For almost a decade, commercial banks have been active in the management and sale of mutual funds.
In the retail market, mutual funds represent the most visible involvement of banks in the management of investment risk and reward.
How has the industry fared? Looking back over this experience, four themes stand out:
Loss of share of wallet. Mutual funds are growing at the expense of the banks' deposit base. And despite the growth of bank-sponsored funds, nonbank mutual funds continue to dominate the market. It appears that consumers are looking for better reward than they can get from bank deposits, and they are skeptical of banks' ability to manage equity or bond investments.
Franchise risk. The business and regulatory factors integral to retaining client assets in the form of mutual funds can stretch banks beyond their resources if they are not attuned to the business. Certainly, mutual funds pose a much stronger franchise risk than traditional deposit taking.
Portfolio management risk. In 1994, extraordinary losses associated with structured notes and derivative investments showed that banks, not investors, may have to bear losses from portfolio risk. This risk has emerged as a critical concern requiring attention, rigorous controls, and strong management oversight.
Need to control sales practices. Banks seem to be held to a higher standard of care with respect to sales practices than are broker-dealers and fund companies - by the press, the public, politicians, and regulators.
The higher standard reflects a perception that banks hold to solid business ethics. If this strong ethical standard is emphasized properly, it could become a positive force in the marketplace. Nonetheless, sales practice risk has become part of the banking landscape and a concern of regulators.
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The verdict on banks' performance in the mutual fund marketplace is unpleasant: low reward and higher-than-expected risk.
For bank management, recapturing consumer assets is an imperative. Given the popularity of mutual funds, this imperative translates into a need to gather and retain fund assets much more aggressively than before.
Successfully implementing the management of portfolio and sales-practice risk is difficult. Devoting attention and risk management resources for a business effort in its early phases of growth and profitability is a hard sell to senior management.
In addition, the risk management and compliance skills for mutual funds differ significantly from other risk management and compliance functions in banking.
Further complicating the picture is the fact that the mutual fund industry is highly competitive, both on the portfolio side and on the sales side.
If risk management is too heavy-handed, it may stifle the initiatives and undermine success, leading to accelerated loss of share of wallet.
But if risk management is too lax, banks are likely to face lawsuits, capital contributions, increased regulatory scrutiny, and adverse publicity - situations that pose serious franchise risks.
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Progressive bankers are beginning to resolve this dilemma by deciding that they must learn to live with - and indeed succeed with - mutual funds. Their questions are no longer whether to commit skills and resources to the mutual fund industry, but how.
There is no cookbook that provides a simple, foolproof method for success in aggressively building a bank mutual fund practice and cost- effectively managing the risks.
Indeed, our experience is that each bank must find a path to success that reflects its own culture, client base, and core skills.
Nonetheless, we can provide a framework for a customer- and business- focused approach to investment risk and reward management. The core of the approach we will outline in the next installment is based on product reliability.
Product reliability is more than compliance. Compliance, however, should not be underestimated, as it is a large component of our framework for designing and implementing reliable products.
Bank mutual fund companies have tended to follow industry practice or convention in developing portfolio compliance programs:
*Portfolio managers are given basic training in compliance.
*Counsel drafts a prospectus entry describing the fund's investment objectives and restrictions.
*Marketing drafts sales language.
*Fund accountants, administrators, or compliance staff periodically review the holdings, and from time to time ask the portfolio managers about compliance conditions.
*Portfolios undergo periodic, independent peer review for compliance.
This approach, when properly implemented, generally results in funds that are in compliance, but these controls are not constructed to detect out-of-the-ordinary or new product structures, such as structured notes and complex hedging transactions. Moreover, these processes do little to ensure product reliability.
Next: Product reliability
Ms. Binstock is national director of the investment management regulatory consulting practice and Mr. Marshall is national director of the bank mutual fund practice at Ernst & Young in New York.
