Let's start with a basic proposition: Banks have to go where their customers are.

Because so many borrowers now use the capital markets instead of banks (at least as their primary funding source), the banks don't need as many deposits as in the past. So it is perfectly natural that the demand for credit will migrate from banks to the mutual funds to be channeled more directly to those who are able to tell their stories to the public markets.

The smart banks want to follow their deposit customers just as many tried to follow their former borrowers -- by underwriting more than just loans.

Advisers to the Affluent

Some proactively try to convert their depositors into owners of mutual fund shares. They do so because (1), in the short run, they can make more money as managers of some types of mutual fund (equity and fixed-income) than they can from issuing some types of deposits (the average CD) and (2), in the long run, they need to establish credibility not simply as deposit takers but also as low-cost financial planners and investment advisors to the affluent component of their customer base.

Let's consider each of these points. Don't banks lose money when their depositors move into mutual funds? If they move from a demand deposit, the answer is yes. If they move from a CD, most likely the answer is no, provided the money moves from the CD into a mutual fund managed by the same bank.

The average CD has a relatively high interest cost and a relatively limited term to maturity. So it just isn't very profitable. In fact, our members suggest that the business of issuing CDs actually destroys shareholder value. That is, it helps to depress the stock price.

Managers Make the Money

In contrast, managing an equity fund is generally highly profitable. That's largely because of the hefty annual management fees (around 1%). And while we expect that such fees will be declining sharply, they are still lofty enough to make managing funds a good business.

So if a bank is able to create the critical mass for an equity fund -- about $500 million -- then a management strategy should prove attractive even if the result is to cannibalized existing deposits (what banks that can't create such a critical mass should do is the subject of a future column). Since most of these deposits are likely to be CDs, the bank should even welcome their departure.

By contrast, encouraging bank CD depositors to move into third-party rather than in-house or proprietary funds that are sold from one's own branch network is not sound strategy (at least, not currently).

That's because, not being the fund manager, the bank gets only a tiny slice of those annual fees. For the most part, its compensation comes from the upfront load. And this usually isn't enough to pay the direct and indirect expenses of a branch sales operation and still provide a decent profit.

Once again, our numbers show that, like the CD business, the practice of selling third-party funds through one's own branches destroys shareholder value. And it will continue to do so until banks negotiate with nonbank fund managers for a bigger (and, I might add, fairer slice of those annual fees.

Customers Want a Plan

Now let me briefly address my second point: the need for banks to establish a credible presence as financial advisors to the affluent. There can be no doubt that, given the mounting threats to their financial futures (uncertain Social Security, less generous private pensions, higher taxes, slowing appreciation of house values, etc.) most middle-class Americans need financial planning services.

An ABA survey showed that while only 3% of retail customers have used a planner at their bank, nearly 40% say they need one and might even be prepared to pay if their bank offered the service.

If banks are to halt the exodus of middle-income customers to competitors, they must offer planning and investment advisory services. And since the conventional wisdom is that you can't sell planning services at a high enough price, smart companies link planning to the provision of mutual fund services.

Witness IDS, which is a highly successful mutual funds company with a reputation as a good planner. In actual fact, only 1% of IDS' revenues come from planning. But by ordering this service, the company unlocks the door to the mutual fund revenues that sustain it.

Selling Information

The inevitable migration of banks into financial planning and investment advisory services for individuals is symptomatic of a basic change in the nature of what the industry can sell. In the past, banks primarily sold or rented money.

Now, increasingly, they sell or rent information -- information to the securities issuer on how to represent his company to the public and information to the rank-and-file investor on how to choose among these financial representations, based on his individual needs and long-term goals. It's all part of the ongoing transition from an economy of borrowers and savers to one of issuers and investors.

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