WASHINGTON -- The sensitive debate on how the sale of mutual funds at banks should be regulated last week reached a key committee of advisers to the Federal Reserve Board for the first time.

In a lively session of the Fed's consumer advisory panel, bankers and state officials squared off against each other about whether banks need tighter oversight and regulation as they begin offering investment products along with the usual insured deposits.

A top consumer affairs official from Minnesota said he sees signs of trouble

in bank sales of mutual funds, and said formal steps may be needed to protect consumers.

Older, first-time investors are increasingly buying mutual funds at banks without fully understanding the risk, D. Douglas Blanke, director of consumer policy at the Office of the Attorney General in Minnesota, told his fellow committee members.

Is Trust Enough?

They are relying instead on the trust they have in their banks, Mr. Blanke said.

So far, banks have used disclosure statements, employee training and a physical separation of insured and uninsured activities to communicate to their customers that mutual funds are not insured, Mr. Blanke noted.

But he said this may not be enough. He said the regulatory guidelines that govern bank sales of investment products should be strengthened and made mandatory. He also endorsed the use of mystery shoppers to find out what consumers are being told at banks.

Bankers on the committee vigorously opposed the need for more regulation.

They reserved their most pungent comments for the mystery shopping initiative that has been spearheaded by the Comptroller of the Currency.

"We aren't Gestapo. This is still a free country," said Michael D. Edwards, president of Prairie Security Bank in Yelm, Wash. "People are presumed to be innocent ... unless proved otherwise."

The Fed has already said it will not participate in sending testers posing as customers to bank branches.

And at the session, Fed Governor Lawrence B. Lindsey poured cold water on the drive to regulate more stringently the sale of mutual funds at banks.

Not a Perfect World

"Let's be a little realistic," Mr. Lindsey told the council.

"There are shady operators. There have always been shady operators. There always will be," Mr. Lindsey said. "There will also be foolish people who don't associate risk and reward."

The solution, he said, is more education, not more regulation.

He warned that more regulation would make it harder for banks to compete with mutual fund companies and others who sell the same products by telephone and mail.

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