competition as a divisible good auction assuming linear bidding strategies. Throughout, the results are the same.

We note that a framework with \(n=2\) investors does not result in an equilibrium. This property has already been identified by Kyle ( 1989 , p. 328) and Heumann ( 2007 , p. 73).

This result has already been observed by Hirth and Walther ( 2018 ).

A sketch of the derivations is provided within appendix 2.

We definitely prefer the term “utility” to the more comprehensive expression “welfare”. The latter might be misleading for two reasons: First, we conduct a partial analysis neglecting real effects of an increase in asset prices (decrease in interest rates). Second, even within a partial analysis the investors’ losses correspond with some gains for the ECB. These gains, however, cannot be valued adequately without an assumption of the ECB’s preferences, which definitely lies beyond the scope of our paper. For an interesting approach to re-transferring gains from banks to investors—though in a quite different context—see Kruschwitz et al. ( 2019 ).

The additional loss can be shown to be a quadratic-concave function in \(\Updelta _{1}\) and \(\Updelta _{2}\) which is characterized by non-negative values and positive partial derivatives at the lower bounds of its domain and positive values at the upper bound.

The implications can easily be derived from our model by letting \(\beta _{t}=q_{t}=0 (t=1,2)\) .

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Acknowledgments

We are very grateful for several helpful suggestions made by Andreas Löffler who discussed our paper at the GEABA symposium 2019 in Vallendar, as well as the many further constructive comments throughout the referee process of the SBR. Moreover, the paper has benefitted from fruitful discussions with Wolfgang Breuer, Hans Hirth, and, in particular, Manfred Stadler.

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1.1 Solving for the Demand Parameters \(\beta _{t}\) and the Portfolio Adjustment Variables \(q_{t}\)

Aggregating the optimal individual demand \((2)\) for all investors \(i\neq k\) , we obtain

Using the market clearing conditions gives

and finally

For any investor \(k\) , the derivative reads

It should be emphasized that this equation holds irrespective of some activity or absence of the ECB (cf. Sect. 4). Equating the derivative to the definition

leads to the equilibrium value of

Within the first period, any investor takes security holdings of

The same procedure as developed for period 2 now reads

1.2 Defining

we finally see that the portfolio adjustment variable is the same for both periods: \(q_{1}=q_{2}=q\) .

1.3 Solving the General Model With the ECB

We start with the investors’ first-order condition

and solve for the second-period demand function

The first-order condition aggregated for the investors reads:

Solving this equation for the second-period price leads to

We can directly compute the equilibrium holdings by inserting the equilibrium market price into the demand function:

In order to derive the corresponding quantities for the first period, we can substitute the equilibrium price \(p_{2}^{*}\) , the optimal holdings \(x_{i2}^{*}\left(x_{i1}\right)\) and \(q_{2}\equiv \frac{\partial x_{i2}}{\partial x_{i1}}\) into the certainty equivalent and take the following first order condition for \(x_{i1}\colon\)

Inserting for \(x_{i2}\) yields the demand function

Only a constant is added to the equation from the reference model. The interaction between the initial portfolio, current price and terminal portfolio remains unaffected. Summing up over the \(n\) investors, we obtain

We can solve for the first-period price

The optimal first-period holdings of the risky asset amount to

The approach to solving for the price differences and for the investors’ utility is obvious even though the derivations for the utility might be a bit lengthy.

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Koziol, C., Neus, W. Capital Market Equilibrium With Imperfect Competition: The Case of the ECB’s Asset Purchase Programme. Schmalenbach Bus Rev 72 , 369–391 (2020). https://doi.org/10.1007/s41464-020-00093-z

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Received : 30 October 2019

Revised : 20 March 2020

Accepted : 12 May 2020

Published : 27 May 2020

Issue Date : July 2020

DOI : https://doi.org/10.1007/s41464-020-00093-z

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Capital Market Definition

The capital market is a financial system where individuals and institutions trade financial securities, including stocks and bonds. This is a place where corporations and governments raise long-term funds, typically in exchange for equity ownership or debt financing.

Types of Capital Markets

When delving deeper into capital markets, two major types become immediately apparent: Stock Markets and Bond Markets .

Stock Markets

Stock markets are often the most commonly associated version of capital markets due to their public visibility and daily trading volume. Here, shares of publicly traded companies are sold and bought, allowing businesses to generate capital for growth or debt repayment. Purchasing a stock means investing in a company’s equity; in other words, the buyer gets a proportional ownership of the company.

This system plays an invaluable role in any economy as it encourages investment by offering potential profits. Simultaneously, it promotes corporate responsibility because companies are incentivized to perform well, their performances being reflected in share values. Volatility is, however, present in stock markets, as share prices fluctuate based on market sentiment, economic indicators, and company performance.

Bond Markets

On the other hand, bond markets form the cornerstone of the debt finance sector. In simple terms, a bond is a loan taken by an entity such as a government or company from an investor. In return, the entity promises to repay the loan amount at a predetermined date, alongside periodic interest payments.

The bond market impacts the economy by providing the government and companies with a source of financing for public and private projects, and operational costs. This market is typically less volatile than the stock market, providing more stability for investors. However, the return or profit potential is generally considered lower.

Comparing the Two

The essential difference between the two is related to their nature; shares are equity-based, giving stockholders a voice in corporate decisions and possible profits, but also carrying a higher risk due to market volatility. Bonds are debt-based, offering more stability and fixed returns, but carry the risk of default by the issuer.

These two types of capital markets link savers and investors, allowing placement of surplus funds into productive avenues. They both significantly contribute to the growth and stability of the economy, and the strength or weakness of these markets often reflect the health of an overall economy.

Accordingly, they provide not only an investment avenue for the individual and institutional investors but also important indicators for policymakers on the economy’s direction. By creating and affecting liquidity, growth, and stability, stock and bond markets are the backbone of contemporary global economies.

Role of Capital Markets in the Economy

Mobilization of savings.

One of the key roles of capital markets in the economy is the mobilization of savings. Through various financial instruments, such as stocks and bonds, capital markets provide a channel for surplus funds from savers to those who are running a deficit. These deficit-running entities generally include corporations, governments, or individuals who need funding for economic activities. The transfer of funds in this manner stimulates economic growth by ensuring that idle funds are put to good use.

Risk Management

Capital markets help with risk management across the economy. They offer a broad range of instruments that enable businesses, investors, and others to manage risks. For instance, derivative instruments like futures and options can be used to hedge against exposure to various risks such as price fluctuations, interest rates, or exchange rates. By providing avenues for risk management, capital markets contribute to the stability of the economy.

Price Determination

Price determination is another vital function of capital markets. This is achieved through the process of continuous buying and selling of securities. The ongoing transactions in the capital market help determine the prices of securities, reflecting the inherent risk and expected return. This price discovery process provides valuable signals to both investors and firms about the value of different investments, therefore enabling efficient allocation of capital in the economy.

Lastly, capital markets provide liquidity to economy. They enable owners of assets to easily convert their assets into cash without causing a significant change in their value. By offering this convertibility, capital markets reduce the risk for investors and increase the willingness of individuals and businesses to invest, in turn encouraging more economic activity.

In a nutshell, the role of capital markets in the economy is vast and crucial. They facilitate the mobilization of savings, allowing for risk management, liquidity provision, and effective price determination. All these are key elements that make capital markets indispensable in promoting sustainable economic growth and development.

Functioning of Capital Markets

Capital markets play an essential role in the mobilization of savings. They offer institutional and individual investors a platform for investing their idle funds for long-term growth. By investing in the capital market, savers get the potential to earn higher returns compared to other forms of investments, such as bank savings. Thus, capital markets encourage savings and translate them into investment opportunities, making these markets vital players in mobilization efforts.

Capital Formation

Furthermore, capital markets also facilitate capital formation. Businesses and governments can raise long-term funds through the issuance of securities such as shares and bonds in these markets. This fundraising allows entities to undertake new projects or expand operations, leading to overall economic growth. Thus, capital markets contribute significantly to wealth creation and capital formation.

One of the often-overlooked functions of the capital market is risk management. Capital markets offer various instruments for hedging risks, such as derivatives. Investors can use these tools to mitigate potential losses, and businesses can safeguard against market fluctuations. By providing these risk management options, capital markets help investors and corporations maintain financial stability.

Efficient Allocation of Financial Resources

The activity of buying and selling in capital markets contributes to the efficient allocation of financial resources. The market participants, based on their risk appetite and return expectations, choose to invest in different sectors and companies. This helps direct funds to sectors where they can yield the highest returns, thus optimizing resource allocation.

These activities in tandem contribute towards economic stability by curbing volatility, managing risk, and ensuring an efficient flow of capital. Simultaneously, they promote economic growth by effectively channeling savings toward productive investments. Through their roles in savings mobilization, capital formation, risk management, and efficient allocation, capital markets act as the lifeblood that enables a robust and thriving economy.

Players in Capital Markets

In the vast landscape of capital markets, a variety of crucial participants or ‘players’ come into play. Collectively, they ensure the functioning, liquidity, and regulation of these markets. Let’s investigate the key players.

H3 Individual Investors

Individual investors are those who invest their personal capital in different forms of securities. They could be amateurs dabbling in the stock market, seasoned investors holding a diverse portfolio, or even individuals staking their retirement funds on bonds or other low-risk assets. It’s vital to note that while the direct impact of individual investors on the capital market seems minor compared to institutional investors, they form a significant portion of the overall investment activity, thus influencing the supply and demand for different securities.

H3 Institutional Investors

Institutional investors are entities that pool large sums of money to invest in securities and other investment assets. They include mutual funds, pension funds, insurance companies, banks, and hedge funds, among others. Because of their sheer size and trading volume, institutional investors can have a profoundly more substantial effect on market prices than individual investors. They often have access to greater resources for market research and specialist investment advice.

H3 Brokers and Dealers

Brokers and dealers act as facilitators in the capital market. While brokers act as agents for investors in helping them buy or sell securities, dealers involve themselves as principal parties in the trade. Both play crucial roles in connecting buyers and sellers and ensuring smooth market transactions.

H3 Market Makers

Market makers are typically large banks or brokerage firms that help maintain market liquidity by always being ready to buy or sell at publicly quoted prices. By doing so, they reduce transaction costs and time, ensuring that trading can happen seamlessly.

H3 Regulators

Regulation of capital markets is critical to maintain investor trust and market stability. In the United States, the primary regulator for most capital market activity is the Securities and Exchange Commission (SEC). The SEC enforces federal securities laws, proposes securities rules, and regulates the securities industry to protect investors, maintain fair and efficient markets, and facilitate capital formation. It’s also responsible for ensuring disclosure of essential information concerning securities sold in the public market.

While these are the primary players, the capital market landscape involves several other participants, like credit rating agencies, audit firms, investment advisors, etc. Together, they all contribute towards the efficient functioning of capital markets.

Financial Instruments in Capital Markets

Bonds are a type of indebtedness. They are long-term promissory notes that obligate the borrower to make payments to the lender at specified times. Typically, these payments consist of periodic interest and a repayment of principal at maturity. Bonds can be issued by governments, municipalities, and corporate entities, and they are vital tools for raising capital. The main appealing point of bonds for investors is their safety if compared to other financial instruments: even if the issuer goes bankrupt, bondholders stand a superior chance of recovering their investment.

Stocks represent ownership stake in companies. They are interchanged five days a week on stock exchanges around the world, becoming one of the most easily accessible markets. Shareholders may benefit from capital gains when stocks appreciate in value and also from dividends which a company distributes from its profit. One thing that distinguishes stocks from bond is that stockholders are the last to receive any residual value if a company fails, after all other obligations have been met.

Derivatives

Derivatives are financial instruments whose value depends on the value of other, more basic, underlying variables. Often these underlying variables are prices of traded assets like stocks, bonds, or foreign currency, but they can also be things like interest rates, stock indices, or commodity prices. Derivatives are primarily used for hedging risk or for obtaining access to otherwise hard-to-trade assets or markets. They can take the form of options, swaps, futures, and forwards amongst others.

Foreign Exchange

Foreign exchange (forex or FX) refers to the global market for the trading of currencies. This includes all aspects of buying, selling and exchanging currencies at current or determined prices. FX is important for international trade as it allows businesses to convert one currency to another. For investors, it also offers a platform for speculation, providing the opportunity to profit from fluctuations in relative currency values.

The Impact of Capital Markets on Corporate Finance

Capital markets play a significant role in the financial decision-making process within corporations. This influence is pervasive, affecting various aspects from the cost of capital determination through to capital structuring and investments.

Influence on Cost of Capital Determination

The cost of capital is a critical element in a corporation’s financial planning. It’s the rate of return that a firm needs to provide to its investors for using their capital. Capital markets often influence this cost. The prevailing rates in the market, the corporation’s credit ratings, the demand and supply factors – all play a role in deciding this cost. When the markets are bullish, corporations can often acquire capital at a lower cost, whereas during a bearish phase, the cost may be high due to market uncertainties.

Role in Capital Structuring

Capital structuring refers to the mix of debt and equity that a company uses to finance its operations. The state of the capital market can heavily influence this mix. For instance, if the market is performing well and equity prices are high, a corporation may decide to issue more shares rather than debt to capitalize on higher returns. Conversely, if the market condition is grim, it may lean towards debt financing. Therefore, decisions about capital structure are often informed by the conditions and forecasts of the capital market.

Impact on Investments

Investment decisions, such as whether to venture into a new project, also hinge on the conditions in the capital market. Corporations look at the market reactions to similar projects, the availability of funds, and the cost of capital to decide whether an investment is worth pursuing. Corporations also gauge market sentiment, which can play a significant role in attracting investors for their projects.

In conclusion, the capital market continuously shapes and informs crucial corporate finance decisions. Through its influence on aspects like cost of capital, capital structuring, and investment decisions, it acts as a barometer used by corporations to strategize their financial management. Companies that have a keen understanding of these dynamics are often better positioned to optimize their financial outcomes in light of market trends.

Risk and Return in Capital Markets

Risk and return are two fundamental concepts in capital markets that often determine the choices investors make.

Risk in Capital Markets

In the world of investing, risk refers to the degree of uncertainty related to the returns on an investment. It’s possible to lose an entire investment. There is an inverse relationship between risk and potential reward – riskier investments usually have the potential for higher returns but also for greater losses. As a result, each investor needs to find a balance they’re comfortable with.

One method that investors use to manage the risk associated with investments is through diversification .

Diversification

Diversification is a risk management strategy where a variety of investments are included in a portfolio. Because the different investments are unlikely to move in the same direction, diversification reduces risks associated with investing in one single asset. It is a strategy that aims to optimize return by investing in different areas that would each react differently to the same event.

Expected Returns

The term expected returns refers to the profits or losses an investor anticipates on an investment. The expected return is calculated by multiplying the potential outcomes by their probabilities and adding these results together. It’s crucial to note that the expected return is just a prediction and thus does not guarantee future results.

Influence on Investment Decisions

Understanding the concepts of risk and expected returns is crucial because they greatly influence investment decisions. Each investor has unique financial goals, risk tolerance, and investment horizon, all of which determine their investment decisions. For instance, an investor with a high-risk tolerance may opt for riskier assets with high expected returns. Alternatively, an investor with a low-risk tolerance may choose safer assets, even if they provide lower returns.

Nevertheless, whether an investor is risk-averse or risk-tolerant, diversification should be a key element of their investment strategy. By spreading resources across various investments, the investor can effectively manage risk and aim for more stable returns.

Effects of Regulations on Capital Markets

Regulatory policies and changes play a significant role in shaping the functioning of the capital market. Their effects can be observed in various aspects such as investor protection and overall market confidence.

Impact on Investor Protection

One of the primary goals of regulatory bodies is to safeguard investor rights. They are tasked with ensuring a fair and transparent environment where investors can make informed decisions. For example, regulations may require companies to disclose essential financial information.

When there is a lack of regulation or inefficient enforcement, potential risks to investors increase. This can lead to market manipulation, insider trading, and fraud. On the other hand, excess regulations or sudden changes may cause market inefficiencies or hamper growth.

Implementing effective regulations can boost investor confidence as it reduces the risk they bear. That has a direct impact on market participation and encourages more investments.

Influence on Market Confidence

The stability and efficiency of capital markets are largely dependent on the confidence of its participants, including both investors and issuers. Regulatory bodies often act as a confidence-building measure through their roles of supervision, regulation, and control.

Effective regulation of capital markets helps maintain stability and prevents significant market disruptions. By ensuring proper implementation of rules and punishing violators, regulatory bodies can promote confidence among investors, leading to more robust and liquid markets.

However, too many changes to regulatory policies can produce market instability leading to decreased investor confidence. Stability in the regulatory environment is just as vital as the regulations themselves.

In conclusion, regulatory changes and policies can either promote or hamper the optimal functioning of the capital market. As such, the challenge for regulators is to strike a balance in crafting policies that ensure market stability and investor protection without stifling growth and innovation. Overall, this often requires careful consideration of the potential trade-offs and adjustment costs associated with implementing new regulations or altering existing ones.

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Issue Cover

Article Contents

1. introduction, 2. life assurance asset management, 4. asset portfolios, 1830–2016, 5. regulation and asset portfolios, 6. firm characteristics and asset portfolios, 7. conclusion, acknowledgements, capital market development over the long run: the portfolios of uk life assurers over two centuries.

  • Article contents
  • Figures & tables
  • Supplementary Data

David A Bogle, Christopher Coyle, John D Turner, Capital market development over the long run: the portfolios of UK life assurers over two centuries, European Review of Economic History , Volume 26, Issue 3, August 2022, Pages 370–398, https://doi.org/10.1093/ereh/heab017

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What shapes and drives capital market development over the long run? In this paper, using the asset portfolios of UK life assurers, we examine the role of regulation, historical contingency, and political reactions to events on the long-run development of the UK capital market. Government response to events such as war, hegemony-secured peace, and the wider macroeconomic environment was the ultimate determinant of major changes in asset allocation since 1800. Furthermore, when we compare the UK with the United States, we find that regulation played a limited role in shaping the asset portfolios of the UK life assurance industry.

An important driver of economic growth is capital market development. Ultimately, investor demand and the supply of capital are critical factors in the development of capital markets ( Albuquerque de Sousa et al. 2016 ). While previous studies have assessed long-run capital market development by examining changes in the overall size of markets, we examine one of the most important channels of supply of capital to markets over the long run—life assurance companies. Life assurance companies have a long history in the UK, stretching back more than 300 years. To perform their societally important function of pooling mortality risk, insurance companies have invested their premium income into capital markets. The assets under management (AUM) of British life assurance companies (which have been as high as 25 percent of the capital market) mean that they have always played a very important role in capital markets. Indeed, until the late 1970s, they were the largest grouping of institutional investors in the UK ( Alborn 2002 ; Office of National Statistics 2020 ). 1

In this paper, we analyse the portfolios of these important asset managers over the past two centuries. In particular, we explore the role of historical contingency and political reactions to events in shaping and driving changes in portfolio composition over time. We consider how the following affected portfolio composition: the supply of financial assets, regulation, the general economic environment, and firm-specific characteristics. To do this, we have compiled large amounts of asset composition data from insurance archives, government publications, and industry reports.

Our results reveal that there have been major changes to the composition of life assurance company assets over the past 200 years. One major change has been the switch away from government debt and relatively unmarketable assets, such as mortgages, towards financial assets traded in nascent capital markets. This switch had been largely completed by the 1920s. Notably, British government debt has at times been the largest asset class, but these occasions have coincided with abundant supplies of government debt having been issued to fight wars. Another major change has been the switch away from fixed-income securities towards equity, which started as far back as the 1890s, but accelerated rapidly after the 1920s.

What were the main drivers of changes in the asset portfolios of life assurance companies? The supply of different types of financial assets played a major role in the 19th century, with the development of the share, debenture, and foreign government debt markets. The availability of these new markets expanded the options for portfolio managers and a sharp switch away from government debt during the Pax Britannica period facilitated investment in these assets. In the 20th century, changes in the wider economic environment appear to have been the main determinant of the changes in portfolios of life assurance companies. The wartime finance needs of governments and the resulting inflation, allied to a healthy equity risk premium, resulted in a move away from government bonds and towards equity.

Actuaries also played a role in the evolution of asset portfolios. The seminal investment canons of the UK life assurance industry, which were articulated by the actuary ( Bailey 1862 ), favoured low-risk fixed interest assets such as mortgages and debentures in the 19th century. However, in the interwar period, the changing macroeconomic climate led to a re-evaluation of these actuarial canons by Smith (1924) , The Economist (1927) , and Raynes (1928) . This re-evaluation was accompanied by an increased investment in equities.

To explore the role played by regulation in the evolution of asset portfolios, we compare the trends in the UK after 1870 to what was happening in the United States. Although the general environment was somewhat similar in terms of wartime finance, inflation, and the equity premium, the regulatory regime in the United States was much stricter in restricting the types of assets that insurance companies could invest in. We suggest that the switch to equity occurred much later in the United States and US life assurers tended to have less property in their portfolios than their UK counterparts because of this more stringent regulatory regime.

It is possible that changing firm characteristics were the main drivers of change in the asset management practices of UK life assurers. Using panel regression analysis, we explore the relationship between firm-specific characteristics of life assurance companies and their asset portfolios. We find little evidence that changes in firm characteristics over time impacted on the composition of asset portfolios.

As well as contributing to our knowledge of what shaped British capital markets over the past 200 years, this paper contributes to the historiography of the asset management practices of UK life assurers. To date, this has consisted of studies of the practices of one company over short periods of time ( Supple 1970 ; Treble 1980 ; Trebilcock 1985 , 1998 ), an analysis of the sector at one point in time ( Johnston and Murphy 1957 ), a study of the interwar period and the rise of the “cult of equity” ( Scott 2002 ), and Baker and Collins (2003 ) decadal analysis of the portfolios of life assurance companies between 1900 and 1965. Our first contribution is to extend the period Baker and Collins (2003) studied by over 120 years. Our second contribution is to compare the long-term trends in the UK with those in the United States. The third is that we explore how firm-specific characteristics affected asset management practices of life assurers. Our final contribution is finding that the rise of the “cult of equity” investment philosophy identified by Scott (2002) in the interwar period was preceded by an increasing propensity for assurance companies to invest in equity.

This paper also adds to the burgeoning literature on historical asset management practices ( Rutterford and Hannah 2016 ; Morecroft 2017 ; Morecroft and Turnbull 2019 ). This literature includes studies of the asset management practices of life assurance companies in other countries such as Australia ( Keneley 2006 , 2012 ), Denmark, France, Germany, and the Netherlands ( Bennet et al. 1984 ); research on the investment practices of banks ( Baker et al. 2009 ); pension funds ( Avrahampour 2015 ); investment trusts ( Hutson 2005 ; Rutterford 2009 ; Chambers and Esteves 2014 ; Rutterford and Sotiropoulos 2016 , 2017 ; Sotiropoulos et al. 2021 ); and research on the asset management style developed by influential figures such as John Maynard Keynes ( Chambers and Dimson 2013 ; Chambers et al. 2015 ).

The rest of the paper proceeds as follows. Section 2 provides some background and outlines potential drivers of change in the asset management practices of life assurance companies. Section 3 describes our data sources. Section 4 examines the asset portfolios of UK life assurance companies from 1830 until 2016. Section 5 examines the role of regulation in shaping asset portfolios by comparing the UK life assurance industry to that of the United States. Section 6 analyses the relationship between firm-specific characteristics and asset portfolios. Section 7 is a brief conclusion.

In life assurance a policyholder pays a series of premiums, so that when the policyholder dies, a beneficiary will receive a payment. The policy could last until the policyholder dies (a whole-life assurance), or the policy could be a more temporary arrangement. Life assurance companies are then responsible for managing the cash flows, so that when it comes to the point at which a policy must be paid out, which may be a long time after the policy was initiated, the company will be able to meet its obligations to the policyholder. Therefore, the way in which life assurance companies invested their assets is critical.

The first thing that affects the portfolio decisions of assurance companies will be the supply of financial assets. At the beginning of the 19th century, there was little to choose from apart from British government bonds. However, with the coming of the railways and liberalisation of incorporation law, there was an increase in the supply of company shares by the early 1860s, such that government debt securities only constituted circa 53 percent of the nominal value securities on the Stock Exchange Official List ( Michie 1999 , p. 88). The continued growth in company shares, the creation of corporate debentures, and increased number of foreign governments raising bond finance in London increased the supply as well as the variety of financial securities that assurance companies could invest in ( Grossman 2002 ; Coyle and Turner 2013 ). By 1893, only 18 percent of the nominal value of securities in the Stock Exchange Official List was UK government debt or public bodies, 21 percent was the debt of foreign and colonial governments, and 61 percent was made up of the shares and bonds of companies ( Michie 1999 , p. 88). In other words, by the end of the 19th century, there was a wide choice of securities for assurance companies to invest in.

What assurance companies invested in over time will ultimately have been determined by their actuaries and the investment canons of the actuarial profession. The articulation of such canons by early actuaries such as Bailey (1862) , a president of the Institute of Actuaries, had a long-lasting influence on the profession. Undoubtedly, the most important of his investment canons was the security of capital. However, changes in the general economic environment could affect which assets were viewed as secure. As the Bailey canons were introduced at a time of stable, low inflation, one would expect a focus on secure fixed-income assets, even if more risky assets such as equities provided a higher return. Increases in inflation may have resulted in assets such as equities being viewed as a more secure investment than fixed-income instruments, although inflation fell until around 1900.

Theoretically speaking, regulation can have a major effect on the asset management practices of life assurance companies. Up until 1870, the UK life assurance industry was largely unregulated. However, the Life Assurance Companies Act of 1870, introduced after the collapse of the Albert Life in 1869, mandated annual revenue accounts and balance sheets to be provided to the Board of Trade . As a result of this new legislation, it became more difficult for such companies to give a false impression of the security of their business to the public. In addition, such disclosure meant that life assurers had to be seen to be investing policyholders’ funds properly. This 1870 Act enshrined “freedom with publicity” as the cornerstone of future regulation of the UK’s life assurance industry. In other words, there was no regulation restricting what life assurance companies could invest in, which was in contrast with the approach taken in the United States.

Asset management practices may have differed across insurers because of different characteristics and these characteristics may have differed across time. Perhaps the most obvious difference was size. Some companies were large conglomerates who would have access to a wide range of assets, whereas other companies were small provincial offices who were more limited in their choice of assets. Another important difference between firms and over time was that some life assurers were owned by the policyholders, e.g., mutuals, while others were owned by shareholders. Another characteristic that differed across time and space was that some companies only offered life assurance, while others offered other insurance products and were known as composite insurance companies. There was also a difference in the nature of the liability faced by owners in the event of failure. One would expect that the greater or more immediate was this liability, the more conservative would have been the asset management practices.

In order to analyse the asset management practices of life assurance companies from 1830 to 2016, we construct a decadal time series of the share of broad asset classes in the portfolios of life insurers. Table 1 shows the years included in our decadal analysis and the data sources for each year.

Data sources for insurance company asset portfolios, 1830–2016

Until the Companies Act 1844, there was no government or centrally produced summary of life assurance company accounts. After 1844, the government-produced summary of accounts only included life assurance companies registered under that Act and its successors. Therefore, for 1830, 1840, 1851, and 1861, we used individual company accounts held by the London Metropolitan Archives . 2 For 1851 and 1861, these were augmented by reports produced by the Government for those companies that were registered under the 1844 Act. 3 From 1871 to 1960, data were collected from reports produced by the Board of Trade, which covered the entire life assurance sector.

After 1960, the Board of Trade stopped publication of its reports on life assurance companies. As a result, the Life Offices Association , the industry’s own trade body, decided to collate and publish such data that had been previously been collated by the Board of Trade . 4 Consequently, it is from the Life Offices Association and its successor body, the Association of British Insurers (ABI), that post-1960 data have been obtained.

While a decadal analysis enables us to identify long-run trends, one drawback of such an approach is that it does not capture year-on-year changes. However, we are constrained by our data sources in this regard because industry-level reports were not produced on an annual basis for most of our period, with annual reports only being produced from 1881 to 1915.

Our sources report the value of assets as they appear on each company’s balance sheet. In terms of the categorization of asset classes, we ultimately rely upon that used in our data sources. There are eight asset classes reported in our data sources, and their definitions are reported in table 2 . Unfortunately, the asset classification used after 1960 does not map exactly to that used by the Board of Trade . The chief difference is that preference shares are included with debentures by the ABI and predecessor bodies, but were classified as stocks and shares by the Board of Trade . As we will see below, this definitional change had little effect on portfolio composition.

Asset class definitions

Notes: Asset classes are taken from the Board of Trade reports (UK) and Institute of Life Insurance (1960) . The Board of Trade data from 1871 to 1960 do not distinguish between domestic and foreign investment with the exception of government securities.

In order to compare the asset portfolios of American and British life assurance companies over the long run, we obtained data on US insurance companies from The Historical Statistics of Life Insurance in the United States, 1759 to 1958 (Institute of Life Insurance 1960) , and the American Council of Life Insurers Life Insurers Fact Book ( American Council of Life Insurers 2017 ). Because these sources use a slightly different asset classification than in the UK sources, we had to map the UK asset classes onto those used in the United States—see table 2 .

Table 3 shows the AUM of the UK life assurance companies from 1871 to 2016 and provides an estimate of the relative importance of the life assurance sector as a supplier of capital. While the AUM as a proportion of the UK’s capital market fluctuates over time, the weight of money held by life assurance companies throughout the period of investigation was significant, especially after the 1930s.

Assets under management (AUM) of life assurance companies, 1871–2016

Sources: AUM—See table 1 . Capital Market: 1871–1960: Michie (1999 , pp. 88, 175, 419), Equity and Corporate Debt: 1970–2001: London Stock Exchange (2011a , 2011b , 2016) . British Government Securities, 1970–2016: Bank of England (2017) .

Notes: AUM data are incomplete prior to 1871. Nominal values have been used for the size of the capital market from 1871 to 1960, with market values used for equities from 1970 onwards (corporate debt and British government securities use nominal values throughout). Before 1960, capital market estimates are only available at certain points in time, so the one closest to the AUM year has been chosen.

Figure 1 shows the average composition of the asset portfolios of UK life assurance companies from 1830 to 2016 and figure 2 shows annual data from 1881 to 1915. Figures 1 and 2 show that there have been marked changes in composition over the past 200 years. In order to understand the reasons for these changes, we will look at each asset class in turn.

Asset portfolios of UK life assurance sector, 1830–2016. Sources: See table 1.

Asset portfolios of UK life assurance sector, 1830–2016 . Sources: See table 1 .

Asset portfolios of UK life assurance sector, 1881–1915. Sources: See table 1.

Asset portfolios of UK life assurance sector, 1881–1915 . Sources: See table 1 .

Trebilcock (1985 , p. 620) finds that nine major insurance companies in 1800 invested over 80 percent of their portfolios in government bonds. Figure 1 shows that government securities still constituted nearly 80 percent of the average portfolio in 1830. Notably, government debt issuance peaked following the Napoleonic Wars. Investment in government debt by life assurers fell sharply after 1830; by 1870, less than 10 percent of the average portfolio was in government bonds. This figure remained low throughout the remainder of the century as the government focused on paying down the national debt during the Pax Britannica period and life assurers rebalanced their portfolios, channelling capital into mortgages and nascent asset markets. Bailey (1862) did not think that the undated nature and fluctuation in value of consols was consistent with his principle of security of capital. He instead favoured mortgages and other secured loans as their capital value did not fluctuate ( Keneley 2006 ). The availability of new corporate security markets also expanded the investment options for life assurers. Low and falling yields around 1900 meant that British government debt remained a relatively unattractive investment ( Morgan and Thomas 1969 , pp. 278–9).

After 1911, we can see from figure 1 that British government securities once again became the dominant asset class, only being surpassed by stocks and shares in 1960. This rise in the importance of government debt is largely explained by the outbreak of the two world wars. As with other financial institutions, during World War I, life assurance firms were persuaded to take on large amounts of British government debt to help fund the war effort ( Scott 2002 ). In doing so, they also had to sell off their other investments, particularly those based overseas ( Morecroft 2017 ). The yield on government bonds remained high into the 1920s, but when yields declined below 3 percent in 1932, life assurance companies began to shift away from government bonds. However, during World War II, life assurance companies were once again required to do their bit to help the government finance the war effort. In addition, the nationalisation of certain British industries by the Attlee government from 1945 to 1951 led assurance companies, in some cases, to exchange private industry shares for government bonds ( Chester 1975 , pp. 240–312).

As can be seen from figure 1 , mortgages on land and property were a popular asset choice in the 19th century, overtaking British government securities as the most popular asset between 1851 and 1861. Although they remained the most popular asset until 1911, the share of mortgages declined steadily and substantially from their high in 1861 and never again regained their importance ( figures 1 and 2 ). Supple (1970 , p. 337) suggests that this fall was largely down to a decrease in the interest rates available from these mortgages, associated with the declining value of land and the agricultural depression of the late 19th century. Notably, when life assurance companies moved away from mortgages in the 20th century, building societies stepped in to fill the void ( Casu and Gall 2016 ).

Figures 1 and 2 show that investment by life assurers in debentures grew rapidly in the decades prior to 1911, coinciding with the initial growth phase of this new market. There were three reasons for this shift into debentures. First, the supply of debentures expanded rapidly from an almost non-existent base in the four decades after 1860 ( Jefferys 1977 , pp. 241–251; Coyle and Turner 2013 ). Second, debentures provided a higher rate of return than other fixed income assets ( Supple 1970 , p. 337; Coyle and Turner 2013 ). Third, the mild deflation of the era meant that the capital invested in debentures was secure. An inspection of individual company data contained within the Board of Trade reports attests to the popularity of investing in railway debentures rather than the debentures of other industries. Railways were by some distance the largest sector listed on the stock exchange in this era, and in addition to being widely available, railway debentures also paid handsome returns and were very safe ( Coyle and Turner 2013 ). However, the popularity of debentures did not last. As can be seen from figure 1 , between 1911 and 1923, the proportion of debentures in portfolios fell substantially. The Railway Act of 1921 reduced the volume of railway debentures available and high wartime inflation made debentures unattractive as an investment ( Coyle and Turner 2013 ). Additionally, the obligation to hold more government bonds during the war may have facilitated the shift away from other fixed income assets, such as debentures. Notably, the Financial Times (1915) forewarned that life assurers would face serious depreciation in their assets because of the war and its associated inflation.

Figure 1 also shows that the proportion of portfolio investment in foreign government securities rose steadily after the 1860s, peaked at 15 percent in 1911, and then declined after 1931. 5 Harding (1894) , when looking at British colonies in Canada, Australia, and South Africa, believed that colonial mortgages and government securities could earn a higher return than their UK equivalents at the time. He therefore recommended such investments as an antidote to the falling interest rates in the UK. Given that these were British colonies, it could be argued that these were stable polities, and so Bailey’s main investment canons were kept intact by investing in these securities.

Figure 1 also shows that in the 50 years prior to 1911, the percentage of the average portfolio invested in company shares increased rather slowly from a very low base. Baker and Collins (2003) suggest that this reluctance to invest in equity was mostly attributable to the prevalence of family ownership. However, recent scholarship has revealed that far from being concentrated in family hands, company ownership was very diffuse even outside the largest public firms ( Acheson et al. 2015 ; Foreman-Peck and Hannah 2012 ).

The reluctance at this stage to invest large proportions in equities could be explained by the adherence to Bailey’s investment principles. As well as the security of the capital being paramount, his second principle was that while “the highest practicable rate of interest be obtained,” this was subordinate to the first canon ( Bailey 1862 , p. 144). Nevertheless, investment in equities increased rapidly between 1891 and 1901. As can be seen in figure 2 , there was a sharp increase in holdings of stocks and shares during the mid-1890s, increasing from 6.10 percent of total assets in 1893 to 11.51 percent of total assets in 1901. 6 This coincided with a collapse in yields on mortgages and bonds ( Treble 1980 ), but also a substantial stock-market promotion boom ( Acheson et al. 2016 , Cheffins 2008 , p. 176; Cottrell 1980 , pp. 168–176, Quinn 2019 ). However, life assurers did not invest in these types of shares. Looking at individual assurance company data from 1901, it appears that most shares in portfolios were railway stocks, which were stable blue-chip companies. Their popularity with life assurance companies also stemmed from their three percent and above dividends ( Alborn 1998 , p. 239), while railway debentures yielded less than 3 percent in the 1890s ( Klovland 1994 ).

As can be seen from figure 1 , starting in the 1890s, stocks and shares had an inexorable rise in the portfolios of assurance companies, with a slight fall between 1911 and 1923. 7 By 1960 it was the largest asset class and the exposure to equity was no longer in railway securities because the railways had been nationalised. By 1991 stocks and shares were by some distance the dominant asset class in the portfolios of assurance companies—the cult of equity had triumphed.

It is important to note that, up and until 1960, the stocks and shares asset class reported in our sources included investments in both ordinary and preference shares. However, from 1911 to 1960, we can obtain a split between ordinary and preference share investment from the Board of Trade summaries. This shows that the proportion invested in ordinary shares relative to preference shares increased over time: in 1911 it was 40 percent, 53 percent in 1923, 51 percent in 1938, 58 percent in 1951, and it had reached 77 percent by 1960. It is difficult to ascertain the split between ordinary and preference shares prior to 1911 because we are reliant on individual company accounts, which did not always differentiate between preference and ordinary shares. Based on the available data, the proportion of stocks and shares invested in ordinary shares was 3 percent in 1881, but it had reached 32 percent by 1901. 8 Overall, the data suggests that the increased investment in stocks and shares by life assurance companies from the 1890s onwards was split evenly between preference and ordinary shares until the 1950s.

To understand the rise of the cult of equity after the 1920s, one must first consider the economic conditions of the interwar period. After the Great Depression, the government’s cheap money strategy led to falling bond yields. As such, assurance companies needed to move to an asset class that would provide a return in the presence of potentially high inflation rates. The American economist Edgar Lawrence Smith found that equities outperformed bonds in the period from 1866 to 1922 ( Smith 1924 ). He suggested that rather than viewing investment in equities as a form of speculation, it should be viewed as a credible long-term investment as part of a diversified asset portfolio. Similarly, a 1927 Economist article, viewed investment in equities as a safeguard against inflation. 9 Then, in 1928, in a re-evaluation of Bailey’s investment principles, the chief actuary of the Legal and General, H. E. Raynes, put forward the idea that investing in equities as part of the diversification of asset portfolios of life assurance companies would improve investment security ( Raynes 1928 ).

After 1960, stocks and shares continued to dominate, representing over half of the asset portfolio by the early 1990s and 2000s. Moody (1964) provides some insights into this phenomenon, noting that the inflation in the preceding 20 years had pushed up share prices and dividends. Indeed, in the view of Baker and Collins (2003) , the fear of inflation was the decisive long-term factor driving the shift to equities in the post-war period.

Were life assurance companies simply moving into equities because they were providing a more substantial return? 10 From figure 3 , we can see a positive but weak correlation between the previous decade’s return on shares and their subsequent asset allocation, which suggests that changes in asset allocation were not just driven by previous returns. For example, the increased investment in equities that occurred in the 1960s and 1970s was despite relatively poor returns compared to previous decades, with some having little confidence in them and even viewing the cult of equity as being dead ( Plender 1982 , p. 38). Other factors beyond returns also help explain the sharp increase in equity investment from 1981 to 1991 (see figure 1 ). This sharp increase coincided with the privatization of various state-owned industries, which increased the supply of high-quality equities available to invest in. In addition, there was an increase in investment in equities by institutional investors after the lifting of exchange controls in 1979 and deregulation of London security markets in the early 1980s ( Cheffins 2008 , pp. 352–3).

Ten-year average annual returns on debentures and equities compared to their percentage holdings by life assurance companies, 1871 to 2011. Sources: Stocks and Shares: 1871–1899: Grossman (2002), 1900–2009: Dimson et al. (2011) 2010: Barclays Capital (2011). Corporate Bonds: Coyle and Turner (2013).

Ten-year average annual returns on debentures and equities compared to their percentage holdings by life assurance companies, 1871 to 2011 . Sources: Stocks and Shares: 1871–1899: Grossman (2002) , 1900–2009: Dimson et al. (2011) 2010: Barclays Capital (2011) . Corporate Bonds: Coyle and Turner (2013) .

As can be seen from figure 1 , the 1960s and 1970s also saw the emergence of property as an important asset class for insurance companies. McIntosh and Sykes (1985 , p. xv) note that institutional investors, such as life assurance companies, increased their investment in properties ten-fold in the 25 years after 1960, and in their view, this was unique to the UK. Barras (1994) finds that while property outperformed equities in the 1970s, by the 1980s, the reverse was the case, which resulted in life assurance companies moving away from property, as seen in figure 1 .

Figures 1 and 2 reveal that loans on rates, which were loans to local authorities to finance infrastructure investment and secured on their rates, were a popular asset class from the 1870s until circa 1900. This period corresponds to a rapid expansion of public infrastructure investment by local authorities. It also corresponds to the period when larger local authorities began to issue their own debt securities on financial markets, which undoubtedly reduced their need to borrow from assurance companies. The disappearance of loans on rates after the 1950s is principally due to the centralisation of government in the UK and the removal of borrowing powers from local government.

The final category of assets in figures 1 and 2 is loans on policies. These loans were made to policyholders on the security of their life assurance policy. These rarely constituted more than five percent of the average portfolio and they had effectively disappeared as an asset class by the 1950s. Notably, there was competition for insurance companies in this sphere as banks also lent against the security of life assurance policies ( Collins and Baker 2003 , pp. 184–6).

The final aspect to consider in this section is whether life assurance companies invested in an optimal manner during their emergence as an important institutional investor. Using data from 1870 to 1913, Goetzmann and Ukhov (2006) define an optimal portfolio for investment in British listed securities. Due to data constraints, we can only compare this optimal portfolio with life assurance portfolios in terms of the proportion of the portfolio in debt and equity. The Goetzmann and Ukhov (2006) optimal portfolio is invested 55.7 percent in debt and 44.3 percent in equity. However, life assurance company portfolios from 1881 to 1913, where we have continuous annual data, invested nine and a half times more in debt than equity, on average. This means that life assurance portfolios were likely to be closer to the minimum variance portfolio on the efficient frontier.

Why was this the case? As regulation at the time placed no restrictions on what life assurance companies could invest in, the answer lies in the adherence to the Bailey canons. While the optimal portfolio is concerned with obtaining the highest rate of return for a given level of risk, the Bailey canons stated that the security of capital took precedence over obtaining the highest return. Therefore, it is no surprise that life assurance companies invested much less in equities than suggested by the optimal portfolio of Goetzmann and Ukhov (2006) .

This section has shown that asset portfolios of UK life assurers have changed substantially over the past 200 years. The evidence thus far suggests that historical contingency and political reaction to events shaped this change in portfolios. However, it is possible that changes in portfolios were principally driven by regulation of the life assurance industry or by changing firm characteristics. We explore these alternative drivers of change in the next two sections.

As mentioned above, the UK life assurance industry was largely unregulated until the passage of the Life Assurance Companies Act of 1870. This Act shaped the philosophy of all future regulation of the UK life assurance sector, which was that assurers had to disclose on an annual basis the status and security of their business, but they were not subject to any regulation with respect to the assets that they could invest in. While a life assurance company’s related liabilities had to be kept separate from other insurance liabilities, there was no restriction on the type of liabilities that a life assurance company could have, and there was no requirement for assets to be ringfenced on the balance sheet for life assurance liabilities. This would suggest that regulation was not a key driver of the change in asset portfolios over the long run. An interesting contrast can be made with another common law country—the United States—to show that regulation potentially can have a major effect on asset portfolios. Unlike the UK, the United States have had much more stringent regulations on what insurance companies could invest in. This contrast between the UK and United States is all the more helpful because the life assurance sectors in the two jurisdictions have had broadly similar environments over the past 150 years or so in terms of the supply of financial assets, the performance of financial assets and the wider macroeconomy.

Figure 4 compares the asset allocation of the US life insurance sector from 1871 to 2016 with that of the UK life assurance sector. Perhaps the most striking difference in figure 4 is that while the UK life assurance sector saw the emergence of equity as the dominant asset class after World War II, this did not happen in the United States until much later. This difference is largely because the investments of life assurance companies in the United States were regulated more stringently than their UK counterparts. Regulation of insurance companies in the United States depends on the state an insurance company is licensed in. New York State is the largest state with regard to life insurance, licensing the majority of US life insurance assets. In addition, the Appleton rule, a 1900 New York State ruling codified in 1939, states that insurers who do business in New York State must abide by the New York Insurance Code in respect of all of their business. This applied even if the business was carried out outside that state, meaning that the impact of New York State regulation was much wider than on the state itself ( Pottier and Sommer 1998 ). Historically, New York State has had some of the most stringent regulation of any state ( Cummins and Sommer 1996 ). For example, New York State restricted the proportions of assets that could be held in equities, property, and bonds not of investment-grade quality ( Kamen and Toppeta 1989 ). Rutterford and Hannah (2016 , p. 250) note that in New York, insurance companies were banned from holding equities in their general accounts until 1951, and the then 20 percent restriction was only lifted in 1990. Only after the deregulation of the insurance market, and the removal of such restrictions, did the percentage holdings in equities substantially rise. The restriction on investment in property by US life insurance companies also meant that they, unlike their UK equivalents, were unable to take advantage of buoyant property markets in the 1970s and 1980s.

Asset portfolios of UK and US life assurance sectors, 1871–2016. Note: Solid line refers to UK and dashed line to US. Sources: UK data: see table 1. US data: 1871 to 1958: The Historical Statistics of Life Insurance in the United States, 1759 to 1958, 1960 to 2016: American Council of Life Insurers (ACLI) Life Insurers Fact Book.

Asset portfolios of UK and US life assurance sectors, 1871–2016 . Note: Solid line refers to UK and dashed line to US. Sources: UK data: see table 1 . US data: 1871 to 1958: The Historical Statistics of Life Insurance in the United States, 1759 to 1958 , 1960 to 2016: American Council of Life Insurers (ACLI) Life Insurers Fact Book .

The fact that US insurance companies were constrained in their ability to invest in equity, meant that by default they had to invest a greater proportion in mortgages and bonds. Indeed, Snowden (1995 , p. 210) notes that insurance companies came to dominate the US mortgage market by developing monitoring structures to assess such mortgages. He also noted that their dominance of the US mortgage market after 1940 was maintained by being involved in mortgage programs provided by the federal government. However, there was a decline in investments in mortgages for US life assurance companies after 1970. Wright (1992) suggests that, due to higher returns available on shares in the 1960s and 1970s, the life insurance sector moved away from offering mortgage loans to individual homeowners.

This comparison with the United States reveals that the US regulatory environment shaped the investment portfolios of its insurance companies by delaying the shift into equity. Ultimately, the comparison reveals that regulation can shape capital market development and the supply of funds to different sectors in the economy.

In this section we examine whether changes in the characteristics of life assurance companies were a major driver of the changes in their asset management practices over the long run. To do so, we use multivariate panel regressions to analyse 10 observable company-specific explanatory variables that might have influenced the asset allocation of assurance companies over time.

First, firm size ( FirmSize ) may have affected portfolios. For example, larger firms may have invested differently from their smaller peers, or may have been able to take more risk or invest more in illiquid assets. Second, we create a binary variable ( LifeFire ) that distinguishes between companies offering life assurance and those offering fire insurance in addition to life assurance. The latter may have had to invest differently because of the different risk profile of fire insurance as opposed to life assurance. Our third explanatory variable is London , which is a binary variable that takes the value one if a firm’s headquarters were in London, and zero otherwise. Firms based in London may have experienced a local or regional effect in that they may have had more choice on what assets they could invest in due to their proximity to the London Stock Exchange. They could have also attracted a different and perhaps more sophisticated type of policyholder by being based in London.

The fourth explanatory variable we include is a binary variable ( Mutual ) that indicates whether an assurance company is mutually owned versus shareholder owned. Mutual companies, owned as they were by policyholders, may have taken less risk with their asset portfolios than a shareholder owned company, as there was no need to provide a return to shareholders. Our fifth explanatory variable is Unlimited , which is a binary variable that equals one if an assurance company had unlimited liability, and zero otherwise. A company with unlimited liability may have had a more cautious investment strategy because its shareholders were fully liable for losses. The sixth explanatory variable is CalledCapitalRatio , which reflects the proportion of the company’s subscribed capital that has been called up. The rationale of this variable is similar to the Unlimited one in that a company with a greater degree of uncalled capital may have had a more cautious strategy due to having more capital to be called up in the event of a company failure.

The seventh explanatory variable is Politicians , which is a binary variable that equals one if the board of directors contains one or more Members of Parliament and zero otherwise. The rationale for including this variable is that studies have shown that companies in Victorian Britain that had politicians on their boards behaved differently than their peers ( Braggion and Moore 2013 ; Campbell and Turner 2011 ). In the case of life assurance companies, having a politician on the board may mean, for example, that the company invests more in government bonds.

Our final explanatory variables are PremiumsRatio , ClaimsRatio , and FundsRatio . While each of these variables relate to the cash flows associated with the policies of the life assurance company, each one looks at a different aspect of life assurance company cash flows. In a given year, every life assurance company will receive premiums from their policyholders to maintain their policy, and also pay out claims to policyholders, should a life assurance policy fall due. PremiumsRatio and ClaimsRatio capture the ratio of premiums and claims in a given year relative to the company’s assets, respectively. In contrast, the FundsRatio variable looks at the liabilities relating to life assurance and annuity policies that the life assurance company will have to meet, when such policies fall due in the future, as opposed to the current year’s claims that were paid out. This variable is the ratio of the company’s life and annuity funds relative to the company’s assets. These three variables are included as they may have influenced the composition of the asset portfolios in terms of asset risk and liquidity.

We have constructed panel data for UK life assurance companies for 1881, 1891, 1901, 1911, 1923, 1931, 1938, 1951, and 1960 to enable a panel regression analysis. We are constrained by data availability because several key variables are not available before 1881 and company-level asset portfolio data are not available after 1960. However, 1881 to 1960 is the period when most changes occurred to insurance company asset portfolios. The asset classes analysed are as in table 2 with the exception of property, but we also examine two combined asset classes—corporate securities (debentures plus stocks and shares) and government securities (British government securities plus foreign government securities). We also carry out a Shapley decomposition, which shows what proportion of the variance in the regression is explained by different categories of variables used in the analysis. We decompose the variance in the regressions into that explained by our explanatory variables, time fixed effect variables, and company fixed effect variables.

The definitions of and data sources for our explanatory variables are in table 4 and table 5 shows the summary statistics for our dependent and explanatory variables. Not every life assurance company in our sample had information on all of the explanatory variables at each observation point. 11 We have 153 unique companies and 691 firm-years in our sample.

Definitions of explanatory variables

Summary statistics

Sources: Statements and Abstracts of Reports Deposited With the Board of Trade , under the Life Assurance Companies Act 1870/Assurance Companies Act 1909, Stock Exchange Yearbooks , 1881, 1891, 1901, 1911, 1923, 1931, 1938, 1951, and 1960, and Investors Monthly Manuals , December 1871, December 1881, December 1891, December 1901, and December 1911.

Table 5 shows wide variation in both the PremiumsRatio and ClaimsRatio variables, having high maximum values. This also occurs, to a much lesser extent, within the categories of assets that we are investigating. While this shows that the investments of life assurance companies were highly varied, this also raises the question of outliers, and the potential for such outliers to affect the results. To address this issue, all variables that are not of a binary or logarithmic nature have been winsorised, at a tolerance of 1 percent in each direction. 12

With the caveat that this is a dataset across time, it is worth noting from table 5 that the majority of companies in our sample was based in London and had Members of Parliament (MPs) on their board. The majority of companies did not offer fire insurance in addition to life assurance, and the proportion of companies with unlimited liability was less than 10 percent.

Tables 6 and 7 show regression results of percentage holdings in each asset against firm characteristics and Shapley decompositions of the regression results. At least four things are worthy of comment from the regression results. First, larger assurance firms invested marginally more in mortgages and loans on policies, but FirmSize overall is not significant for most asset classes.

Panel regression on life assurance asset portfolios, excluding called capital

*** significant at a 1% level, ** significant at a 5% level, * significant at a 10% level.

Notes: This table shows the results of various panel OLS regressions with fixed effects and robust standard errors. The years included in the analysis are 1881, 1891, 1901, 1911, 1923, 1931, 1938, 1951, and 1960. The dependent variables are shown across the top row of the table and are percentage holdings in the respective asset class. Please see table 2 for more information. The explanatory variables used are in the first column of the table and are defined in table 4 . Mutual companies do not have uncalled capital and so the CalledCapitalRatio variable has been excluded. A Hausman test was conducted, and it was determined that company and time fixed effects should be used.

Panel regression on life assurance asset portfolios, excluding mutual companies

Notes: This table shows the results of various panel OLS regressions with fixed effects and robust standard errors. The years included in the analysis are 1881, 1891, 1901, 1911, 1923, 1931, 1938, 1951, and 1960. The dependent variables are shown across the top row of the table and are percentage holdings in the respective asset class. Please see table 2 for more information. The explanatory variables used are in the first column of the table and are defined in table 4 . Mutual companies do not have uncalled capital and so mutual companies have been excluded. A Hausman test was conducted, and it was determined that company and time fixed effects should be used.

Second, mutual companies invested in a different way to their non-mutual peers. Table 6 shows that mutual companies invested significantly more in debentures and stocks and shares than non-mutual companies, investing 13.5 percent and 12.4 percent more than non-mutual companies, respectively. However, they invested substantially less in mortgages and loans on policies than non-mutual companies. At first glance, it seems surprising that it was mutual companies that invested more in stocks and shares. However, Morecroft and Turnbull (2019) point out that a more sophisticated investment strategy originated in the mutual companies in the 1920s. Notably, in a 1922 speech, J. M. Keynes wanted the mutual life assurance company to lead the way in improving investment principles. 13 The nature of the with-profits life assurance policy that was associated with the mutual life assurance company may explain why they invested more in shares. Because profits were distributed to the policyholders rather than going to shareholders, there was a greater benefit to members from investing in higher yielding assets such as equities. 14 However, the proportion of life assurance companies that were mutual did not change much over time, ranging from 25 percent in 1881 to 33 percent in 1960. Therefore, changes in the proportion of mutual companies over time cannot explain the changes in overall asset allocation in the life assurance industry.

Third, the results in tables 6 and 7 indicate that unlimited liability and the amount of uncalled capital had little bearing on the asset portfolios of insurance companies. In other words, the downside risk faced by shareholders did not affect how companies invested their funds. This, however, is not to say that these features did not affect the riskiness of a life assurance company’s business model.

Fourth, the coefficients on the ratio variables relating to premiums paid in, claims paid out, and life and annuity liabilities held by life assurance companies reveal some interesting findings. The regression results show that companies with a higher proportion of premiums to assets ( PremiumsRatio ) invested more in equities and corporate securities. Firms with a higher proportion of life and annuity liabilities relative to assets ( FundsRatio ) invested significantly more in debentures. Conversely, companies that had a higher proportion of claims relative to assets ( ClaimsRatio ) invested in relatively fewer equities and debentures.

However, as with the findings for the Mutual variable, these correlations cannot explain the overall changes in asset allocation of the industry over time. For example, figure 1 shows that the proportion of portfolios invested in equities increased over time, yet the average ratio of premiums to assets ( PremiumsRatio ) decreased over the period we analyse in the panel regressions. The increase in investment in equities is most pronounced between 1923 and 1960, but the average ClaimsRatio barely changes over this period. Similarly, the rise in debentures is most pronounced between 1881 and 1911, but that coincided with a decrease in the average ratio of life and annuity liabilities to assets ( FundsRatio ). Therefore, the changes in industry asset allocations over time do not occur in a way that is consistent with the results implied by changes in these variables alone.

Overall, the regression results suggest that while these firm-specific characteristics can explain some of the variation in asset allocation within life assurance firms, they cannot explain the observed shifts in the industry’s asset allocation over time. This is supported by Shapley decompositions of our regressions. The Shapley decompositions in tables 6 and 7 show that the firm-specific explanatory variables together can only explain a minority of the variation in the regressions. For example, table 6 shows that our firm-specific variables can explain between 4.8 percent and 22 percent of the variation in portfolio asset allocation.

Company fixed effects explain far more of the variation in these regressions, ranging from 31 to 80 percent depending on the asset class. Company fixed effects control for company characteristics that we cannot measure or observe, but that do not vary over time or change at a constant rate over time. Some examples of this would be the asset management style of the company, their adherence to investment canons, and their actuarial expertise.

Time fixed effects explain anywhere from 18 to 54 percent of the variation in these regressions. Time fixed effects control for factors that change over time but do not vary across firms. Notably, the Shapley decomposition for the amount invested in government bonds suggests that time fixed effects are the main explanatory factor. This aligns with our earlier observation that the supply of government bonds varied greatly across the two centuries of our sample due to government war needs. Other examples of time fixed effects could include changes in economic and demographic factors such as inflation, the equity risk premium, and the proportion of pensioners in the population. As we can observe these three potentially important factors, we run further regressions including them. However, as our panel data are decadal, these results must be viewed with the caveat that there are just nine observations for each of these variables and we cannot include time fixed effects in these regressions because of multicollinearity with these three variables. The results in Tables A1 and A2 show, for example, that the equity risk premium and the proportion of the population over 65 have a significant and positive relationship with investment in equities, and that inflation has a negative and significant relationship with debenture investment.

Overall, the findings in this section are consistent with the explanations put forward in section 4 for the changes in life assurance company asset portfolios over time, in that it is a reaction to the underlying macroeconomic and societal conditions, rather than any change in the companies themselves. The Shapley decompositions of our regression results reveal that company and time fixed effects appear to be the most important determinants of the asset allocations by life assurance companies. In other words, the drivers of changes in asset portfolio over time were events in the wider economy and how insurance companies adapted to those changes through industry-wide changes in investment canons and asset management practices.

In this paper we explored the development of the UK’s capital market over the past two centuries through the lens of the most important institutional investor and asset manager—the life assurance industry. Our findings suggest that there have been four epochs in the development of the asset portfolios of UK life assurance companies and therefore in the development of capital markets. The first epoch from c.1800 to c.1850 was where government securities dominated portfolios. This was an era where government debt was in plentiful supply thanks to the Napoleonic Wars. The second epoch from c.1850 to c.1913 was one where mortgages were, by some distance, the principal asset in the portfolios of life assurance companies and where corporate securities, particularly debentures, were becoming increasingly important. Increased availability, as well as the sharp switch of capital away from government debt, enabled investment in these burgeoning asset markets. The third epoch from c.1913 to c.1950 was marked by the reemergence of government debt, the fall in other fixed-income assets such as mortgages and debentures, and the rise of the cult of equity. Government debt was issued in abundance to fund the effort of two world wars and moral suasion was used by the treasury to encourage insurance companies to do their bit to support the war efforts. Inflation during World War I contributed to the diminution of investment in other fixed-income assets and made investment in equities much more attractive because they acted as a hedge against inflation. The fourth and final epoch from c.1950 to the present day was marked by the ascent of equity as the dominant asset class. High inflation in the 1970s contributed to this ascent, as did lifting of exchange controls, privatization, and deregulation of security markets in the 1980s. Fixed-income assets such as company debentures only returned to favour once inflation had been tamed.

Our findings do not imply that deep-seated historical factors that persist over time played no role in the evolution of UK capital markets. Indeed, legal origin, historical religion, or historical decisions about the nature of government may not only have had persistent effects on UK capital markets in and of themselves, but they may also have shaped how political systems responded to historical contingency.

We would like to thank the seminar participants at Queen’s University Belfast, the editor, and the two anonymous referees for very helpful comments and suggestions. Thanks to Ian Webster for sharing company accounts data and thanks to the archivists at the Institute and Faculty of Actuaries Library, Edinburgh, for their help. Bogle acknowledges financial support from the NINE/ESRC Doctoral Training Partnership.

By 1970, the assets of the insurance sector even exceeded the total assets of the UK banking system ( Sheppard 1971 , pp.116–7, 157–8; Ryan 1973 ).

Thanks to Ian Webster for sharing these accounts with us.

The data prior to 1871 do not capture the assets held by the entire life assurance sector, but a comparison with the 1871 data suggests that our data are representative.

London Metropolitan Archives, Life Offices Association, L. O. A. Circular 15/1970.

There was a steep increase in foreign government securities and loans on rates between 1910 and 1911—see figure 2 . This was due to a reclassification of assets by the Board of Trade , which expanded the foreign government securities to include municipal and provincial securities for the first time. They had previously been recorded as loans on rates.

In monetary terms, investment in stocks and shares increased from £13.6 m to £34.6 m in this period.

This may be driven by the amalgamation of railways following the Railway Act of 1921. However, the individual investment level data for this period do not exist.

Detailed data are available for 80 percent of the total equity assets in 1881, but only around a third of the total equity assets in 1901.

The Economist, “Life Office Investments,” 28 October 1927.

Avrahampour (2015) notes that after the Second World War, Ross Goobey, the chief actuary of Imperial Tobacco pension fund, changed the fund’s investments depending on what type of asset gave the highest return, and shifted into equities as a result.

Where a life assurance company did not have all the information required for a given year, it has been dropped as a data entry for that year.

This made little difference to our results.

Report to the Annual Meeting of the National Mutual, 18 January 1922.

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*** —significant at a 1% level, ** —significant at a 5% level, * —significant at a 10% level

Notes : This table shows the results of various panel OLS regressions with fixed effects and robust standard errors. The years included in the analysis are 1881, 1891, 1901, 1911, 1923, 1931, 1938, 1951 and 1960. The dependent variables are shown across the top row of the table and are percentage holdings in the respective asset class. Please see Table 2 for more information. The explanatory variables used are in the first column of the table and are defined in Table 4 . Mutual companies do not have uncalled capital and so the CalledCapitalRatio variable has been excluded. Time fixed effect variables are not included because of collinearity with ERP, Inflation and Prop 65. Sources of these three variables are as follows: ERP: See Figure 3 . Inflation: Bank of England: A millennium of macroeconomic data, A47. Wages and Prices. Prop 65: Mitchell (1988 , pp. 15–17). The ERP variable is defined as the average difference in return between equities and gilts, over the prior 10 years. The Inflation variable is defined as the annualised 10 year inflation rate over the prior 10 years. The Prop65 variable is the proportion of the Great Britain population aged 65 and over, derived using the most recent census data as set out in Mitchell (1988) , or via linear interpolation of these figures.

Notes : This table shows the results of various panel OLS regressions with fixed effects and robust standard errors. The years included in the analysis are 1881, 1891, 1901, 1911, 1923, 1931, 1938, 1951 and 1960. The dependent variables are shown across the top row of the table and are percentage holdings in the respective asset class. Please see Table 2 for more information. The explanatory variables used are in the first column of the table, and are defined in Table 4 . Mutual companies do not have uncalled capital and so mutual companies have been excluded. Time fixed effect variables are not included because of collinearity with ERP, Inflation and Prop 65. Sources of these three variables are as follows: ERP: See Figure 3 . Inflation: Bank of England: A millennium of macroeconomic data, A47. Wages and Prices. Prop 65: Mitchell (1988 , pp. 15–17). The ERP variable is defined as the average difference in return between equities and gilts, over the prior 10 years. The Inflation variable is defined as the annualised 10 year inflation rate over the prior 10 years. The Prop65 variable is the proportion of the Great Britain population aged 65 and over, derived using the most recent census data as set out in Mitchell (1988) , or via linear interpolation of these figures.

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7 Best Money Market Funds for 2024

These money market funds have the best overall combination of low fees and high yields.

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Money market funds are typically characterized by high liquidity, strong credit ratings and short maturities.

There's a compelling argument for maintaining a portion of your portfolio in less risky assets, even for the most ardent and risk-tolerant stock market enthusiasts.

Consider the importance of maintaining an emergency fund. Unexpected events, like job loss or medical emergencies, can significantly impact financial stability. Having a safety net provides peace of mind and aids in a quicker recovery.

Holding individual stocks carries its own set of risks. A market-wide sell-off can diminish the value of even fundamentally strong stocks. In such scenarios, cash reserves can act as "dry powder," allowing investors to purchase shares at lower prices.

Furthermore, for those planning significant near-term expenses, such as a down payment on a house, cash offers unmatched flexibility. Unlike certificates of deposit , which lock up funds for a specified term, cash is readily accessible and liquid.

However, this doesn't mean one must settle for the minimal interest offered by traditional savings accounts. By opting for a money market fund through a brokerage, investors can enjoy competitive yields with excellent flexibility and safety.

"Money market mutual funds are great investments for short-term, conservative investors," says Nafis Smith, principal and head of taxable money markets at Vanguard. "This is because they typically invest in very liquid securities with the objective of preserving your capital while also providing income at prevailing market rates."

These unique mutual funds primarily hold fixed-income instruments like Treasury bills, certificates of deposit, repurchase agreements and commercial paper. In general, these assets are characterized by high liquidity, strong credit ratings and short maturities.

By holding these instruments, money market funds are able to maintain a stable net asset value , or NAV, per share of $1. This means that barring extreme market disruptions, their value does not fluctuate. This relative lack of volatility makes money market funds a haven for investors seeking safety of principal.

In addition, most money market funds pay monthly interest distributions, with yields moving in lockstep with prevailing interest rates. Right now, investors can earn a competitive yield with low risk.

"With short-term interest rates above 5%, money market funds have again become a meaningful part of the investment landscape," says James Dowd, CEO at North Capital. "Consumers are savvy – they will not settle for a 1% interest rate at their bank if they can easily invest in a money market fund and earn five times the return."

Here are seven of the best money market funds to buy today:

North Capital Treasury Money Market Fund (NCGXX)

Investors searching for the lowest fees and highest yields in a money market fund will appreciate NCGXX, which is currently waiving fees and sports a 0% expense ratio. This makes the fund free to invest in and helps boost its seven-day SEC yield up to 5.4%. Despite being an institutional class fund, NCGXX is open to retail investors and readily accessible with no minimum required investment.

"By offering an institutional share class with same-day liquidity to institutions and individuals, we hope to encourage all types of investors to incorporate NCGXX into their liquidity management," Dowd says. NCGXX operates as a government money market fund, which is legally required to invest at least 99.5% of its assets in U.S. government-issued or guaranteed securities, giving it great safety.

Vanguard Federal Money Market Fund (VMFXX)

"Money market funds can be a great way to save for short-term goals like buying a car, a down payment or building your emergency savings," says Sophoan Prak, a certified financial planner and financial advisor at Vanguard. "Generally, if you have a planned expense within one year, a money market fund can be a good investment option for it." Vanguard's main offering in this niche is VMFXX.

VMFXX is also a government money market fund, and thus holds a portfolio of U.S. government Treasury bills, obligations, and repurchase agreements collateralized by cash or other government securities. Investors can expect a 5.3% seven-day SEC yield, just a smidge lower than NCGXX's. VFMXX charges a 0.11% expense ratio and requires a $3,000 minimum initial investment.

Vanguard Treasury Money Market Fund (VUSXX)

VUSXX is also classified as a government money market fund, albeit one that invests more conservatively compared to VMFXX. Unlike VMFXX, VUSXX currently holds 98.7% of its assets in Treasury bills, or T-bills, which are federal government-issued bonds with a short maturity. By doing so, VUSXX delivers an ironclad credit quality and an average maturity of just 43 days, which reduces interest rate risk significantly.

Otherwise, VUSXX functions similarly to VMFXX, with a NAV per share pegged at $1 and monthly income distributions . Currently, investors can expect the same 5.3% seven-day SEC yield offered by VMFXX. While VUSXX's portfolio of T-bills yields slightly less than VMFXX's portfolio, it also charges a lower 0.09% expense ratio, which helps it keep net yields similar.

Vanguard Municipal Money Market Fund (VMSXX)

Taxes can eat into the overall returns investors can expect from a money market fund. For example, VMFXX has earned a 10-year annualized return of 1.2%. However, after accounting for taxes, the average investor would have seen that reduced to an annualized 0.71%. This effect is even more pronounced for high-income-bracket investors who plan to hold money market accounts outside of a 401(k) or individual retirement account (IRA).

For these investors, one viable alternative is municipal money market funds like VMSXX. "One of the benefits of investing in VMSXX is receiving federally tax-exempt interest income," Prak says. Despite paying a lower 3.3% seven-day SEC yield, the overall net-of-tax returns received by high-income investors in this fund could be higher than other options. VMSXX charges a 0.15% expense ratio.

Fidelity Money Market Fund (SPRXX)

All three of the aforementioned Vanguard money market funds require a $3,000 minimum investment, which may render them inaccessible to investors with smaller portfolios or cash management needs. A viable alternative to consider is SPRXX, which has no minimum initial investment requirement. On Fidelity's platform, this fund also charges no transaction fees or sales loads.

Unlike the previous funds, SPRXX is a prime money market fund. These money market funds differ from the government variants by being able to hold additional assets like demand notes, time deposits and commercial paper. These corporate securities carry higher risk but can pay higher yields. Investors can expect a 5% seven-day SEC yield with SPRXX, which is lower due to its higher 0.42% expense ratio.

Schwab Value Advantage Money Fund - Investor Shares (SWVXX)

Investors on Charles Schwab's brokerage platform can also find a no-minimum-investment money market fund in the form of SWVXX. Like SPRXX, SWVXX is also a prime money market fund. It is actively managed to select a portfolio of asset-backed commercial paper, certificates of deposit and time deposits primarily issued by financial institutions, in addition to the usual repurchase agreements.

This fund has been in existence since 1992, having survived market sell-offs during the dot-com bubble, the 2008 financial crisis and the 2020 COVID-19 crash. For investors looking for safety, a track record of resilience during historical financial calamities is an important factor to weigh when selecting a money market fund. SWVXX currently pays a 5.2% seven-day SEC yield and charges a 0.34% expense ratio.

BlackRock Wealth Liquid Environmentally Aware Fund (PINXX)

Investors prioritizing environmental, social and governance , or ESG considerations today have a wide variety of equity and even bond funds to pick from. However, these investors can also get a leg up when it comes to cash management needs via funds like PINXX. This money market fund evaluates potential holdings based on MSCI's screening criteria to ensure compliance with its environmental mandate.

As a prime money market fund, PINXX holds the usual repurchase agreements, certificates of deposit, commercial paper and time deposits. However, it does not hold issuers that are involved in controversial weapons, nuclear weapons, civilian firearms, tobacco, thermal coal, oil sands or those that violate the United Nations Global Compact. PINXX pays a 5% seven-day SEC yield and charges a 0.49% expense ratio.

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    June 2014 · Ekonomika. Augustas Degutis. Lina Novickytė. The development of the capital markets is changing the relevance and empirical validity of the efficient market hypothesis. The dynamism ...

  12. Efficient Capital Markets: a Review of Theory and Empirical Work*

    Journal of Finance. Efficient Capital Markets: A Review of Theory and Empirical Work Author (s): Eugene F. Fama Source: The Journal of Finance, Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), pp. 383-417 Published by: Blackwell ...

  13. The year in review: capital markets in USA

    The year in review. Debt and equity markets in the United States had a strong run in 2020, which continued into 2021 despite lingering uncertainty resulting from the covid-19 pandemic. The strong ...

  14. Capital Market Equilibrium With Imperfect Competition: The ...

    2.1 The Setting. For our analysis, we consider an equilibrium pricing model with imperfect competition. The analytical framework rests on Mossin and extends his approach by imperfect competition, to be more precise a Cournot-Nash behavior of the investors.We analyze a capital market with \(n\) investors. In the market, two assets are traded, a riskless asset whose return is normalized to zero ...

  15. Full article: Reporting matters: the real effects of financial

    Firms must identify the chief decision maker and use the segment information this person(s) reviews to determine the segments to include in the notes to the financial statements. Cho (Citation 2015) exploits this change to examine a firm's internal capital markets, finding an improvement in capital allocation post adoption of SFAS 131. The ...

  16. Full article: Capital market response to high quality annual reporting

    Abstract. We examine the capital market response to the publication of annual reports shortlisted for corporate reporting awards. We find weaker capital market reactions to the publication of shortlisted annual reports compared with a matched sample of non-shortlisted annual reports, consistent with shortlisted reports containing similar or less price sensitive information relative to non ...

  17. Capital Markets Insights

    Major U.S. indices increased in 2021 as economy began to recover from the impact of Covid-19. The DJIA gained 18.7%, the S&P 500 added 26.9% and the NASDAQ increased 21.4% since December 31, 2020. U.S. companies raised a record $302 billion through stock market listings. Over 700 SPACs went public in 2021, more than 5 times the number from the ...

  18. Capital Market: Understanding Its Role and Impact in Finance

    Capital Market Definition. The capital market is a financial system where individuals and institutions trade financial securities, including stocks and bonds. This is a place where corporations and governments raise long-term funds, typically in exchange for equity ownership or debt financing.

  19. Capital market development over the long run: the portfolios of UK life

    1. Introduction. An important driver of economic growth is capital market development. Ultimately, investor demand and the supply of capital are critical factors in the development of capital markets (Albuquerque de Sousa et al. 2016).While previous studies have assessed long-run capital market development by examining changes in the overall size of markets, we examine one of the most ...

  20. Journal of Capital Markets Studies

    Journal of Capital Markets Studies - Literati Award Winners 2020. Journal of Capital Markets Studies publishes peer-reviewed research in the areas of economics and finance with a specific focus on capital markets. JCMS is published in association with the Turkish Capital Markets Association (TCMA). ISSN: 2514-4774.

  21. Financial Institutions: Articles, Research, & Case Studies on Financial

    Read Articles about Financial Institutions- HBS Working Knowledge: The latest business management research and ideas from HBS faculty. ... Financial planners must find new ways to market to tech-savvy millennials and gen Z investors or risk irrelevancy. ... exchanges in countries with better shareholder protection allowed younger and less ...

  22. Determinants of capital market in the new member EU countries

    The remainder of this article is organised as follows: Section 2 briefly reviews basic determinants of capital market development in the selected countries, and Section 3 describes the dataset and econometric methodology. Section 4 reveals the empirical results and the conclusion is outlined in the final section.

  23. SNB Says Review of UBS Capital Needed Due to Increased Scale

    As capital requirements progress according to size and market share, "a review needs to be made as to whether the progression takes adequate account of this increase in systemic importance ...

  24. Bank of America revamps its capital markets division, memo says

    The firm has named Gregg Nabhan, chair of equity capital markets, and Mike Browne, head of North America leveraged finance, to lead its capital markets advisory unit, the memo said.

  25. (PDF) Indian Capital Market: A Review

    The present review article is an attempt by the researchers to make a descriptive as well as analytical study of work done in the field of Indian capital market. This study will be focusing on ...

  26. 7 Best Money Market Funds for 2024

    "With short-term interest rates above 5%, money market funds have again become a meaningful part of the investment landscape," says James Dowd, CEO at North Capital.