The expanding role of mutual funds - and bank's participation in that growth - has important implications for the performance and structure of financial markets, according to Mr. Mack, who works for the Fed's division of research and statics.

In an article published in the November issue of the 1993 Federal Reserved Bulletin, he said mutual funds are improving the efficiency of financial intermediation by reducing transaction costs.

But at the same time, he said mutual funds are cutting into the traditional role of banks and thrifts as providers of credit, and "consequently have affected the relationship between money and economic activity."

Mr. Mack's article, prepared with research assistance from Michael a. Schoenbeck, is excerpted below:

The strong inflows to mutual funds reflect their popularity among households.

According to preliminary data from the Federal Reserve Board's Survey of Consumer Finances, households shifted assets from deposits to mutual funds in the 1989-92 period.

They held about 13% of their financial assests in long-term mutual funds at the end of 1992, up from about 10% in 1989, while their holdings of deposits and money funds fell from about 37% to 31%.

Direct holdings of stocks, bonds, and other financial assets also slightly increased during this period.

Shifting from Deposits

The dispersal of ownership of long-term mutual funds also increased, from about 12% of households in 1989 to 15.5% in 1992. The increase in new ownership was most heavily concentrated among households in which the head was between 55 and 64 years of age.

These households apparently shifted assets away from bank deposits and money funds into long-term mutual funds.

Their holdings of bank deposits and money fund shares fell from about 40% of their financial assets in 1989 to about 22% in 1992, while the share of long-term mutual funds in their portfolios rose from about 11% to 17% over the same period.

Somewhat in contrast, the households in the 35-44 age group maintained the share of their financial assets in bank deposits and money funds shares, at about 33%, over the 1989-92 period.

The share of long-term funds in their portfolios did grow, however, from about 9.5% to about 12.5%, while the share of other financial assets declined.

Supplying Debt, Equity

With their rapid growth, mutual funds have become increasingly important suppliers of debt and equity funds.

Indeed, corporations with access to the reduced interest rates and elevated share prices of the capital markets have benefited from the surge in mutual fund assets: In recent years, mutual funds as a group have been the largest net purchaser of equities and a major purchaser of corporate bonds.

Companies have repaid shorter-term debt -- especially bank loans -- and lowered the costs of long-term debt, while reducing overall balance sheet leverage.

Such financial restructuring has been a particularly urgent priority for many of the firms that issued high-yield ("junk") bonds in the 1980s.

Mutual funds have been one of the major suppliers of credit in the high-yield bond market, as certain other institutional investors have pulled back from riskier investments.

Bank-related Mutual Funds

Funds have also increased their presence in the market for tax-exempt securitiesp; they are now the largest net purchaser in that market and are offsetting the reduced net purchases by households and the runoff at commercial banks.

In response to the outflow of deposits, banks are increasingly participating in the mutual fund business through the advising of mutual funds and the brokering of mutual fund shares.

Banks and bank holding companies are prohibited from underwriting, distributing, or sponsoring mutual funds, according to interpretations of the Glass-Steagall Act of 1933 by the courts and federal regulatory agencies.

Nevertheless, several rule changes have made it possible for banks to increase their participation in the industry.

In 1972, the Federal Reserve Board authorized bank holding companies to act as mutual fund investment advisers, transfer agents, and custodians.

In an accompanying interpretation, the board placed several restrictions on the activities of bank holding companies that advise mutual funds.

For example, neither a bank holding company nor its bank or nonbank affiliates could promote any mutual fund or provide investment advise to any customer investing in any mutual fund, for which it acted as an investment adviser.

In addition, the board cautioned bank holding companies from advising a mutual fund unless the fund was located off the bank's premises.

Restrictions Eased

In 1992 the board relaxed some of these restrictions.

Provided that a number of disclosures are made to customers regarding the bank holding company's relationship to the mutual fund and the status of mutual funds as an uninsured investment products, the board allowed a bank holding company or its subsidiary to provide investment advice and other brokerage services to customers investing in any bank-advised fund.

In addition, the board eliminated the location restriction.

A banking organization can participate in the mutual funds industry in several ways.

One is through a proprietary mutual fund (a fund advised by the bank), with the shares brokered by the bank primarily to its customers.

An unafilliated third party, however, organizes the fund and an unaffiliated distributor underwriters the shares.

Nonproprietary Funds

In addition, a bank can sell shares of nonproprietary funds, for which it acts only as broker. Involvement in the brokerage of these funds can range from renting lobby space to an unaffiliated broker to selling fund shares through a brokerage firm affiliated with the bank.

Although the bank is providing only brokerage services, it does earn fee income from sales commissions, and enters the retail mutual funds market at a low initial expense.

Net assets of bank proprietary mutual funds, including both long-term and money market funds, are estimated to have increased from $31 billion at the end of 1987 to $162 billion at the end of the first quarter of 1993.

Growth Area

Money market funds account for the majority of bank-related mutual fund assets, but bank-related long-term funds have grown rapidly in the past several years and are about evenly split between stock and bond funds.

Between 1987 and early 1993, banks increased their market share of total industry assets from 4% to nearly 10%. However, they have had much greater penetration in the money fund sector than in the stock and bond sectors.

At the end of the first quarter of 1993, bank money funds accounted for about 20% of total money fund assets, whereas bank long-term mutual funds were only about 4% of total stock and bond fund assets.

By providing savers with investment options and by participating in the market for securities, mutual funds compete with other financial intermediaries.

Greater Efficiency

Although some intermediaries may have been adversely affected, by the rise of such competition, mutual funds have tended to make the financial system more efficient by reducing the transactions cost to households seeking saving alternatives and to borrowers issuing securities.

Clearly, the growth of the mutual fund industry has challenged the traditional role of banks. Mutual funds pose a competitive threat by offering saving instruments that have become more attractive alternatives to bank deposits, given their liquidity and other characteristics.

Recent experience also suggests that households are quite sensitive to changes in returns on bank deposits relative to those on mutual fund shares. Mutual funds are attempting to exploit the greater household awareness by offering new types of funds, additional shareholder services, and retirement products.

Alternatives to Bank Loans

Mutual funds also challenge banks to the extent that bank borrowers can directly tap the capital markets.

As mutual funds grow, they make securities markets accessible to many borrowers that were previously confined to bank loans -- medium-size businesses and individuals, who gain indirect access to the public market through asset securitization.

As investors, mutual funds have played an important role in the development of markets for securitized financial assets. Securitization began with mortgages in the 1970s and has since spread to other types of financial assets, such as automobile loans and credit card receivables.

Banks and other nonbank institutions have increasingly securitized such assets and sold them to various investors, including mutual funds.

Securitization allows banks and thrift institutions to continue to originate loans by having mutual funds and other investors fund such loans.

This form of intermediation thus complements lending by depository institutions but also produces greater competition in the provision of financial services.

Asset quality problems, higher regulatory capital requirements, and cautions lending also have added to the downward trend in intermediation through banks in recent years.

Money Growth Slows

Accompanying this diminished role for depository institutions in the credit markets has been the slow growth in broad measures of the money supply.

Such slowness is reflected in the velocity of M2, which is the ratio of gross domestic products to M2.

In the past, decreases in short-term interest rates have lowered the opportunity cost of holding deposits. Deposit rates typically lagged the decline in market yields, causing the level of M2 to rise relative to output and its velocity to fall.

In the past three years, however, the velocity of M2 has risen in the face of the general decline in market interest rates.

The mutual fund industry will remain an important investment option for household savings and an important funding source for corporations and state and local governments that can directly tap the capital markets.

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