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
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
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
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
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
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
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.
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
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
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.
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
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 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
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 Estimated Trust Conversions ($ Millions)
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
1994 study of proprietary funds, 36 trust conversions
accounted for approximately 30 percent of the new money that flowed into bank proprietary
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
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
fund sales involved proprietary funds. This percentage dipped to 40.6 percent in 1992, but grew
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
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
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
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
(26 percent) were money-market funds. These 2,208 funds held $327.7 billion in assets (15
of the industry), of which $189.2 billion, or 58 percent, were money-market funds. Not only are
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
of mutual funds. The outcome will depend on how efficiently banks are able to provide services
products relative to alternative sources. In order to thrive, individual banks may need to establish
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
Market Share by the Numbers
A review of the literature on bank involvement in the mutual fund industry quickly reveals a lack
agreement on the extent of bank penetration of the market. The apparent discrepancies are
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
mutual fund and annuity sales as part of the quarterly Report of Condition and Income (Call
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
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
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,
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
an informal survey of several banks with proprietary funds determined that Mellon Bank has
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
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,
Call Report instructions may be modified to ensure uniformity. However, as bank involvement in
mutual fund industry develops, innovations and changes in fund structures and distribution
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
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
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
of the percentage of mutual fund assets managed by bank-related entities.
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
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
have been reporting to the ICI appear to have applied the same method when reporting on the
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
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.
It is more difficult to define a money-market sale than to define the sale of a long-term fund.
investors treat money-market funds like a transaction account, increasing and decreasing the
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
non-interest-bearing transaction account into a money-market fund at the end of each day. The
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
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,
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
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
total of sales of proprietary products among those sales. Results are as follows:
Bank and Thrift Sales of Mutual Funds ($ in Thousands)