Elizabeth Laderman

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 93-43, December 17, 1993
Banks and Mutual Funds
Mutual funds, especially those that invest in
stocks and bonds, are attracting ever greater
shares of households' financial assets. While it is
impossible to trace the flow of money to mutual
funds, observers generally agree that bank de-
posits constitute a major source of those assets.
In order to profit from the growing demand for
mutual funds, banks themselves have begun to
get more deeply involved in mutual funds in
various ways. In a recent survey of large banks,
the great majority stated that they currently of-
fered mutual funds to retail customers.
In this Weekly, I discuss the implications for
banks and the economy of banks' involvement
with mutual funds. I conclude that, for the most
part, banks' mutual fund activities confirm
broader trends that have been developing over
the past 15 years or so.
What are mutual funds?
A mutual fund is a company that makes invest-
ments on behalf of individuals and institutions,
who buy shares in the fund. (The term "mutual
fund" also may refer to the pool of money that
is invested.) Funds differ according to their in-
vestment objectives. Objectives may include.
stability-protecting the original investment
(principal) from loss; growth-increasing the
value ofthe principal; or income-generating a
continuous flow of income through dividends.
Mutual funds also can be categorized into long-
term funds and short-term funds. Long-term funds
invest mainly in stocks and/or bonds, whereas
short-term funds invest in taxabie or tax-exempt
money market instruments. Money market mu-
tual funds are prohibited from holding any instru-
ment with a maturity greater than 13 months, and
the dollar-weighted average maturity ofthe fund
must be no greater than 90 days. Shareholders in
both long- and short-term funds have the right to
redeem part of all oftheir holdings at any time.
Mutual funds differ from bank deposits in two
important ways. First, a mutual fund share is like
a share of stock in that the return on each share
is proportional to the return earned by the fund.
This means that the mutual fund shareholder will
benefit from an unusually high return on the
fund's investment. In contrast, a bank deposit is a
debt contract; the return, in the form of the inter-
est rate, whether fixed or variable, is independent
of bank profitability. Second, mutual fund invest-
ments are not insured, whereas bank deposits
are. Just as a mutual fund shareholder may reap
an unexpectedly high return, she may on the
other hand lose part or all of her principal. How-
ever, bank deposits are federally insured up to
$100,000, and, in practice, depositors have some-
times retrieved even more when banks have failed.
Mutual funds have been growing recently, both
in absolute terms and relative to other invest-
ments. According to the Federal Reserve's Flow
of Funds Accounts, the category "households"
(which includes personal trusts and nonprofit
organizations) accounts for about 85 percent of
all mutual fund assets, and their holdings have
grown from $933 billion at the beginning of 1991
to $1.38 trillion in June 1993. Stock and bond
funds held by households have shown especially
strong growth; around the beginning of 1991,
stock and bond funds were 52.9 percent of
households' total mutual fund assets, and by the
end ofJune this year, the share had risen to about
68.4 percent.
Banks' involvement
Banks may sell their own "proprietary" and
"private label" funds, both of which are sold
exclusively through the bank and have names
chosen by the bank. The difference between
them is simply that proprietary funds also obtain
investment advice and portfolio management
from the bank. Banks also may sell third party
funds, which include many of the nonbank funds
that are also sold to investors either directly or
through other channels such as brokers. Banks'
mutual fund activities do not violate the Glass-
Steagall Act, which separates commercial from
investment banking, because, in all cases, un-
affiliated companies underwrite and distribute
the shares.
For the most part, bank involvement in mutual
funds is relatively recent. In a survey of largeFRBSF
banks, 93 percent stated that they currently of-
fered mutual funds to retail customers. However,
of these, 73 percent began marketing mutual
funds only within the past seven years, and 50
percent only within the past five years. In addi-
tion, the size and availability of banks' mutual
fund sales forces have increased over the past
three years.
In this relatively short time, banks have become
fairly important conduits for mutual funds. For
example, in 1991, bank sales accounted for almost
12 percent of all mutual fund industry assets.
According to the Investment Company Institute
(1(1), about one-third of all mutual funds are
available through the bank channel. Bank in-
volvement can also be measured in terms of
dollars of new sales. The ICi reports that in the
first half of 1992, banks were the channels for
about a third of all new sales of money market
funds and about 14 percent of all new sales of
long-term funds.
Implications
One obvious reason banks benefit from getting
involved with mutual funds is that they earn fee
income that would otherwise go to nonbanks.
This is especially so for banks' proprietary funds,
where they typically earn annual custodial and
management fees and receive the entire sales
commission on each sale.
But there is more to the story. For example, since
banks generally are not expanding, they must,
to some degree, be shifting productive resources
out ofsome other area and into mutual fund
activities. Most obviously, banks are doing less
lending than even two years ago and, consistent
with this, less deposit-taking. In each of the quar-
ters between the fourth quarter of 1990 and the
second quarter of1993, banks actually showed
absolute year-over-year declines in commercial
loans outstanding, and year-over~year growth in
deposits has been negative two of the four quar-
ters ending June this year.
There is some debate as to whether recent slug-
gish conditions in banking are due mostly to
reductions in the supply or demand for loans. It
is likely that both playa role. In any case, though,
banks' mutual fund activities might be seen as
exacerbating and prolonging the recent decline
in lending and deposit-taking. By offering an es-
pecially convenient method ofpurchasing mutual
funds, banks might be viewed as spurring their
depositors into making mutual fund investments
that they might not otherwise have made, thereby
reducing the funds that banks have available to
lend.
Also, even if they preserve their relationships
with depositors by being the channel through
which depositors invest in mutual funds, this
strategy may backfire. For example, as depositors
increase .in sophistication, they may eventually
bypass banks and invest in nonbank mutual
funds directly. If banks do lose their relationship
with depositors who invest in mutual funds,
banks may find it costly to attract depositors
once loan demand picks up again (or, depending
on your point of view, once banks decide to start
supplying loans again). At that point, banks may
find that they need to offer unusually high inter-
est rates to attract deposit funds and may there-
fore decide that deposit-taking and lending are
just too costly.
Part of a longer-term trend
While banks' recent mutual fund activities may
be viewed as contributing to the current weak-
ness of their lending and deposit-taking activi-
ties, they may also be viewed as a response to
the recent weakness of these activities, an effort
to shift into more profitable areas. Both views
can be consistent with pictures in which the re-
cent reduction in loan volume is either supply or
demand driven. However, an alternative to both
of these views is that banks' involvement in mu-
tual funds is not so much a symptom or a cause
of recent conditions as it is a symptom of long-
established trends in the relative market shares
of banks and mutual funds.
The longer-run trends are illustrated in Figures 1
and 2. Figure 1 shows the funding side ofthe
story: Households' bank deposits as a proportion
oftheir total assets have been falling fairly stead-
ily, if slightly erratically, since about 1978 (and
especially so since about 1984), while mutual
funds' share, including stock and bond funds and
money market funds, has been more or less con-
sistently rising. Figure 2 shows the credit side of
the story: The share of total credit market assets
in the u.s. held by commercial banks (mostly in
the form of loans) has been falling at a remark-
ably steady pace since about 1974, while the
share of credit held by mutual funds (which ex-
cludes equities held by mutual funds) has been
rising since about 1978.
These long-term trends indicate a secular shift in
demand away from bank intermediation of fundsPerrent
Figure 1: Shares of Household Assets
30
25
20
15
,," '''·~.I1·''''''Il. ...." ••
,',11 .. II "', Bank Deposits
, II· ' '•• ~ ..
.",." .. ..
.. ' ....'1"-
,..',
'.
drop-offs in the bank shares or sharp jumps in
the mutual fund shares in the last few years;
banks' rates of loss and mutual funds' rates of
gain have been fairly steady. In addition, there is
little doubt that banks have devoted costly pro-
ductive resources, including training expenses,
advertising, and planning, to mutual fund ac-
tivities. Such costs are more likely to be under-
taken in response to well-established conditions
than to recently appearing, perhaps temporary,
circumstances.
Perrent
Figure 2: Credit Market Shares
Note: Data are quarterly and are obtained from
the Flow of Funds Accounts.
Also, although long-term funds' share of mutual
funds has increased significantly, mutual funds'
overall importance as gatherers of funds and sup-
pliers of funds through the credit markets has
grown over the past few years at roughly the
same pace as seen over the past fifteen. So, even
though banks' recent mutual fund activities have
likely drained some resources away from more
traditional activities, the secular shift away from
bank intermediation and toward mutual funds has
been largely independent ofthis behavior. Finally,
the profitability of shifting resources out oftradi-
tional banking activities and into mutual fund
activities depends more on the rate of growth of
mutual funds relative to banks than on the rate
of growth of banks relative to their own past
growth. Therefore, ifandwhen bank lending re-
sumes growing at rates closer to historical aver-
ages, bank mutualfund activity probably will
continue to expand.
.~ ,I .... .... "
......... '..................
..........
'. Banks ... -'II..,
........"..............
5
10
oC~~::::+::+~~-+-+-+-+-++-+-+--1-+-+
m n u % ~ W ~ M M ~. 00 ~
35
30
25
20
Note: Data are quarterly and are obtained from
the Flow of Funds Accounts.
o-i='=l"""''''f=''''''''''''F''FF=t=+-f-l-+-If-+-+-f-+-+-+-+-+-+
w n u % ~ W ~ M % M 00 ~
and toward mutual fund intermediation. It is
likely that banks' involvement in mutual funds
is related more to this shift than to recent reduc-
tions in bank lending. The deeper involvement of
banks in mutual funds in the past few years has
not been accompanied by any appreciable de-
crease in the rate of growth ofdeposits or bank
loans relative to mutual fund growth in the anal-
ogous categories. The figures do not show sharp
15
10
5
Mutual Funds
Conclusion
Although banks' involvement in mutual funds
has deepened only in recent years, it is probably
largely a reflection of broader changes that have
been taking place for a much longer period. Spe-
cifically, banks' share of household assets and
their share ofthe credit market began shrinking
long before banks became active in mutual
funds, yet it is these trends that have likely moti-
vated banks to delve into the mutual fund area.
At the same time, the independence ofthese
trends from bank to mutual fund activity indi-
cates that, even if banks were not mutual fund
conduits, their relative importance as intermedi-
aries in the economy would continue to shrink.
Banks' involvement with mutual funds is best
viewed as evidence of banks' recognition ofthis
fact and their attempt to profit from it.
Elizabeth Laderman
Economist
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.~ 1%\ 's~u! ueaq.los 41!M
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Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER TITLE AUTHOR
5/21
5/28
6/4
6/18
6/25
7/16
7/23
8/8
8/20
9/3
9/10
9/17
9/24
10/1
10/8
10/15
10/22
10/29
11/5
11/12
11/19
11/26
12/3
93-20
93-21
93-22
93-23
93-24
93-25
93-26
93-27
93-28
93-29
93-30
93-31
93-32
93-33
93-34
93-35
93-36
93-37
93-38
93-39
93-40
93-41
93-42
Western Metal Mining
Federal Reserve Independence and the Accord of 1951
China on the Fast Track
Interdependence: u.s. and japanese Real Interest Rates
NAFTA and u.s. jobs
japan's Keiretsu and Korea's Chaebol
Interest Rate Risk at u.s. Commercial Banks
Whither California?
Economic Impacts ofMilitary Base Closings and Realignments
Bank Lending and the Transmission ofMonetary Policy
Summer Special Edition: Touring the West
The Federal Budget Deficit, Saving and Investment, and Growth
Adequate's not Good Enough
Have Recessions Become Shorter?
California's Neighbors
Inflation, Interest Rates and Seasonality
Difficult Times for japanese Agencies and Branches
Regional Comparative Advantage
Real Interest Rates
A Pacific Economic Bloc: Is There Such an Animal?
NAFTA and the Western Economy
Are World Incomes Converging?
Monetary Policy and Long-Term Real Interest Rates
Schmidt
Walsh
Cheng
Hutchison
Moreno
Huh/Kim
Neuberger
Sherwood-Call
Sherwood-Call
Trehan
Cromwell
Throop
Furlong
Huh
Cromwell
Biehl/judd
Zimmerman
Schmidt
Trehan
Frankel/Wei
SchmidUSherwood-Call
Moreno
Cogley
The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.

Banks and mutual funds

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Banks and mutual funds

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