The explosive growth in mutual-fund and pension investments, which has already changed financial markets, now is transforming the economy itself.
During this year's first four months alone, $99 billion of new money poured into mutual funds, already outpacing last year's record $128 billion. "The U.S. is in the midst of creating a whole new financial system in which the mutual-fund sector is increasingly displacing commercial banks as the major repositories of household wealth, as well as suppliers of capital," says David Hale, the chief economist at Zurich Kemper Investments. All this makes the U.S. financial structure look quite different from that of other industrial nations.New businesses and technologies are created faster in the U.S. than elsewhere - a trend that will continue. "It's not because our scientists are smarter than their scientists," says Richard Breeden, former chairman of the Securities and Exchange Commission. "It's because we're creating a system that provides capital more quickly to people willing to take the big risks . . . and our economy is reaping the rewards."
In other industrialized countries, "investment decision making is concentrated in the hands of just a few dozen gatekeepers at banks and investment firms," he says. The result is that financing tends to flow primarily to a cadre of established businesses with strong relationships to the old guard. By contrast, Breeden says, the United States has "literally thousands of gatekeepers in our increasingly decentralized capital markets, many of them with a much higher appetite for risk."
The effect on venture capital is significant. "There are more opportunities today than I've seen in 30 years in the business," says William Burgin of Boston venture-investor Bessemer Partners. Because of the surge in new stock issues, he says, "we have far more liquidity" and "recycle cash into new investments more quickly." But, he warns, the money flood can lead to "some ridiculous valuations. . . . Where we used to be able to take a couple of months to evaluate a deal, they now want a decision by next Tuesday."
This lets start-ups race into initial stock offerings rather than go through two or three rounds of normal financing. "Mutual funds are in dire need of a place to put all the cash that's coming in; so IPOs are becoming our primary competitor," says Ken Wilcox, executive vice president of Silicon Valley Bank, in Santa Clara, Calif., which finances high-tech companies. "We're really hustling to stay ahead."
Global markets have adjusted to these huge fund flows. Five years ago, for example, small investors in the United States couldn't get a piece of a South Korean steel mill. Today, they merely place a toll-free telephone call to the appropriate overseas fund.
The volume of American investment overseas is staggering. Led by U.S. fund managers, private equity flows into emerging markets will reach an estimated $105 billion this year, according to the Institute of International Finance, which represents global banks and fund investors. The ex-Communist economies of Eastern Europe are especially hot; equity investment there may total $12 billion in 1996, triple that of only two years ago.
As a result, international capital flows more and more resemble those in a market, with some striking effects. In the bleakest moment of its 1995 economic troubles - right after the peso collapsed - Mexico's net capital inflow still exceeded $100 million as risk-takers sought bargains. "Telmex (Tele-fonos de Mexico) was never going to be cheaper," says Breeden, now a partner at Coopers & Lybrand.
Commercial banks may be the biggest losers. Their share of the U.S. credit market has declined to about 15 percent, compared with 21 percent for pension and mutual funds. "Borrowers that once might have gone to a bank are going to securities markets," says John Rae, chief economist for the Investment Company Institute. "This is changing the structure of the financial system."
Another effect: "Households are increasingly becoming financial risk-takers, shifting their savings into mutual funds," economist Henry Kaufman says.
To survive, banks seek laws and regulations allowing them into new markets. Some rules already have been eased; banks now account for 12 percent of mutual-fund sales and a rising, though still small, share of insurance sales. "We have to think about the world differently," says James Chessen, an American Bankers Association economist. "If you're in financial services and aren't offering mutual funds, insurance and pension products, you aren't going to be in the game."
Fund investments are accelerating as baby boomers go gray. "What we've seen so far is the tip of the iceberg of the benefits of a broader investment culture in this country," Breeden says. He expects these investments to raise the chronically low U.S. savings rate. A partial privatization of Social Security would multiply this effect.
These changes complicate the Federal Reserve's job of guarding against systemic risk. With capital flows faster and more liquid than ever, markets are more volatile and economies more susceptible to unexpected shocks. When banks were dominant, the Fed could act as lender of last resort. Now "there's no built-in safety valve," Kaufman says.
There is some danger because older economic institutions can't keep pace with the new ways. But so far the benefits have been well worth the risks.