A battle is brewing in Indiana over proposed legislation that would let counties, cities, and towns invest in mutual funds.

Banking groups argue that local governments would shift money from deposit accounts to funds that invest in Treasury bills and other government securities. This, they say, would hurt local communities as well as the small banks that serve them.

"We have a lot of community banks that depend on public funds-in many cases it might be 10% to 15% of total deposits," said William H. King, president of the Indiana Bankers Association. "This would surely hurt their ability to lend in those communities."

But the bill's proponents say local governments should have more options for investing taxpayers' money.

Brian L. Burdick, a lawyer representing the Indiana County Treasurers Association, said banks are willing to pay favorable interest rates now to attract deposits because they need the money to make loans. That was not the case in the early 1990s, when banks were making fewer loans and paying lower interest rates, said Mr. Burdick, who used to be Indiana's deputy treasurer.

The proposal "would provide some kind of mechanism in all economic cycles so that the taxpayer doesn't suffer if loan demand is low," he said.

The idea seems to be gaining momentum. Though similar bills were introduced in Indiana's General Assembly during the last five sessions, all were defeated in the House Financial Institutions Committee. This year, however, the proposal was referred to the Local Government Committee, which approved it last week on a 9-to-5 vote.

Proponents also have a strong ally in the incoming state treasurer, Tim Berry. Mr. Berry, who takes office next Wednesday, testified in favor of the legislation at a hearing in Indianapolis last week. The outgoing treasurer, Joyce Brinkman, has historically sided with community banks on the issue.

Indiana law regarding the investment of public funds is among the nation's most conservative. Though most states let local governments buy shares in money market mutual funds, Indiana allows counties, cities, and towns to buy individual Treasury bills and other government securities.

Even under the proposed law, local governments would only be able to buy funds that invest directly in federal securities or "fully collateralized" repurchase agreements backed by the federal government. The funds would have to have a Standard & Poor's rating of AAAm or a rating of Aaa from Moody's Investors Service Inc.

Testifying before state lawmakers last week, one community banker questioned whether the move would increase government entities' returns.

Stefan Anderson, chairman of First Merchants Bank in Muncie, Ind., said his bank currently pays the city of Muncie an average of 4.77% on short- term deposits. By comparison, the average national yield on all money market mutual funds right now is 4.54%.

"The result of such legislation would be to erode the deposit base of Indiana community banks, jeopardize funding for local economic development ... and put the taxpayers' money at increased risk without an increase in the rate of return," he said.

Another banker also told lawmakers that the loss of deposits could mean a loss of bank jobs.

But Mr. Burdick called that testimony "reckless," saying the bankers "are painting a picture of total despair" if there's competition for public dollars. "I've never heard of a jobs-to-deposit ratio, have you?" he asked.

Mr. Burdick also said other sources of funds than deposits are available to banks, such as Federal Home Loan Bank advances.

Though the Indiana Bankers Association is fighting the bill, its large- bank members back it because they stand to collect fee income from the sale of money market mutual funds.

A companion bill has been introduced in the Indiana Senate. No date has been set for a vote in the House. Indiana's legislative session ends April 30.

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