Abstract:This paper analyzes the mechanism and preconditions whereby accumulation of pension funds leads to initiation of development of capital markets. The mechanism is in essence posited a process of internalizing the pecuniary external effects arising from risk taking within a market-based financial system. The preconditions consist of the scale condition with respect to the size of pension funds and an 'institutions condition' to ensure efficient management of assets of pension funds. Results from empirical analyses confirm the 'externality hypothesis' for the mechanism. Differing patterns of the effects of pension funds on capital markets between the Anglo-Saxon countries and the countries of Continental Europe and Japan attest to the existence of the two preconditions for the spillover effects. These imply that achieving a critical mass of pension funds and securing institutional settings for efficient management of pension funds may suffice for pension reforms to succeed in initiating development of capital markets.