Institutional Investors and Corporate Governance Stilpon Nestor OECD Good afternoon I am honoured to have been invited by my good friend Professor Hasung Jang to address this important gathering, on the ocassion of the launch of the Asian Institute for Corporate Governance. I am also delighted to be among so many frineds in this room.

Issues The role of institutional investors in promoting corporate governance The role of institutional investors in Korea Corporate governance progress in Korea and its perception by the markets. In his invitation, Hasung has asked me to adress the relationship of institutional investors and corporate governance. Indeed over the best part of the next 20-0r so minutes I will argue that institutionla investors are the prime pull of corporate governance deman globally for a number of reasons. Later in the day Hasung has added a twist: he asked me to talk about institutionla investors views of Korea-- I think I am not the placed person to address this. The mebers of the finacial community here are probably closer to the issue. However, I am prepaed to say a few works on two other related issues: what is the actual and potential role of the battered Korean institutionla investors of Korea? Where does Korean stand on its corporate governance reform?

equity markets have grown at an impressive and steady rate in the OECD area over the last 10 years.On average, OECD area market capitalisation/GDP has more than doubled in during the last decade--even with the dismal equity performance in 2001, chances are that market cap/GDP will still be over 100%. This suggests a trend that will be hard to reverse.

In some countries the change has been phenomenal In some countries the change has been phenomenal. Partly due to privatisation, countries like Italy and Spain have seen the size of their market capitalisation grow from 14 and 23 % of the GDP in 1990, to 72 and 90% in 1997 respectively. The US has seen its own market capitalisation to GDP treble between 1990 and end 2000— even after the severe correction in the NASDAQ in the second part of last year--I will get back to the Korean case shortly.

Corporate governance and equity risk Equity is a bundle of risks: Business plan Execution (management and financial structure) Corporate governance (expropriation) Investors adjust for this risk The growth of equity markets is what has brought corporate governance to the fore, and made it a household concept.Why? Because corporate governance is a key constituent of the bundle of risk embedded in an equity claim. While the business plan and its execution constitue the most obvious elements of the equity risk that investors bear, governace has also a very clear impact on the downside of equity risk. Bad corporate governance means a high probability of expropriation of shareholder value. A firm’s value is-- or should be--adjusted to this governance risk. The firm would thus face a higher cost of capital.Time does not allow me to discuss this more, but in my mind this is the key to understanding investor behaviour as opposed to looking at the impact of governance on performance in general.

Financial Assets of Institutional Investors As a Percent of GDP Equity market growth is closely related to the growth of institutional investors. Investment company (open and closed mutual funds), insurance company and pension fund assets stood at146% of the GDP of OECD countries in 2000, they represented only 38 % of GDP in 1981 and 81% ten years ago. US and UK institutions control 76% of all assets in the top 5 liquid equity markets. They owned approximately 1.8 trillion of foreign equity in 1999-- 18% of their portfolio--up from 8% in 1999. Recent research indicates that more than 95% of the 1.8 trillion is concentrated in no more than 50 institutions. From a geographical perspective, a vast part of this equity portfolio is concentrated in the large European markets.

Portfolio composition of institutional investors in the OECD Moreover, the percentage of equity investment in the portfolios of these institutions has almost doubled over the last decade , to more than 40% of their portfolio. As their exposure to equity increases their interest in corporate governance also increases. Moreover, instituional investors are holding more equity in foreign countries .They owned approximately 1.8 trillion of foreign equity in 1999-- 18% of their portfolio--up from 8% in 1999. Recent research indicates that more than 95% of the 1.8 trillion is concentrated in no more than 50 institutions. From a geographical perspective, a vast part of this equity portfolio is concentrated in the large European markets. But their attitude is substantially different depending on their profile and purpose.

Pension funds 300 largest pension funds manage more than $ 6 trillion in 2000--up 8.5% from 1999. They have grown 158% over the last 10 years 8 of the top 10 are based in the US Equity exposure varies. In the UK is more than 70%. In Japan it is tiny. The 300 largest pension funds in the world manage more than $ 6 trillion in 2000-- this figure is up from 8.5% in 1999 and more than 158% over the last 10 years. 8 of the top 10 pension funds are based in the US. The other tow are in Japan and the Netherlands. Equity exposure varies. In the UK is more than 70%. In Japan it is tiny--albeit growing.

Pension funds Diversification is the key risk strategy Drivers of better governance in 2 ways governance consciousness +active ownership Liability profile Indexing Investment in asset classes of low liquidity Global fiduciaries Politics Portfolio diversification is the primary tool of prudent investment management. But in additon to diversification pensio funds some very good reason to be directly concerned by corporate governance.By directly concerned I eman tow things that might not necessarily occur in parallel :there is a conciousness of the govewrnance risk, which means that pension funds and their msnagers are actively looking at this issues more and more when they are investong; and ite means active ownership, which means that funda acxtually spend resources in actively managing their stakes instead of just exiting when they perceive the risk. More and more funds see themselves as active owners. Pension funds have a long-term view of investment because of the maturity profile of their liabilitities is also very long; they are not interest in short term trading gains. Because of regulatory and other reasons a large part of their portfolio reflects stock market indexes and therefore cannot exit underlying ivestments--they have to exercise their voice if they want to protect their interests as shareholders of these corporations. As pension funds grow they diversify into other asset classes where liquidity is low and exit difficult. One such class is emerging markets equity.Another is private equity and venture funds. In the US pension fund investment in those tow classes grew by 63% and 94% respectively in the year to September 30. Finally, there is an argument that pension funds are global fiduciaries they buy “the economy”rather than companies--and the do that in several markets around the world with a long term parspective. As globalfiduciaries they are internalising what for other investors are regulatory externalities, such as the longer term efficency of markets or broader corporate social responsibility concerns. A more cynical view of the world might attribute the attitude of some of the bigger pension funds towards socially responsible investment to their political masters--in the case of the large public pension funds , like CalPeRS; or dsome of the large trade union funds.In any event many pension funds are getting aggressive about corporate gvernance as regards they portfolios that they manage--and they are also pushing their asset managers to adopt active policies.Hermes, ne of thlargest pension managers in the UK is a case in point.By addressing these issue, they can claim to effectively and transparently manage risk in their portfolios and thus discharge adequately their own fiduciary duties towards their millions of beneficial owners.

Pension funds: dynamics US  waiting for the Enron effectdiversification in 401K plans indexing Unilever/Mercury in the UK more prudence by managers more indexing and focus on CG risk Other (Japan, Scandinavia): pension funds diversification to other equity classes seeking a more active corporate governance role Other (Germany, France, Italy)  pension reform important growth in the medium term But not all pension funds are active. Quite the contrary, the sleeping ginat is just awakening.The Enron debacle in the US foc used the spotlight on large occupational/company pension funds.While the older defined contribution plans have to follow strict diversification rules in their portfolios, defined benefit individual plans --the 401K-- can be and often are invested primarily in company stock. This is clealry facilitated by compnay stock contributions and the fact that the company os often in control fo the administration. Already before ENRON these plans had seen a severe contraction in the US: by September 30 more than 25% of the largest compnay plans they were down by more than 30%--they were all invested more than half of their portfolio in compnay stock. Expect, therefore regualtory intervention and an even more pronounced turn towrads indexing. This latter was alredy occuring since ealry 2001, which saw indexed assets of the largest funds shoot up by more than 30%. The recent settlement between Merryl Lynch and the Unilever pension fund also marks another important milestone, as the fund industry seems to be accepting its liability for poor performance. This might agin drive more money to indexedf funds and increase the watchfulness of the managers. In sime countries with substantial pension fund sectors, regulations are progressively relaxed and invetsment in equity is growing. These funds are in scrambling to aquire some knowledge on active investmetn and c vorporate governsance assessment. Finally, pension reform is waiting in the wings for some of the largst economies in the world, like Germany and France.An argument that strikes deeply in the national soul, is that a strong pension sector is the only way to avoid seeing the largest domestic corporations turn to theforeigners for equity funding and the best way to effectively put domestic saving into good use.

Finally, investment companies and mutual funds have also grown considerably, riding on the back of a growing interest of the pub lic in investing directly. While mutual funds are not the “natural” long-term owners as is the case with pension funds they have been focusing on governance incresingly. They might be less “active”in the sence that pension funds are but they are becoming systematically concious of the governance risk-- and will take action if they have to .A more active stance is required when tax, low liquidity and poor market infrastructure issues have made exit quite costly in a large number of markets. And even in the most developed of markets, poor governance will often result in nasty surprises related to the price of shares they hold. To quote Bob Pozen, the managing director of Fidelity “institutional invetsors do not set out to micromanage companies but…when the company’s stock price is at stake, the costs of activism may be worth the benefits in shareholder returns”.

Korea is a country with a relatively small institutional sector Korea is a country with a relatively small institutional sector. Only in the two post crisis years has the size of the assets to GDP rpresented appreciably more than half of the OECD average--and the resons for this might not be the good ones, as I will come to in a second.The reason for the relatively low stock of instituional assets in Korea is the lack of an appreciable private pension fund sector. This will adress an ageing problem that the country will be facing acutely and abruptly in the next generation. The current national pension system is weak. And the capital markets will get a great boost by the presence of large domestic investors commited to long term growth.

COMPOSITION OF FINANCIAL ASSETS OF INSTITUTIONAL INVESTORS The composition of finaciql assets of institutional investors in Korea testifies to their realtive aversion towards equity. Institutions are not present in the equity market.The composition of assets --and their surge in 1998-99 also tells a different story. Most instituions in Korea are captive to the corporate sector. In 97-98 the chaebol went through a frenzy pof bond and share issuance which was absorved to a large degree by these instituions. In many cases it bvrought them to their knees with the government having to step in and rescue them.

DISTRIBUTION OF FINANCIAL ASSETS OF INSTITUTIONAL INVESTORS IN KOREA The amount of bnds and loans that investemetn and insurance companies had to absorb--investmetn that in their great majority turned sour as a number of large chaebol collapsed--is made more evdent in these sector secific charts. In any event, following the collapse of many NBFIs, itr is now time to review fundamntally their role in promoting a hrealthy capital amrkte, mainly by ensuring their independence from the corporate sector.

Let me now discuss briefly the Korean market and its relationship to governance. In contrast, to other OECD countries, Korea has seen a contraction of its market cap/GDP. Most interestingly , after the crisis Korea has seen some wild swings in the size of the value of its market. After going down to an abysmall 9% in 1997, it climber to an impressive 75% in 1999, only to fall back ro a low 32% in 2000.A lot of these wild swing have to do with the tech bubble--which has big in Korea. They also have to do with an increased issuance of shares by chebol to bring down their D/E ration to a government mandated 200%. Whatever the case, It is likely that we will see market cap/GDP climbing sifgnificanlty in 2001, as Korea is the only market that is witnessing a significant upwartd trend in 2001 share prices, with a 36% rise in the INDEX since last December.

The Korea discount P/Es, PBs and dividend yields have been among the lowest in the region CLSA study: Korea 16th out of 25 emerging markets Two reasons: too much government interference too much corporate suspicion Along with a very low market cap/GDP for an OECD country, Korea has experienced some of the olower valuation in tehAsian region in its markets, at least until recently. Why is this? On one hand, there is still a lot to be done as regards industrial restrcuturing and dealing with the overinvestment and over-capacity. The industrial orgnaisation that led to these phenomana does seem to be changing--with 14 out of the 30 lkargest chaebol out of business and the stock of FDI rising rapidly.The government has chnaged a number of important laws and has introduced better accounting standards. In fact, it has taken quite a few steps in changing the rules of the game. But until recently the private sector has been in no mood to give Korea the benefit of the doubt. In April 2001, an expensive CLSA CG study, and rating exercise put Korea on the 16th slot among 25 emerging markets. I believe that thids ois due to tow reasons: Investors still see the government as setting the pace and controling the developmetn of the corporate and finacial sectors. This does not create confidence. Even some of the key reforms were undertaken under governemtn fiat-- expedient but easily reverseble as the countless futile efforts to regulate the chabol since the 80s have proven. The overwhealming governmet presence in the banking sector is also not encourging. Banks need to be privatised very soon. The rising markets and healthy growth prospects mght represent a window of opportubity The second reason--which is not unrelated to the fiorst-- is a still obviously suspicious attitude of the corporate sector in Korea toward better governace. Too many Korea corpoates waste their time fighting rear-guard action against better governance. They are fighting against very powerful global forces. The effective globalisation of capital markets has meant that friendly banks and other domestic financial institutions are becoming less friendly as they are themselves increasingly subject to international competition and tighter supervision.. Instead of been dragged towards change, corporations should grasp the opportunity for creating value in this new environment. History has shown that it is counterproductive to wait for the crunch, i.e. a crisis or a showdown. .

Conclusions Institutional investors are driving corporate governance demand globally and will continue to do so Korea needs stronger independent institutional investors as a key component of its domestic investment process Korea has made progress in corporate governance but is not out of the woods yet