Researchers at the BCF have been doing cutting-edge research on institutional finance since its beginning in 1997. Traditional finance models treat institutions such as banks, insurance companies, mutual funds, and pension funds as “veils” or pure pass-throughs. In these models, prices and allocations in financial markets are ultimately determined by the preferences and beliefs of households. In contrast, institutional finance studies how frictions affect prices and allocations when institutions act as intermediaries in financial markets. These frictions can arise from many sources including principal-agent problems, regulation, and market power. Institutional finance is multi-disciplinary, drawing on ideas and techniques from macro, industrial organization, financial engineering, and econometrics. Thus, the multi-disciplinary researchers at the BCF are well positioned to make further contributions to this field.
One of the key players in institutional finance is insurance companies. The liabilities of U.S. life insurers amounted to $5.9 trillion in 2015, compared with $12.9 trillion in mutual funds, $8.0 trillion in savings deposits, and $5.4 trillion in private DC plans. Life insurers provide three important functions to the economy. First, they provide long-term stable funding for macro investment and growth as the largest institutional owners of corporate bonds. Second, they diversify the most important sources of idiosyncratic risk that are important for household welfare. Third, they insure aggregate risk over time through guaranteed return products, taking on the traditional role of pension plans and Social Security.
Motohiro Yogo, a faculty member of the BCF, has been studying the life insurance industry as part of the research effort on institutional finance. His work with Ralph Koijen of NYU shows the importance of financial and regulatory frictions in determining insurance prices, contract characteristics, and the size of the insurance sector. Koijen and Yogo (2015) shows that life insurers sold annuities and life insurance at deep discounts during the 2008 financial crisis in order to raise risk-based capital. Koijen and Yogo (2016) shows that life insurers move a significant share of liabilities off balance sheet through “shadow insurance” to reduce the impact of risk-based capital regulation. Koijen and Yogo (2017) shows that guaranteed return products that attempt to smooth market risk over time is now the largest category of life insurer liabilities. This represents a significant departure from their traditional business, and the supply of guaranteed return products appears to be fragile to aggregate risk mismatch on life insurer balance sheets.