Although banks are moving rapidly into the mutual funds market - and with greater success than ever - I hope the surge won't prove detrimental to the banking industry's greatest competitive edge: its core customer franchise.
I also hope it doesn't lead to the creation of a supplemental (rather than complementary) cost structure that could involve a complex restructuring when the markets turn south.
Federal Reserve Chairman Alan Greenspan helped save the U.S. banking industry through management of short-term interest rates. There was, however, a price to be paid: Savers provided a massive subsidy for the cleanup of banks' problem assets.
Yet during the early 1980s, they were conditioned to rely on the cash flow associated with high interest rates to fund their day-to-day needs. In our current world of 2% to 3% savings rates, core customers have been forced to disintermediate from their traditional deposit home - the banks.
Long-Term Trend
This merely reflects an acceleration of a long-term trend. In 1983, bank time deposits and mutual fund assets totaled $1.8 trillion, with banks holding an 84% share. By March of this year, the market had grown to $3.75 trillion, but the banks controlled just a little over 50%.
Banks faced the dilemma of "getting on the boat" or losing the funds to outsiders and, because of low credit demand, were awash with liquidity from core deposits.
Working first with mutual fund companies as third-party providers and later through sales of proprietary funds, banks have amassed a 10% to 15% share of mutual fund holdings. In the year ended June 30, bank propriety funds grew 36%, far out-pacing the 23% for overall fund growth.
Do Customers Know the Risks?
There are, nonetheless, risks associated with this foray into fund sales.
Do bank customers truly understand the risk to their principal associated with their investments? However much bank sales staff insist they are explaining risk, I remain unconvinced.
Perhaps the strongest competitive advantage of banks has been customer inertia. Over 60% of small-business owners (sales less than $5 million) have similar long-term relationships. These relatively unsophisticated customers have always relied on the protection of principal (legal through Federal Deposit Insurance Corp. insurance, and de facto in bank failures).
In chasing current bond and stock fund yields, I believe that customers have implicitly - not consciously - taken on market and principal risk.
Chain Reaction
When rates rise, bond fund principal will be lost, and equity markets will drop from current high valuations. At that point, there are going to be a lot of angry bank consumers and small-business owners. They are a different type of investor than traditional mutual fund purchasers, being more reliant on cash flow from their savings.
It's true that bank funds are still dominated by less interest-sensitive money market funds (over two-thirds of bank-managed funds, as estimated by Lipper Analytical Services), yet that still leaves $29 billion in equities and $24 billion in fixed-income funds under bank management - a source of significant down-side potential for customers.
Meanwhile, I am convinced that the banks are creating an incremental cost structure driven by the top of the market (in terms of trading/purchase volumes) that will be hard to dismantle in a downturn.
For example, there are three approaches to fund sales that banks have taken: (1) creating new, supplemental costs in a dedicated fund sales force for proprietary funds; (2) selling such funds through their traditional platform staff, and (3) retaining a "variablized" cost structure by selling through the staff of third-party providers.
Each approach has its pros and cons. The first maximizes returns from funds and keeps a distinct cost structure that can be taken down (a la brokerage houses) when volumes decline. The second takes the full return and can appear to achieve economies of marketing expense through "piggybacking" off existing sales resources - but at the expense of complexity in terms of future downsizing.
Dismantling the Structure
The third gives up return to the third-party supplier, but if the relationship is properly structured it is the easiest to unwind and may offer some protection against customer anger and franchise erosion.
Moreover, many banks are creating a new back-office cost structure to service fund sales and management. This may consist of distinct, severable expenses, or a "band-aid" adjustment to existing systems. The concern about dismantling these costs in a market downturn also arises here.
While banks have faced the dilemma of either accepting core deposit runoff or jumping on the mutual fund bandwagon, I do not think they have properly weighed the risks I have outlined. I am nonetheless confident that there is a role for banks in these markets but that it must be properly structured:
* Sales force management: Many bank purchasers of mutual funds are unsophisticated market investors and need exceptional sales guidance in understanding principal risk. If not properly structured, volume targets and incentives for sales staff may run counter to this responsibility.
* Customer portfolio management: Linked to sales force management is a premium that should be placed on helping customers with timing and stop-loss management.
* Cost management: Banks should be planning how structure the incremental costs of mutual funds marketing, research, and back-office support in the event of a market pull-back.
It would be fortunate if the new investment products' cost structures became another "loss leader" for the banks (perhaps like discount brokerage costs in the mid 1980s).
* Proprietary/third-party fund balance: To satisfy each of these points, an explicit decision on the tradeoffs of return/risk from the balance of proprietary and third-party funds needs to be made.
