Over the past two years, Securities and Exchange Commission member Richard Y. Roberts has kept a keen eye on the banking industry's growing mutual fund activities.
While Mr. Roberts welcomes banks' entry into mutual funds, he has also raised some concerns, particularly banks' exemption from some aspects of SEC supervision.
In a recent speech to the Bank Securities Association's 1994 National Compliance Conference, Mr. Roberts outlined his views. Excerpts follow.
Mutual funds have become America's investment vehicle of choice because they provide individuals with a wide array of liquid, low-cost, and professionallymanaged investment alternatives.
The increased competition and convenience offered by bank involvement in this industry should only benefit consumers. However, the growth that the banking industry has enjoyed in the investment company business is inextricably linked to investor comfort and acceptance.
I suspect that maintenance of a high degree of investor comfort and acceptance is much more challenging in a rising interest rate market environment. Some in the banking industry are now discovering what the securities industry already knew -- the mutual fund business is very competitive, particularly with a stagnant market.
The level of growth and prosperity that banks will enjoy in this industry in the future will be directly proportional to the level of investor confidence in bank mutual fund services.
Thus, in addition to being attentive to your own individual mutual fund operations, bank mutual fund participants should be pointing out bad apples and questionable practices that may be occurring in connection with bank mutual fund activities, They should be identifying those stretching too far for short-term yield or engaging in inappropriate sales practices.
Certainly, one of the banking industry's foremost challenges will be to maintain investor confidence in bank-managed and bank-sold mutual funds.
Amid this strong growth in bank mutual fund activity, it is perhaps ironic that Sections 16and 21 of the Glass-Steagall Act still prohibit national banks and their subsidiaries from underwriting and dealing in securities such as mutual funds.
State-chartered banks are prohibited under other federal provisions. Obviously, the GlassSteagall prohibition has been interpreted flexibly, which accounts for the bank activity in the mutual fund area.
First, banks are not prohibited from acting as brokers for their customers. Generally, this is accomplished in one of three fashions. Either the bank routes its customer orders through a separate affiliated broker-dealer, enters into a networking arrangement with an unaffiliated broker-dealer, or it sells the funds directly.
Although this difference in structure should not be significant from a regulatory standpoint, in fact the structural difference does have significant regulatory repercussions.
Separate broker-dealers must register and be subject to the review of the SEC and the National Association of Securities Dealers, whereas direct bank sales are exempt from SEC and NASD oversight pursuant to Section 3(a)(4) of the Securities Exchange Act of 1934, which expressly exempts banks from the definition of "broker."
This distinction does not make much sense to me, and thus I continue to argue that this statutory exemption should be deleted. Second, banks generally are not prohibited from acting as investment advisers.
The National Bank Act permits national banks to advise funds, the Federal Deposit Insurance Corp. has permitted state-chartered banks to enter the field, and the Federal Reserve Board has permitted bank holding companies and their nonbank subsidiaries to serve as advisers, with some safeguards to protect against conflicts of interest.
The major remaining obstacle to banks entering the mutual fund business is the prohibition against underwriting, sponsoring, and distributing funds.
With other types of securities, banks have been able to engage in the securities business by establishing an affiliate under the bank holding company (as opposed to a subsidiary of the bank itself) under Section 20 of Glass-Steagall.
Section 20 provides that affiliates of banks may underwrite and deal in securities so long as the affiliate is not deemed to be "principally engaged" in underwriting.
The Fed has interpreted this provision to mean that no more than 10% of the affiliate's revenues may be derived from underwriting and dealing activities. The Fed has prohibited the underwriting of mutual funds because funds, by their nature, are under continuous registration.
State-chartered banks have an easier time in that they need only state and FDIC approval. It is my understanding that the FDIC granted conditional approval in September 1992 for state-chartered nonmember banks to underwrite mutual fund shares through a subsidiary.
One issue in this area is whether banks should conduct their securities activities in subsidiaries or affiliates. There are considerable operational differences between these two types of entities under federal banking law.
For example, under current federal banking law, a subsidiary of a bank is considered to be an extension of the bank itself. Thus, the nonbank subsidiary's capital is generally included in the calculation of the parent bank's capital.
On the other hand, a nonbank affiliate of a bank holding company is entirely separate from any affiliated bank. The bank holding company must separately capitalize the nonbank affiliate, and the nonbank affiliate's capital is not counted as the capital of any affiliated bank.
Further, bank subsidiaries are not subject to the conflict of interest and self-dealing restrictions that are applicable to bank holding company affiliates under Sections 23A and 23B of the Federal Reserve Act.
Obviously, I would prefer to see bank mutual fund activities restricted, either legislatively or by regulatory order, to nonbank affiliates of the bank holding company rather than extended to bank subsidiaries.