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FDIC Banking Review

Vol. 8 No. 3 - Article II - Published: February, 1996 - Full Article

Banks and Mutual Funds
by Jay W. Golter*

Mutual funds are the fastest-growing segment of the financial-services industry. Assets under management by mutual funds have grown from $134.8 billion in 1980, to $1,066.8 billion in 1990, to $2,161.5 billion at year-end 1994. In comparison to deposits at commercial banks and savings banks during those years, mutual fund investments equaled 8.3 percent of deposits in 1980, 37.3 percent of deposits in 1990, and 75.2 percent of deposits in 1994.

This paper first traces the growth of mutual funds. The next section describes the major functionaries employed by a mutual fund and the extent to which banks or bank affiliates have provided these services for mutual funds. The paper concludes with an examination of the ways that banks have entered the distribution channel by selling mutual funds to their customers.

History of Mutual Funds

A mutual fund offers shares to investors. The proceeds from the sale of shares are used to purchase a portfolio of investment assets, generally financial securities. In an open-ended mutual fund, investors may redeem shares previously purchased, or purchase new shares, at a price called the "net asset value," or NAV. The NAV is calculated at least daily, usually at the close of financial markets, to reflect the marked-to-market value of the pro rata portion of the portfolio represented by each share. As more fund shares are purchased (redeemed) by investors, the investment portfolio increases (decreases) in size. As the market value of the securities held in the portfolio increases (declines), the NAV increases (decreases). Portfolio earnings and losses are thus passed on directly to the investors.

Mutual funds in the United States can trace their origins to investment trusts established in England and Scotland in the early 19th century. 1 Those trusts actively provided capital to American businesses that emerged after the Civil War. The first American mutual funds were formed in 1924 in Boston and New York. Many closed-end 2 investment companies were formed during the years preceding the stock market crash of 1929. These companies tended to hold highly speculative portfolios and performed poorly during the crash. Investor confidence in all forms of mutual funds was further shaken by unscrupulous practices in some closed-end companies. 3

Congress sought to address this problem in 1935 by ordering the Securities and Exchange Commission (SEC) to study the industry. The SEC'S report formed the foundation for the Investment Company Act of 1940, the primary statute that regulates mutual funds. In addition, a myriad of other statutes govern the management of mutual funds. Since the passage of the 1940 Act, the mutual fund industry has grown substantially in both absolute size and in terms of market share among financial-services providers.

Mutual fund portfolios are generally constructed in order to achieve specific investment objectives. Among the broad classification schemes are short-term (taxable and tax-exempt money-market funds) versus long-term (bond and equity) funds. Individual short-term funds may hold specialized portfolios; for example, some money-market funds invest entirely in U.S. Government instruments. Long-term funds are usually characterized by their investment strategies. Examples include funds that invest primarily in equities of small companies (small cap funds); equities with high dividend yields (income funds); bonds below investment grade (high-yield funds); securities issued by firms in particular industries (sector funds); securities issued in developing countries (emerging market funds); and balanced funds, which hold both equities and debt securities. In the 1994 Mutual Fund Fact Book, the Investment Company Institute classified all mutual funds by 21 separate investment objectives.

Mutual fund sponsors often offer a variety of funds in which to invest. This enables investors to match their own investment needs and objectives with the strategy of a particular fund or combination of funds. The largest fund complex, Fidelity, offered 171 funds as of year-end 1993. 4 Only one other fund group, Merrill Lynch, offered more than 100 separate funds. Among the 34 fund groups that each sponsored funds with aggregate assets exceeding $10 billion, the average number of funds offered was 47. Two fund groups with historical ties to bank holding companies are included on this list. 5 Pacific Horizon Funds, which ranked 30th on the list with 19 funds and had a combined $11.5 billion in assets under management, was associated with Security Pacific National Bank and now performs many services for the mutual fund complex that was formed in the aftermath of that bank's merger with BankAmerica. Nations Funds, which is associated with NationsBank, ranked 33rd in size, encompassing 47 funds with a total of $10.5 billion in assets under management. As of year-end 1993, 93.6 percent of the assets managed by Pacific Horizon Funds and 72 percent of the assets managed by Nations Funds were in money-market funds. Thus, while the combined assets of the two fund families totaled slightly more than one percent of the industry's total, the $18.4 billion of money-market funds that the two complexes managed represented 3.3 percent of the short-term fund market.

In contrast, at year-end 1993, the Fidelity group had $219 billion in assets under management, or 10.6 percent of the total industry. The top five fund groups had $629.7 billion in assets under management, or 29.9 percent of the total industry. One group of note is Federated Funds, the 13th largest group at year-end 1993, with $29.3 billion in assets under management. Although Federated is not associated with any single bank holding company, the firm assists banks in establishing mutual fund sales programs and performs all necessary functions for banks that create their own mutual funds. It has been estimated 6 that 80 percent of Federated's sales occurred in banks.

Mutual funds are governed by the Securities Act of 1933 (the 1933 Act), the Securities Exchange Act of 1934 (the 1934 Act), the Investment Company Act of 1940 (the 1940 Act), the Investment Advisers Act of 1940, relevant sections of the Internal Revenue Act and Blue Sky laws of each state in which a fund operates. The success of these statutes in creating a climate of investor confidence is evidenced by the extraordinary growth of the mutual fund industry over the past decades.

The Securities Act of 1933 and Securities Exchange Act of 1934. The 1933 Act requires mutual funds to file registration statements with the SEC. All purchasers of "securities" (the definition of which includes mutual fund shares) must be provided with a prospectus. The 1934 Act, among other provisions, requires that broker/dealers who sell mutual funds must register with the SEC. Bank employees are exempt from this requirement as long as they do not receive transaction-related compensation (commissions).

The Investment Company Act of 1940. The 1940 Act requires that investment companies register with the SEC. The registration statements must include information about the investment objectives and strategies of the fund. These policies can not be changed without approval of the majority of investors in the fund. The Act also imposes restrictions on the amount of leverage that a fund may employ. Among other major provisions, the 1940 Act empowers the National Association of Securities Dealers (NASD) to regulate sales charges (loads) on mutual funds.

A fund's board of directors will determine which firms should be awarded contracts, and at what levels of compensation, for providing the services needed to maintain operations. Because a fund's sponsor may perform many of those services, and would have selected the original board, "there is obvious potential for conflict between the interests of the investment company sponsors and managers and the interests of the investment company shareholders." 7 The 1940 Act addresses this problem by establishing that the investment advisers and the board of directors of a fund have a fiduciary obligation to the investors of the fund. The composition of the board is further restricted by the 1940 Act to enhance its independence from sponsoring organizations or other "interested parties." Furthermore, shareholders must approve all management contracts. The 1940 Act also requires investment companies to provide semiannual statements to investors and empowers the SEC to establish appropriate accounting standards. The SEC is authorized to regulate all sales literature and advertisements of investment companies.

The Investment Advisers Act of 1940 . The investment adviser is the key provider of services to a mutual fund. The Advisers Act requires that investment advisers register with the SEC. However, banks (though not bank affiliates) acting as investment advisers to mutual funds are explicitly exempted from these provisions. The Advisers Act also imposes restrictions on the contracts that mutual funds enter into with their advisers. These provisions, which apply to banks as well as nonbank advisers, require that the terms of the agreement not exceed two years, that a majority of outside directors approve all renewals, and that the contract may be terminated, without penalty, by the fund at any time with 60 days' notice.

The Internal Revenue Act. Mutual funds can avoid a direct income tax assessment and pass taxable income and capital gains through to the fund's investors. Subchapter M of the Internal Revenue Code defines a series of tests that a mutual fund must pass in order to qualify as a "regulated investment company" (RIC). The failure of a mutual fund to meet all of the following requirements would result in an onerous tax obligation:

  • The mutual fund must be registered under the 1940 Act for the entire taxable year.

  • At least 90 percent of the RIC's gross income must be derived from dividends, interest, gains on sales of securities, and other qualifying income from investments in securities. Examples of non-qualifying income would include income derived from partnerships investing in real estate or oil drilling leases.

  • Less than 30 percent of a RIC's gross income may be derived from the sale of instruments held less than three months.

  • At the end of each quarter, at least 50 percent of the RIC's portfolio must consist of cash, cash items, U.S. Government securities, securities of other RICs and other securities in which no one issuer's securities will exceed five percent of the RIC's assets and no more than ten percent of any issuer's outstanding voting securities are held by the RIC.

  • At least 90 percent of the RIC's income must be distributed to the investors.
Blue Sky Laws. States have authority, subject to the primacy of federal laws, to regulate the securities activities that occur within their respective borders. Mutual funds must register, and pay filing fees, with the state securities agency in each of the 50 states, Puerto Rico and the District of Columbia, in which the fund will be distributed. Because there are variances in the procedures followed by each of the 52 jurisdictions, Blue Sky law compliance can be complicated. 8


When the Investment Company Act of 1940 was enacted, the mutual fund industry consisted of 296,000 shareholder accounts investing in portfolios with an aggregate asset value of $448 million. 9 In contrast, FDIC-insured commercial and savings banks held combined assets of $72.7 billion, 10 or 162 times the assets held by the mutual fund industry. By year-end 1994, mutual funds held assets of $2.16 trillion, 11 while commercial and savings banks held assets of $4.01 trillion. 12 The growth of the two industries is shown in Figures 1A and 1B.

As shown in Figures 1A and 1B, the mutual fund industry has grown rapidly during the past 15 years. Figure 2 indicates that the intensity of some of the periods of growth can be explained by contemporary market conditions.

The bull market of the 1960s contributed to the run up in mutual fund assets. At the start of the 1960s, mutual funds held about $16 billion in assets. By the late 1960s, mutual fund assets exceeded $47 billion, a threefold increase. Mutual fund assets hit a temporary peak of $59.8 billion at year-end 1972. However, the effects of a prolonged bear market caught up with the industry, and the value of assets under management declined to $34.1 billion by year-end 1974. Although traditional (equity and bond) funds gradually began to increase in value the following year, they did not regain their asset level of 1972 until 1982. However, 1974 also marks the first year in which money-market mutual funds, first launched in 1971, 13 surpassed $1 billion in assets.

Money-market mutual funds invest in high-quality, short-term instruments. The 1940 Act imposes a series of tests on a fund portfolio to assure that standards of quality and liquidity are met. Funds that meet the standards are allowed to call themselves money-market mutual funds and to use the daily increase in portfolio value to issue new shares to investors such that the fund's net asset value is maintained at $1.00 per share. Because of the apparent safety of the portfolio, many investors view money-market mutual funds as a substitute for bank deposits. This attitude was reinforced when Merrill Lynch in 1977 introduced its "Cash Management Account," which allowed money-market account holders to withdraw their funds by writing a check, now a standard feature of retail-oriented money-market funds.

The rapid public acceptance of money-market funds may be explained by the previously imposed constraints on the ability of commercial banks and thrifts to provide their customers with alternative products that earned a market rate of interest. In 1933, the Federal Reserve Board was given authority to restrict the interest rates that member banks were permitted to pay depositors. These restrictions were codified in Regulation Q of the Federal Reserve Act. Authority to impose restrictions on nonmember banks was extended to the FDIC in 1935.

Until the late 1960s, market interest rates never exceeded the savings rates that regulators permitted banks to offer for time deposits. However, when Regulation Q became a binding constraint, the market created pressure for an alternative savings vehicle to develop. Ironically, the first move to relax Regulation Q helped to spur the development of money-market mutual funds. In 1970, the Penn Central Railroad became the first major firm to default on its commercial paper. Fearful that investors would abandon the market, and that commercial banks would not have the liquidity to provide bank loans to firms trying to refinance their short-term debt, the Federal Reserve Board removed interest-rate restrictions on certificates of deposit greater than $100,000. Although this easing of Regulation Q enabled banks to serve institutional and wealthy investors adequately, the retail investor was left without any means to earn market rates.

Figure 3 shows that in their early years of existence, money-market mutual funds held a large percentage of their investment portfolios in bank deposits. This represented an opportunity on their part to intermediate between banks and bank customers, thereby offering the latter the ability to aggregate funds and receive market rates. As money-market funds became established, direct investment in commercial paper became an increasing proportion of their portfolios, and bank instruments became less important.

As the 1970s ended, interest rates were still rising and money-market funds had grown to $45 billion. This movement of funds from the banking sector to the mutual fund industry was termed disintermediation, although a more appropriate term may have been redesigned-intermediation because depositors were using alternative channels of intermediation rather than directly financing commercial enterprises. Money-market funds function as intermediaries by bringing together entities with excess funds and entities in need of funds. Further, liquidity is provided to savers through the law of large numbers. That is because on an average day the amount of invested funds redeemed by savers is largely offset by the amount of additional funds invested by savers with new temporary surpluses. As intermediaries, mutual funds differ from banks by passing more risks back to investors. In particular, banks shield insured depositors from the credit risk associated with lending. Mutual funds, of course, pass on any changes in value, whether caused by changes in credit quality or interest-rate movements, directly to the investors.

As vehicles for bringing a class of short-term borrowers (those entities with access to the commercial paper market) and short-term investors together, money-market funds have certain advantages over banks. Although both intermediaries are highly regulated, the regulatory costs imposed on bank intermediation include variable costs. Specifically, banks are assessed reserve requirements and deposit insurance premiums on each additional dollar of deposits. In contrast, each additional dollar invested in a money-market fund can be used in full to purchase money-market instruments.

These efficiencies, combined with a possible increase in investors' willingness to bear risk, contributed to the growing acceptance of money-market mutual funds. However, a nascent industry faced at least two significant obstacles. The first was a need to attain investor confidence; the second was the development cost of the systems and infrastructure necessary to support the operations of a money-market fund. Regulation Q provided large returns to savers switching from bank products. Such returns may have been necessary to overcome depositors' concerns about the increased risk of the new intermediation channel. A large potential market, consisting of all retail bank depositors, thus existed to justify the early development costs incurred by money-market funds.

Congress responded to the reduction in bank deposits by passing the Depository Institutions Deregulation and Monetary Control Act of 1980, which mandated the gradual elimination of Regulation Q ceilings. In the interim, money-market fund assets grew rapidly. During 1980, money-market funds nearly doubled in size to $74.5 billion. In the following year they more than doubled to $181.9 billion. The Garn-St Germain Depository Institutions Act of 1982 enabled banks and thrifts to offer deposit accounts with attributes similar to money-market funds. However, the money-market fund had already become an important component of the financial system. Growth in these funds stabilized as banks were able to retain their depositors, albeit at a higher cost than prior to deregulation. Subsequent growth in assets under management by money-market funds has been related to periods characterized by high short-term interest rates, as shown in Figure 4.

A new product was introduced in 1976: money-market funds that invest only in short-term municipal obligations. The earnings received by investors in such accounts are therefore exempt from federal income taxes. These funds, which first reached an appreciable asset size in 1979, have grown at a stable pace, with one exception. In 1986, the assets held by tax-exempt money-market funds increased from $36.3 billion to $63.8 billion. That jump can probably be explained by the passage of the Tax Reform Act of 1986, which ended the preferential tax treatment conferred on many other types of investments.

The bull market of the 1980s was favorable to long-term mutual funds. The assets of mutual funds and money-market funds totaled $94.5 billion at the start of the decade. This equaled 5.1 percent of the $1.839 trillion in assets held by FDIC-insured commercial banks and mutual savings banks at that time. By year-end 1989, total mutual fund assets had grown tenfold to $982 billion, or 27.4 percent of the $3.579 trillion in assets held then by the banking industry. During the next four years, mutual fund assets more than doubled to $2.075 trillion. This represented 56 percent of the $3.706 trillion in assets held by BIF-member 14 depository institutions at year-end 1993.

On seven occasions during 1994 the Federal Reserve Board increased short-term interest rates. Secondary market prices of previously issued bonds fell, thus creating losses for mutual funds that held those instruments. This, in turn, led to investor redemptions, which caused assets held by the mutual fund industry to decrease even more. The stock market also performed poorly, resulting in losses or disappointing returns to investors in mutual funds that held equities. Furthermore, the attractiveness of bank deposits relative to mutual fund investments improved as CD rates increased and investors experienced the riskiness of mutual fund investments. By year-end 1994, mutual fund assets had increased by only $86.1 billion, the smallest annual increase since 1983, the last year in which assets under management declined. The mutual fund industry entered 1995 with a total of $2.162 trillion in assets, or 53.9 percent of the $4.010 trillion in assets held in BIF-member depository institutions.

Bank Involvement in the Mutual Fund Industry

Mutual funds are unusual among business enterprises in that they seldom have any direct employees. Instead, a fund is created with a board of directors (or trustees) that is responsible for contracting out a variety of functions to other entities. Some of these functions, such as fund attorney, are not appropriate for a bank organization to perform. Furthermore, banks are prohibited by Glass-Steagall restrictions from performing the functions of the fund underwriter. 15

However, there are several ways in which banks and bank holding companies are able to participate in the mutual fund industry. Banking organizations were first authorized by the Federal Reserve Board to become directly involved in mutual fund operations in 1972, the year in which mutual fund assets peaked. The authorization permitted holding companies to act as transfer agents, custodians, and investment advisers for mutual funds, subject to various restrictions. Over time, additional interpretations by bank regulators have relaxed many of those initial restrictions. 16 As the mutual fund industry developed into a major vehicle for financial intermediation, bank involvement with the industry grew. The most visible way is through sales of mutual funds to bank customers. Banks have become a significant component of the distribution channel.

Banks as Transfer Agents. Transfer agents maintain the records concerning customer accounts. They record purchase and redemption transactions and disburse payments of dividends, interest and capital gain distributions. They prepare confirmation notices of all investor transactions and report year-end tax and withholding information to the Internal Revenue Service. Banks and bank holding companies may be transfer agents for mutual funds as well as for other incorporated businesses.

Transfer agents must register with the appropriate regulatory agency as defined in the Securities Exchange Act of 1934. 17 Banks and subsidiaries of banks register with their primary federal regulator. 18 Transfer agencies that are subsidiaries of bank holding companies register with the Federal Reserve Board. All other transfer agents, including thrifts and subsidiaries of thrifts, must register with the SEC. When a bank is transfer agent for a proprietary fund, 19 the investment adviser may not maintain time deposits with affiliated banks and must keep the fund's transaction balances with affiliated banks at minimal levels.

Transfer agents may subcontract a portion of their activities to a shareholder servicer. This sub-agent handles the aspects of the service that most closely interface with the investor, for example, preparing regular statements or answering telephone inquiries. The shareholder servicing agent generally will be compensated based on a formula that incorporates the number of shareholders serviced and the amount of activity that occurs. 20 In 1986, the Federal Reserve Board explicitly permitted bank holding companies to receive fees for shareholder servicing. 21 The FDIC permitted state-chartered nonmember banks to conduct certain shareholder services in 1989. 22

A 1994 survey 23 of banks with proprietary funds indicated that approximately 29 percent were acting as their own transfer agent and an additional five percent were planning to do so. This same survey indicated that approximately 58 percent of the banks with proprietary funds performed shareholder servicing functions for their funds and an additional four percent were planning to do so. However, another analysis, which was conducted in March 1994, concluded that 65 of the 103 banks that offered proprietary funds to retail customers used affiliated transfer agents. 24

Banks as Custodians. Fund custodians execute the portfolio transactions that are directed by the investment adviser. They provide safekeeping of securities; monitor events that affect the portfolio's securities such as splits, calls and tenders; report on cash balances and provide cash projections for the fund; and keep the investment adviser informed about changes in foreign and domestic tax laws or market practices that could affect the investment practices of the fund.

Although the 1940 Act permits funds to use banks, national securities exchange members, or the fund itself as custodian, the requirements of SEC rule 17f-1 are so strict that most custody is performed by banks. 25 Of the ten largest custodians 26 in 1993, only one, Brown Brothers Harriman, is not a bank. The eighth largest, Putnam Fiduciary Trust, is a chartered commercial bank, but it performs little or no traditional banking activity. The largest custodian, State Street Bank and Trust, acted as custodian for 1,704 funds with combined assets under management of $407.5 billion. The second-largest custodian, Chase Manhattan Bank, was custodian for 154 funds with combined assets of $173.9 billion.

In 1994, nearly 50 percent of the banks with proprietary funds acted as their own custodian and another 25 percent had plans to do so. 27 In March 1995, 53 of the 103 banks that offered proprietary funds to retail customers used affiliated custodians. 28

Banks as Investment Advisers. The most important functionary of a mutual fund is the investment adviser. This is also the function that offers the highest potential earnings within a mutual fund. An investment adviser is responsible for managing the investment portfolio in order to attain the greatest return consistent with the investment strategy established by the board of directors. Investment advisers in traditional fund structures would also perform such administrative functions as filing all required documents; providing accounting, data processing and clerical services; preparing financial statements; and coordinating the relationships among the various other entities, for example, transfer agents and legal counsel operating the funds. However, bank-sponsored funds often contract out the administrative tasks to a third party who acts as fund administrator.

Investment adviser fees are detailed in a contract that is reviewed annually by the board of directors. Generally, fees constitute a percentage of the funds under management; however, due to scale economies in portfolio management, contracts often will specify diminishing rates as the fund reaches specified levels. Performance incentives, and in some cases penalties, are also included in many advisory contracts. Bank revenues 29 from investment advisory activities grew steadily from $175 million in 1989 to about $450 million in 1993. In just the first three quarters of 1994, those revenues doubled to approximately $900 million. The growth is accounted for by both the increase in the size of bank proprietary funds and an increase in the percentage of such funds that was held in long-term funds, which provide higher management fees to the investment adviser.

Bank Distribution Channel. The most visible way in which banks have participated in the growth of mutual funds has been through the sale of mutual funds to bank customers and on bank premises. In 1991, 13 percent of all long-term fund sales occurred through banks. The bank share was 12.7 percent in 1992 and then increased to 14 percent in 1993. In absolute terms, banks sold $28.1 billion of long-term mutual funds in 1991, $43.8 billion in 1992, and $67.5 billion in 1993. 30 (An alternative estimate 31 indicates that bank sales of long-term mutual funds represented four percent of the market in 1992, eight percent in 1993 and nine percent in 1994.) Banks account for a larger percentage of money-market fund sales. In 1991, they accounted for 22.4 percent of all sales of short-term funds. This market share grew to 26.8 percent in 1992 and 28.7 percent in 1993. In absolute terms, banks sold $122.8 billion of money-market funds in 1991, $149.8 billion in 1992 and $165.9 billion in 1993. This pattern of sales indicates that banks are becoming more diverse in the types of funds that they sell. In 1991, 77 percent of the funds sold through banks were money-market funds; by 1993, this percentage had declined to 56 percent.

There are three basic ways in which a bank can offer mutual funds to its customers. The methods, in increasing order of complexity, are to offer third-party funds, private label funds, or proprietary funds. In addition, the bank must decide who will be making the actual sales presentation. The options are to use bank employees, employees of a broker/dealer affiliate or subsidiary, employees of an outside broker/dealer, or some combination thereof.

When a bank offers third-party funds, for example, funds sponsored by Fidelity, it receives a fee or commission. However, the bank may sacrifice any ongoing benefits from that customer's savings. In fact, the fund will communicate directly with the investor, potentially eroding the customer's ties with the bank.

A bank that wishes to maintain an identity with the customers buying funds may choose to establish a private label arrangement. In these arrangements, the sponsor creates a fund (or a group of funds) with a name that may be associated with the bank that will be selling the fund's shares. The bank, depending on its operational capacity, may perform some of the functions required of the fund, such as transfer agent or shareholder servicing agent. Communications between the fund and the customer may be tailored to enhance the connection between the bank and the customer. While this type of arrangement maintains the bank's relationship with its customers, it limits the financial benefits that the bank could reap from providing full services to the fund.

The establishment of a proprietary fund is an option available to banks that wish to retain the maximum benefit of providing mutual funds to their customers. In these arrangements, the bank, or an affiliate, becomes the investment adviser. Depending on the extent to which the bank felt it could perform specialized functions, the bank or its affiliates could also become fund administrator, custodian or transfer agent.

However, the formation of a new mutual fund involves considerable expense. According to one estimate 32 of the start-up costs, legal fees alone can range from $25,000 to $350,000 for a single bank-sponsored fund. In addition, the SEC and state securities commissions charge filing fees for registering the fund and its securities. A standard rule of thumb has been that a bond or equity fund had to exceed $100 million in assets in order to attain the economies of scale necessary to compete with other funds. Many observers believe that this threshold has increased during the past few years; however, there is no general consensus on what the new minimum level should be. 33

In order to attain the threshold level quickly, many banks have looked to their trust departments. Trust departments manage funds for individuals and institutional customers. Some of the investments are placed in collective investment funds (CIFs), which are managed in a manner similar to a mutual fund. Many banks have converted CIFs into proprietary mutual funds. Most of these conversions have occurred with CIFs holding funds for employee benefit plans because, in these cases only, there is no capital gains tax consequence.

Banks have been willing to incur the administrative costs of converting CIFs for several reasons. 34 First, trust departments are restricted from assessing fees on CIFs. However, mutual funds generate a variety of fees, including fees paid to the investment advisers, transfer agents, and custodians, some or all of whom may be affiliated with the bank. Second, mutual funds may advertise, subject to regulations of the NASD. CIFs, except for those restricted to employee benefit accounts, are prohibited from advertising performance results. Finally, mutual funds may receive investment funds from the public as well as from trust department customers. A fund may even issue a variety of "classes" of shares with different fee structures and balance and transaction minimums which are each targeted to different groups of potential customers. CIFs, however, are restricted from receiving personal funds that are not part of a fiduciary trust account. Furthermore, each CIF is restricted to investing funds from personal trusts or from agency accounts, increasing the difficulty of growing to take advantage of scale economies.

Trust department customers may also benefit from having funds invested in mutual funds rather than CIFs. First, the customer will be able to track the performance of the fund in the daily newspaper, and be better able to compare the performance with alternative funds. Also, distributions to beneficiaries of the trust funds in CIFs must be made in cash. Trust funds invested in mutual funds may make "in kind" distributions with mutual fund shares. In some cases, the recipients of these distributions will have more flexibility to time the realization of capital gains.

A 1995 study 35 estimates that, excluding the Dreyfus funds now managed by Mellon Bank, 60 percent of the bank-managed fund assets (75 percent of the assets managed by the ten banks with the largest portfolios) originated as trust department conversions. The U.S. General Accounting Office derived a different estimate of the level of trust conversions by assuming that any time a bank proprietary fund was launched with a large amount of assets, the funds came from converted trust accounts. Although this method fails to capture conversions of trust assets into already existing proprietary funds, trends can be discerned from Table 1.

Table 1
Estimated Trust Conversions ($ Millions)

                                                Long-Term Fund 
         Money-                                 as a Percent of
         Market     Long-Term      Total             Total
Year     Funds        Funds     Conversions       Conversions
1985     $  178     $      0     $    178                0%
1986        915           20          935                2
1987      2,128           55        2,183                3
1988      2,552        1,340        3,892               34
1989      2,056        1,024        3,080               33
1990        773          640        1,413               45
1991        802        2,123        2,925               73
1992      2,696        6,624        9,320               71
TOTAL   $12,100      $11,826      $23,926               49%
Source: Lipper Analytical Services as reported by U.S. General Accounting Office Trust Assets: Investment of Trust Assets in Bank Proprietary Mutual Funds.

By 1988, as banks started to expand their fund offerings, bond and equity portfolios in trust departments became significant sources of assets for conversion into mutual funds. According to one 1994 study of proprietary funds, 36 trust conversions accounted for approximately 30 percent of the new money that flowed into bank proprietary funds in 1992. The following year, trust conversions accounted for only about 15 percent of the total. Proprietary funds represent a growing proportion of mutual fund sales at banks. By 1985, 25 banks 37 had established proprietary mutual funds. At year-end 1994, 119 banks were offering proprietary funds. 38 One survey 39 indicated that in 1991, 44.7 percent of bank mutual fund sales involved proprietary funds. This percentage dipped to 40.6 percent in 1992, but grew to 48.7 percent in 1993. The drop in 1992 may have been due to the relatively modest growth industry-wide in money-market mutual funds at a time when long-term funds were growing quickly. At that time, bank proprietary funds were mostly represented by short-term funds.

In 1990, banks sponsored 517 mutual funds 40 (16 percent of the funds offered industry-wide), of which 252 (49 percent) were money-market funds. These 517 funds held $85.9 billion in assets (eight percent of the industry total), of which $73 billion, or 85 percent, were in money-market funds. By 1992, banks sponsored 892 funds (20 percent of the industry total), of which 377 (42 percent) were money-market funds. These 892 funds held $158.8 billion (ten percent of the industry), of which $111 billion, or 70 percent, were in money-market funds. As of March 1995, banks sponsored 2,208 funds (28 percent of the industry), of which 578 (26 percent) were money-market funds. These 2,208 funds held $327.7 billion in assets (15 percent of the industry), of which $189.2 billion, or 58 percent, were money-market funds. Not only are bank proprietary funds a growing segment of the mutual fund industry, but banks also are sponsoring a growing variety of fund types, and managing increasingly-diverse portfolios.

It is too soon to evaluate the long-term importance and profitability to the banking industry of the sale of mutual funds. The outcome will depend on how efficiently banks are able to provide services and products relative to alternative sources. In order to thrive, individual banks may need to establish a national presence for their mutual fund programs so that they can better realize scale economies. Opportunities to consolidate mutual fund operations will act as an additional incentive to the consolidation that is occurring within the banking industry and that is expected to continue as full interstate banking becomes a reality. In addition, further innovations in the structure and administration of bank proprietary mutual funds should occur as each firm finds its place in the mutual fund world.

Market Share by the Numbers

A review of the literature on bank involvement in the mutual fund industry quickly reveals a lack of agreement on the extent of bank penetration of the market. The apparent discrepancies are caused by differing methodologies and different definitions of bank sales.

Since 1994, all banks and savings-and-loan associations have been required to report the volumes of mutual fund and annuity sales as part of the quarterly Report of Condition and Income (Call Reports). A comparison of some of the definitions described in the Call Report instruction manual 1 with the definitions used in other studies explains some of the variations in reported results.

Call Report totals differ from many other data sources because participation is compulsory. Many figures cited in the accompanying article are derived from surveys taken among willing participants. As such, they necessarily represent less than the full universe of banks participating in the market. Mutual funds are similarly compelled to file regular reports with the SEC on portfolio size and composition.


Some analysts classify all funds in which the investment adviser is a bank or bank affiliate as "bank related." Although this method yields useful results, some sources of conflict with other estimates will occur. First, sales at banks of third-party funds are not included in the analysis. Similarly, sales of bank-related funds that take place through other channels, such as third-party distributors, are included. In addition, the fund sponsor is not always clearly identified. For example, if an independent mutual fund sponsor offered a fund that only held municipal bonds issued within one state (so that investor income would be tax-exempt at both the federal level and state level for residents of that state), it might utilize a leading local bank's specialized knowledge of the area by selecting it to be the investment adviser. 2

Unfortunately, some classification problems exist among the banks filing Call Reports. For example, an informal survey of several banks with proprietary funds determined that Mellon Bank has included all of the fund sales made by its Dreyfus affiliate in the sales total. 3 However, Chase Manhattan Bank and other banks with proprietary funds that are sold outside of the bank's own channel reported only the portion of the fund's sales that occurred on the bank's premises or to the bank's customers. As inconsistencies across reporting banks are discovered, the Call Report instructions may be modified to ensure uniformity. However, as bank involvement in the mutual fund industry develops, innovations and changes in fund structures and distribution systems may make it increasingly difficult to precisely define banks' sales volume.

Flows vs. Stocks

The Call Report requires quarterly data on the level of fund sales (a flow). However, banks do not report on the volume of funds under management (a stock). The SEC filings report asset levels. Changes in portfolio size across reporting periods can be attributed to several factors, including: sales; redemptions; fund performance; expenses; levels of investor reinvestment of earnings; and the purchase of, or merger with, another fund. Measurements of bank involvement in the mutual fund industry based on market share of new sales will not necessarily move in tandem with measurements of the percentage of mutual fund assets managed by bank-related entities.

Sales Charges

Many mutual funds, and most of the funds sold through banks, are sold with an associated sales charge or "load." In the case of "front loaded" funds, the charge, which is used to pay sales commissions and marketing expenses, is taken at the time of sale. In the case of "back loads" (contingent deferred sales charges), charges are taken out of the fund over time and when the funds are withdrawn. The Investment Company Institute (ICI) requires that its members report sales figures net of front loads, but without adjustment for back loads. The Call Report instructions are silent on whether to report sales net of charges. Large institutions that have proprietary funds that have been reporting to the ICI appear to have applied the same method when reporting on the Call Report. However, it is not clear whether all banks are calculating sales in the same manner.

Exchanges and Reinvestments

Many mutual fund families permit investors to open several funds with differing investment strategies. The investor is then permitted to transfer money among these funds without incurring new sales charges. Also, most mutual funds permit investors to automatically reinvest earnings and capital gains distributions. Mutual fund companies provide the ICI with separate figures for sales, redemptions, exchanges, and reinvested earnings. However, banks are instructed to include reinvestments and exchanges in the Call Report sales totals.

Money-Market Sales

It is more difficult to define a money-market sale than to define the sale of a long-term fund. Many investors treat money-market funds like a transaction account, increasing and decreasing the balance frequently during reporting periods. This is especially true in the commercial bank environment where many commercial customers have arrangements with the bank to sweep excess funds from a non-interest-bearing transaction account into a money-market fund at the end of each day. The funds are then restored to the transaction account the next morning. Banks are instructed to report the daily average of these sweeps during the quarter, rather than the aggregate amount of all funds swept during the quarter. This procedure, if correctly followed, would reflect fairly the activity over a reporting period. However, the same activity would also be reported in each subsequent quarter, thus producing an inflated impression of the sales volume over a year.

Reported Sales Volume

The Call Report requires that banks report separate sales volumes for money-market mutual funds, equity mutual funds, bond mutual funds, all other mutual funds (for example, balanced funds that include debt instruments and equities), and annuities. As of 1995, banks must report the aggregated total of sales of proprietary products among those sales. Results are as follows:

Bank and Thrift Sales of Mutual Funds ($ in Thousands)

Quarter           Funds           Equity          Bond            Other       Proprietary  4 
Q1, 94        $109,731,971     $4,576,083     $ 3,361,389      $1,457,198         N/A
Q2, 94          93,392,669      3,185,274       3,486,109       1,484,284         N/A
Q3, 94         131,191,366      4,975,811       3,085,619       3,464,703         N/A
Q4, 94         146,237,577      3,923,607       3,733,798       3,066,925         N/A
Q1, 95         140,154,679      4,156,618       3,401,001       1,470,019     $117,087,618
Q2, 95         164,355,672      5,354,626       3,183,745       1,109,702      146,443,097


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