Bankers who have been pushing mutual funds to their customers are nervously watching interest rates.

When rates climb, as they must eventually, customers could see big declines in the net asset value of their government and municipal bond investments.

Fear of Losses

Bond funds are far and away the most popular fund investments sold through banks. They are deemed more conservative than equity funds, and therefore more appropriate for cautious bank depositors who have moved out of low-return certificates of deposit.

Though the erosion of principal in the fixed-income funds is likely to be short-lived, it nevertheless will be a new and unnerving experience for risk-averse savers, bankers fear.

"Everybody's willing to take a risk until they lose," said David J. Cariseo, vice president of Citibank Global Asset Management "At the end of the day, everyone will say their No. 1 priority is protecting principal."

Bankers' worries go beyond angry customers. Though most say they have taken pains to inform their customers of the risks of all uninsured investments, they are subject to regulatory scrutiny and could even be charged with failing to supervise their sales forces.

"We're in an environment where we're encouraging disintermediation," said Robert Kurucza, a partner with the Washington law firm Morrison & Foerster. "I suspect a number of customers don't really understand the nature of the product they're getting into."

Fund officials are already saying the fault lies not so much with the sellers as the buyers.

|Dumb Decisions'

"All of our folks are trained to give the no-free-lunch presentation. But customers are so hungry for yield now that they're making dumb decisions," said a mutual fund executive attending a recent industry convention. The executive requested anonymity.

For banks, however, the blame game is irrelevant. Any loss of customer confidence, justified or not, would be a stiff blow to an industry that got into mutual fund sales chiefly to preserve customer relationships.

"If you switch customers to a product where they have the possibility of losing some principal, you really have a responsibility to educate them to the fact that they're now exposed," Owen Carney, senior investment adviser at the Office of the Comptroller of the Currency, told an industry group recently. "It probably won't insulate you from litigation. But it may provide you a reasonable defense."

Big Share of Market

Banks - which found that fee income goes right along with a preserved relationship - now account for about one-third of all mutual fund sales in the United States, according to Henry Shilling, a senior analyst with Moody's Investors Service.

That means, of course, that there's a lot at stake. Many banks are attempting to head off fallout from a rate rise by intensifying their compliance efforts.

"We have been very careful to have a supervisor review every single [mutual fund] sale the next day to make sure that it was an appropriate sale," said James R. Waterston, group executive vice president and chief banking officer at KeyCorp.

Customers who buy mutual funds from the Albany-based company are counseled on investment risks and required to acknowledge the risks in writing. "Whether some of them will conveniently forget, that's another matter," Mr. Waterston said.

At Boatmen's National Bank of St. Louis, securities salespeople are told to maintain a dialogue with customers to make sure they remain comfortable with their investment choices.

Source of Unhappiness

"When the market does turn down and your customers haven't heard from you in 12 months, they're going to be unhappy," said L. Rainey Gray, a senior vice president at Boatmen's.

Mark Mitchell, senior vice president of First Federal Bank in Waterbury, Conn., said his investment consultants develop a detailed, written profile of each customer's risk tolerance, investment experience, and financial objectives before selling any mutual funds.

As a consequence, he said, it would be "a stretch" for any customer to say they were steered to a bad investment by the bank. The bank's principal defensive strategy, Mr. Mitchell added, is to put the final decision in the investor's hands.

"In the end, they're going to be choosing tradeoffs between risk and reward."

As a result, he said, many customers decide to keep their money in CDs.

A Moderate View

Even though bankers are concerned about a rate rise, some say the risks may be overstated. Citibank's Mr. Cariseo suggested that bond fund investors shouldn't feel much pain if asset values erode, because "there will be a lag time before income starts to come down."

In any case, he added, many retired people had no choice but to put some of their principal at risk to get income to live on.

And despite the warnings going out to bankers, some lawyers say they are better positioned than their brokerage counterparts to defend themselves against angry customers and vengeful regulators.

After all, they have been hearing preachments on the banking side about attention to detail and vigorous monitoring for years.

"Bankers are used to being regulated from cradle to grave." Mr. Kurucza said. "They follow the rules."

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