Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Financial Institutions, Supervision, Regulation and Deposit Insurance of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, March 8, 1994 - Statements to Congress - Transcript

Federal Reserve Bulletin, May, 1994

I am pleased to appear before the Financial Institutions Subcommittee today on behalf of the Federal Reserve Board to describe the actions the Board has taken to regulate bank sales of mutual funds and to present the Board's views on what additional regulatory or congressional action is necessary.

GROWTH OF MUTUAL FUNDS

Before describing the action the Board has taken, I would like to make some observations about the recent growth in the mutual fund industry. Growth in mutual fund assets in recent years has been nothing short of explosive. Last year, the public bought a record $294 billion of shares of mutual funds, nearly all of which was in stock and bond funds, bringing assets under management in the mutual fund industry to slightly more than $2.0 trillion at year-end. As a consequence, mutual fund assets have surpassed the life insurance industry in size and, today, are exceeded only by commercial banks and pension funds. The strong inflows into mutual funds reflect their popularity among households. It is estimated that nearly a fifth of all households own shares in at least one mutual fund.

As mutual funds have become a significant competitor to depository institutions, these institutions have increased their participation in the mutual fund industry. The net assets of bank proprietary mutual funds are estimated to have increased from $44 billion at the end of 1988 to $220 billion at the end of 1993. Between 1988 and 1993, the market share of bank proprietary funds doubled from 5-1/2 percent to more than 10 percent of the total assets of the mutual fund industry.

The potential for customer confusion clearly exists when mutual funds are sold to the public by depository institutions, given their traditional insured deposit activities. The chief concern is that depositors may not understand that the mutual fund investments they buy from a depository institution are not deposits and are not covered by Federal Deposit Insurance Corporation (FDIC) insurance. It is also possible that depository institution customers who buy mutual funds may receive less than adequate investment advice about mutual funds if sales personnel ar e not properly trained or their sales practices are not properly supervised.

This potential for customer confusion involving mutual fund sales could adversely affect the safety and soundness of a depository institution. If depositors suffer losses on investments they have purchased from a depository institution, the institution's reputation, and possibly its financial condition, could be adversely affected. More specifically, litigation risk and possible deposit withdrawals could affect a bank unfavorably.

BOARD ACTIONS REGARDING INVOLVEMENT BY BANKING ORGANIZATIONS WITH MUTUAL FUNDS

The Board takes these concerns seriously. Over the years, the Board and its staff members have issued several interpretive opinions, supervisory letters, and informal staff opinions addressing issues relating to bank sales of uninsured investment products, including mutual funds. Many of these statements have been issued either in connection with the authorization of additional activities for bank holding companies or when the Board and its examiners have concluded that regulatory guidelines are necessary to address the manner in which an activity is being conducted. All of these statements reflect the Board's long-standing policy that when banks sell uninsured investment products to their customers they should do so in a manner that clearly distinguishes these products from insured deposits.

The first regulatory action that the Board took concerning mutual funds was a 1972 interpretive rule relating to conflicts that may rise when a bank holding company acts as an investment adviser to mutual funds. This rule authorized bank holding companies to act as investment advisers to mutual funds and, at the same time, created safeguards designed to assure a separation between the mutual fund being advised and the holding company's subsidiary banks.

During the mid-eighties, as bank holding companies and banks received authorization to engage in discount and full service brokerage, the Board and its staff members, through orders, opinion letters, and informal staff interpretations, adopted disclosure requirements that are applicable when these powers are used by banks and bank holding companies to sell mutual funds. Pursuant to these requirements, bank holding companies and banks are required to inform a customer that investments in a fund's shares are not obligations of a bank and are not insured by the FDIC. More recently, the Board revised its 1972 rule regarding investment advisory activities of bank holding companies to require that banks that sell or provide investment advice about mutual funds that are advised by an affiliate must disclose to customers the relationship between the affiliate and the fund.

INTERAGENCY GUIDELINES

In response to the rapidly growing involvement of depository institutions in the sales of mutual funds, the Board and the other bank regulatory agencies last month jointly issued a comprehensive set of guidelines governing the retail sale of mutual funds and other nondeposit investment products by depository insitutions.