As mutual funds become a bigger part of banks' retail strategies, they, are attracting attention from policymakers.

The following article on that trend - written by Michelle A. Clark, an economist at the Federal Reserve Bank of St. Louis - appeared in the summer edition of the Central Banker, the bank's quarterly newsletter.

A more detailed analysis will be published in the October issue of the bank's Regional Economist.

Every banking industry trade group seems to be organizing conferences and running stories on mutual funds in its trade publications these days.

Why all the interest? A number of bankers and industry analysts view the provision of mutual funds as a way to stem the flow of deposits - and more important, customers - out of banks and into brokerage and investment houses in this low-interest-rate environment.

In addition, banks can earn nominal fees by selling third-party mutual funds or more substantial income by offering their own funds.

12% of Outstanding Shares

Although hard numbers on the extent of banks' involvement in the mutual fund business are lacking, a number of estimates exist.

A recent study by the Investment Company Institute, the mutual fund industry's trade group, found that banks accounted for about one-third of new sales of money market mutual funds and about 14% of new sales of bond and equity funds in the first half of 1992. That was enough to push banks' share of the business to $175.5 billion, or 12% of the $1.5 trillion in mutual fund shares outstanding in mid-1992. Since then, banks' share of a growing market has probably risen even further.

While mutual funds sales took like a win-win situation from the banking industry's perspective, some observers aren't so sure. Their major concern is that customers may mistakenly believe their investments are FDIC-insured, like deposits.

Guidelines from Regulators

To ensure that customers aren't confused, the regulatory agencies have begun advising banks to produce clear disclosures and to be sure that deposit and investment activities are physically separate.

It's not just regulators who are concerned. Congressional leaders have asked the General Accounting Office to conduct a study on the adequacy of banks' mutual fund disclosures and regulatory supervision, and have urged the Securities and Exchange Commission and the National Association of Securities Dealers to take a closer look at banks' sales practices.

First-time investors are of special interest. The ICI has estimated that 10% of households that own mutual funds began purchasing them in January 1991 or later. No one knows what proportion of those funds was bought through banks, but some believe it is substantial.

Market Fluctuations

The first-timers may not fully understand the risks associated with investments in equity and bond funds.

If the stock market turns down, equity funds will go down in value and if interest rates go up, bond funds will - and equity funds could - decline in value.

Credit risk is also a factor with bond funds, whose market value declines if the credit ratings of bonds in the portfolio are downgraded.

The Backlash Factor

Bank customers accustomed to fixed CD yields could be in for a rude shock if the value of their mutual fund investments - their principal - goes down.

And the more closely associated banks are to mutual funds, especially though a private-label or proprietary relationship, the more likely they are to suffer customer backlash if market prices take a big plunge.

Because the value of a bank's franchise is largely related to its reputation for safety and soundness, it's in banks' interest to exercise caution in selling mutual funds to novice investors.

The bottom line: Banks' entry into the mutual fund business - like any new business - presents risks as well as rewards.

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