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For Release on Delivery
10:00 a.m. EST
March 8, 1994
Testimony of
John P. LaWare
Member, Board of Governors of the Federal Reserve System
Before the
Subcommittee on Financial Institutions Supervision, Regulation
and Deposit Insurance
of the
Committee on Banking, Finance and Urban Affairs
United States House of Representatives
March 8, 1994
I am pleased to appear before the Financial
Institutions Subcommittee today on behalf of the Federal Reserve
Board to describe the actions the Board has taken to regulate
bank sales of mutual funds and to present the Board's views on
what additional regulatory or Congressional action is necessary.
Growth of Mutual Funds
Before describing the actions the Board has taken, I
would like to make some observations about the recent growth in
the mutual fund industry.
Growth in mutual fund assets in recent
years has been nothing short of explosive.
Last year, the public
bought a record $294 billion shares of mutual funds, nearly all
of which was in stock and bond funds, bringing assets under
management in the mutual fund industry to slightly over $2.0
trillion at year-end.
As a consequence, mutual fund assets have
surpassed the life insurance industry in size and, today, are
exceeded only by commercial banks and pension funds. The strong
inflows into mutual funds reflect their popularity among
households.
It is estimated that nearly a fifth of all
households own shares in at least one mutual fund.
As mutual funds have become a significant competitor to
depository institutions, these institutions have increased their
participation in the mutual fund industry.
The net assets of
bank proprietary mutual funds are estimated to have increased
from $44 billion at the end of 1988 to $220 billion at the end of
1993.
Between 1988 and 1993, the market share of bank
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proprietary funds doubled from 5 1/2 percent to over 10 percent
of the total mutual fund industry assets.
The potential for customer confusion clearly exists
when mutual funds are sold to the public by depository
institutions, given their traditional insured deposit activities.
The chief concern is that depositors may not understand that the
mutual fund investments they buy from a depository institution
are not deposits and are not covered by FDIC insurance.
There is
also the possibility that depository institution customers who
buy mutual funds may receive less than adequate investment advice
about mutual funds if sales personnel are not properly trained or
their sales practices are not properly supervised.
This potential for customer confusion involving mutual
fund sales could adversely affect the safety and soundness of a
depository institution.
If depositors suffer losses on
investments they have purchased from a depository institution,
the institution's reputation, and possibly its financial
condition, could be adversely affected.
More specifically,
litigation risk and possible deposit withdrawals could affect a
bank unfavorably.
Board Actions Regarding Involvement by Banking Organizations with
Mutual Funds
The Board takes these concerns seriously.
Over the
years, the Board and its staff have issued a number of
interpretive opinions, supervisory letters, and informal staff
opinions addressing issues relating to bank sales of uninsured
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investment products, including mutual funds.
Many of these
statements have been issued either in connection with the
authorization of additional activities for bank holding companies
or when the Board and its examiners have concluded that
regulatory guidelines are necessary to address the manner in
which an activity is being conducted.
All of these statements
reflect the Board's longstanding policy that when banks sell
uninsured investment products to their customers, they should do
so in a manner that clearly distinguishes these products from
insured deposits.
The first regulatory action that the Board took
concerning mutual funds was a 1972 interpretive rule relating to
conflicts that may arise when a bank holding company acts as an
investment adviser to mutual funds.
This rule authorized bank
holding companies to act as investment advisers to mutual funds
and, at the same time, created safeguards designed to assure a
separation between the mutual fund being advised and the holding
company's subsidiary banks.
During the mid-80's, as bank holding companies and
banks received authorization to engage in discount and full
service brokerage, the Board and its staff, through orders,
opinion letters, and informal staff interpretations, adopted
disclosure requirements that are applicable when these powers are
used by banks and bank holding companies to sell mutual funds.
Pursuant to these requirements, bank holding companies and banks
are required to inform a customer that investments in a fund's
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shares are not obligations of a bank and are not insured by the
FDIC.
More recently, the Board revised its 1972 rule regarding
investment advisory activities of bank holding companies to
require that banks that sell or provide investment advice about
mutual funds that are advised by an affiliate must disclose to
customers the relationship between the affiliate and the fund.
Interagency Guidelines
In response to the rapidly growing involvement of
depository institutions, in the sales of mutual funds, the Board
and the other bank regulatory agencies last month jointly .issued
a comprehensive set of guidelines governing the retail sale of
rr.utual funds.and other nondeposit investment products by
depository institutions.
I.
would like today to focus on those aspects of the
statement that are intended to address directly the question of
potential customer confusion regarding the uninsured status of
mutual funds and similar investment products, their nondeposit
character, and the risks inherent in investing in such products.
Assuring that customers are not confused about the products they
are purchasing is not simply a matter of providing accurate
disclosure.
which produce
Experience has demonstrated that the "manner" in
are sold -- the location of the sales, the
experience and training of the personnel selling the products,
and the conduct of sales programs -- all contribute to the
customer's understanding of the nature and risk associated with
their investments.
5
A. Disclosure
In developing the interagency guidelines, one of the
goals of the agencies was to standardize the basic disclosures
that banks provide customers about mutual funds and other
uninsured investment products.
The disclosures provided for by
the interagency statement must, at the very minimum, indicate
that the product is not insured by the FDIC, is not a deposit or
other obligation of, or guaranteed by, the selling depository
institution, and is subject to investment risks, including
possible loss of the principal amount invested.
These
disclosures should be provided orally during any sales
presentations or when investment advice is given; orally and in
writing prior to or at the time an investment account is opened;
and must be contained in all advertisements and other promotional
materials.
When the disclosures are provided in writing, they
should be conspicuous and presented in a clear and concise
manner.
A depository institution also should disclose the
existence of any advisory or other material relationship between
the institution, or an affiliate of the institution, and a mutual
fund whose shares are sold by the institution.
Any other
material relationship between the institution and an affiliate
involved in providing the investment products should also be
disclosed.
The agencies also provide for a disclosure concerning
the Securities Investor Protection Corporation ("SIPC") and other
forms of insurance when mutual funds are sold by broker-dealers
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on bank premises.
The interagency guidelines specifically state
that if sales activities include any written or oral
representations concerning insurance coverage provided by SIPC or
any other insurance fund or company, then a clear and accurate
explanation of the coverage must be provided.
There should not
be any suggestion or implication that an alternative form of
insurance coverage is the same or similar to FDIC insurance of
bank deposits.
The interagency guidelines also provide that
advertisements and other promotional and sales materials
conspicuously include at least the minimum disclosures and must
not suggest or convey a misleading impression about the nature of
the investment product or its lack of FDIC insurance.
The
minimum disclosures also should be emphasized in telemarketing
contacts.
Written materials that contain information about both
FDIC-insured deposits and nondeposit investment products should
clearly segregate the two types of information.
B. Location of Sales
In order to further minimize the potential for customer
confusion, the interagency guidelines provide that, except in
very limited situations where physical considerations prevent it,
sales or recommendations relating to nondeposit investment
products should be conducted in a physical location distinct from
the area where retail deposits are taken.
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C. Personnel
Another element that must be considered in minimizing
the potential for customer confusion relates to the personnel who
provide advice about, or sell, mutual funds or other nondeposit
investment products.
The interagency guidelines provide that
tellers and other employees should not make general or specific
investment recommendations or accept orders for nondeposit
investment products, even if unsolicited, while located in the
routine deposit taking area.
Tellers and other employees who are
not authorized to sell nondeposit investment products may only
refer customers to individuals who are specifically trained to
sell nondeposit investment products.
The interagency guidelines provide that depository
institution personnel who sell, or provide investment advice
about, nondeposit investment products should receive training
that is the substantive equivalent of the type of training
required for brokers licensed by the National Association of
Securities Dealers ("NASD").
In addition, a depository
institution should provide training to its employees who may have
direct contact with customers to ensure a basic understanding of
the institution's sales activities and the limits on their
involvement in selling such nondeposit investment products.
D. Suitability
The guidelines also provide that depository institution
personnel who recommend nondeposit investment products should
have reasonable grounds for believing that a specific product is
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suitable for the particular customer on the basis of information
disclosed by the customer.
Personnel should make reasonable
efforts to obtain information directly from the customer
regarding, at a minimum, the customer's financial and tax status,
investment objectives, and other information that may be useful
in making an investment recommendation.
Personnel who are
authorized to sell nondeposit investment products may receive
incentive compensation for transactions entered into by
customers; however, incentive compensation programs should not be
structured in such a way as to result in unsuitable
recommendations.
Board Supervision of Mutual Fund Activities
With regard to possible congressional action regarding
mutual fund activities by banking organizations, the fact that
the substantive provisions of H.R. 3306 are essentially mirrored
in the agencies' guidelines reduces the need for legislative
action at this time.
If a depository institution or any of its
employees do not follow the guidelines, the regulators have ample
authority to address any unsafe and unsound practices regarding
the sale of mutual funds by depository institutions and to
sanction misconduct where appropriate.
The Federal Reserve is also augmenting its current
examination procedures regarding sales of mutual funds by state
member banks or affiliated broker-dealers to assure that the
guidance contained in the recent interagency statement is being
heeded.
Sales of mutual funds by State member banks
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traditionally have been supervised and examined by the Federal
Reserve in the same manner as sales of other securities and
nondeposit, uninsured financial instruments.
Before the adoption
of the interagency statement, the Board in June 1993 issued
specific supervisory guidance for examiner use concerning proper
disclosure and the separation of mutual fund sales from deposit
taking activities on bank premises.
Over the years, the Federal
Reserve has developed product-specific examination procedures to
ensure that these activities are carried out in a safe and sound
manner.
Further, the procedures are intended to address the
Board's commitment to adequate disclosure of the uninsured nature
of these retail investment products.
Federal Reserve examiners
have been reviewing on a regular basis the sales practices
associated with.uninsured, nondeposit investment instruments for
compliance with our policies.
Prior to the issuance of the interagency statement, the
Board assembled an inter-district task force composed of senior
examiners who have experience supervising and examining brokerage
affiliates of banks and bank holding companies.
That task force
has been revising and expanding the Board's existing securities
examination procedures to incorporate specifically the
inter'-gency sLatcrr.ont.
Cu: . :ntly, the task force is field-
testing and refining the expanded procedures at an examination of
a large regional bank holding company and its securities
affiliate that is actively involved in sales of mutual funds on
the subsidiary banks' premises.
Upon completion of the
10
examination within the next several weeks, the task force will
assemble in Washington, D.C. to finalize the revised mutual fund
examination procedures and they will be implemented immediately
thereafter.
To avoid unnecessary regulatory burden on banks and
affiliated broker-dealers, and in recognition of the expertise
developed by the securities self-regulatory organizations, the
Board initiated discussions with the NASD pertaining to its
examinations of bank affiliated broker-dealers.
The NASD
examines bank affiliated broker-dealers for compliance with its
rules regarding sales practices, recordkeeping and other
applicable customer protection requirements.
Based on an
informal survey of our Reserve Banks, we understand that about
85 percent of those State member banks that sell mutual funds do
so through a registered broker-dealer selling on bank premises.
About half of these registered broker-dealers are bank
affiliated.
All registered broker-dealers are subject to SEC
oversight and to the additional requirements and rules adopted by
their self-regulatory organizations.
Our discussions with the NASD have focused on
cooperative efforts to minimize unnecessary duplication of
examination efforts.
These initiatives include examiner support
and possible information sharing regarding bank affiliated
broker-dealers.
In this regard, an NASD examiner went on-site
with our examiner task force in field testing our mutual fund
examination procedures.
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Aside from new examination initiatives, the Board is
considering expanding the scope of the consumer education
seminars now being offered by the Federal Reserve Banks around
the country to address specifically consumer issues related to
mutual funds.
Conclusion
The issues raised by this hearing today are of extreme
importance to both consumers who are faced with increasingly
complex choices about investments and savings, and to banks that
must address their customers' need for access to a variety of
investment and savings vehicles.
Saving for a college education
or for retirement is no longer as simple as depositing a set
amount in a bank account each week.
We believe that banks are in
a unique position to help consumers understand the choices before
them.
But banks must recognize and affirmatively address the
potential for customer confusion and the need to provide
consumers with complete and accurate information.
We intend to
take all actions within our power to ensure that the depository
institutions subject to the Board's jurisdiction do so.
Selling
mutual funds and other investment products in a manner that is
not misleading and that provides customers with accurate and
complete information is an important element of safe and sound
banking which we intend to enforce.
@FedFRASER