Bank Mutual Funds: Sales Practices and Regulatory Issues
Released: 1995-10-27T00:00:00

Letter

Introduction

The mutual fund industry’s growth in the last decade has been phenomenal. At the end of 1984, mutual funds managed assets totaling about $371 billion. By 1990 managed assets had grown to over $1 trillion, and by December 1994 this figure had doubled to about $2.2 trillion, second only to the $2.4 trillion in total deposits held in U.S. commercial banks.

According to the Investment Company Institute (ICI), the national trade association of the mutual fund industry, there are a number of reasons for the industry’s growth. These include appreciation in the value of assets held by the mutual funds; additional purchases by existing shareholders; the introduction of new types of products and services; the growth of the retirement plan market; increased investment by institutional investors; the introduction of new distribution channels—such as banks; and a shift by individual investors from direct investments in stocks, bonds, and other securities to investment in securities through mutual funds. Also, in recent years investors have shifted to mutual funds in an attempt to obtain a better investment return than has been available through alternative investments, such as certificates of deposit.

Background

A mutual fund, formally known as an open-end investment company, pools the money of many investors. These investors, which can be either individuals or institutions, have similar investment objectives, such as maximizing income or having their investment capital appreciate in value. Their money is invested by a professional manager in a variety of securities to help the investors in the fund reach their objectives. By investing in a mutual fund, investors are able to obtain the benefits of owning a diversified portfolio of securities rather than a limited number of securities. This can lessen the risks of ownership. In addition, investors gain access to professional money managers, whose services they might otherwise be unable to obtain or afford.

Each dollar that an investor puts into a mutual fund represents some portion of ownership in that fund. Funds must calculate their share price on days on which purchase or redemption requests have been made based on the market value of the assets in the fund’s portfolio, after expenses, divided by the number of shares outstanding. This leads to a figure known as the net asset value (NAV). Per-share values change as the value of the assets in the fund’s portfolio changes. Investors can sell their shares back to the fund at any time at the current NAV. Many newspapers carry the purchase and redemption prices for mutual funds on a daily basis.

A mutual fund is owned by its hundreds or thousands of shareholders. A board of directors is responsible for overseeing the fund’s investment policies and objectives. The board generally does not do the work of the fund itself, but instead contracts with third parties to provide the necessary services. The Investment Company Act of 1940 requires that at least 40 percent of the board of directors be independent of the fund, its adviser, and underwriter. One of the functions of the board is to approve the mutual fund’s contracts with its investment adviser. The investment adviser plays a key role in the operation of a mutual fund. The investment adviser manages the fund’s investment portfolio by deciding what securities to buy and sell in accordance with the fund’s stated investment objectives. Other functions of the board include choosing the administrator, who generally acts as the fund’s manager by keeping the books and records, filing necessary reports with the Securities and Exchange Commission (SEC), and calculating NAV; the distributor or “underwriter,” who either sells the fund’s shares directly to the public or enters into agreements with broker-dealers or banks that will in turn sell them to retail customers; the transfer agent, who keeps track of fund shareholders and maintains information about the number of shares owned by investors; and the custodian, who is responsible for safeguarding the cash and securities assets of the fund, paying for securities when they are purchased by the fund, and collecting the income due when securities are sold.

Mutual funds are sold to the public in two basic ways: directly to the public or through a sales force, such as a broker. With direct marketing, funds often solicit customers through newspaper, television, and magazine advertising or direct mail. These funds typically have low or no sales fees, or “loads.” Funds that are marketed primarily through a sales force are usually available through a variety of channels, including brokers, financial planners, banks, and insurance agents. These sales people may be compensated through a load, which is included in the price at which the fund’s shares are offered; through a distribution fee paid by the fund; or both.

Regulation of Bank and Thrift Mutual Fund Activities

The mutual fund activities of banks and thrifts are subject to a number of federal and state securities and banking laws and regulations—and to the shared oversight of a variety of federal and state securities and banking regulators. In general, the mandate of securities laws is to protect investors through full and timely disclosures, while many banking laws are geared to protecting depositors and ensuring bank safety and soundness.

Federal Securities Laws Apply to Mutual Fund Activities

The principal securities laws that apply to mutual funds are the Investment Company Act of 1940; a companion law, the Investment Advisers Act of 1940; and the Securities Act of 1933. These laws are intended to foster full disclosure of the risks involved in buying mutual funds and to protect investors.

The Investment Company Act requires all mutual funds to register with SEC. The act contains numerous requirements relating to the operation of funds, including rules on the composition and election of boards of directors, disclosure of investment objectives and policies, approval of investment advisory and underwriting contracts, limitations on transactions with affiliates, permissible capital structures, custodial arrangements, reports to shareholders, and corporate reorganizations.

Investment advisers to mutual funds, except banks, are subject to the Investment Advisers Act, which requires that any firm in the business of advising others as to the value of securities register with SEC. The Advisers Act also imposes reporting requirements on registered investment advisers and subjects them to restrictions against fraudulent, deceptive, or manipulative acts or practices.

The Securities Act of 1933 requires that all publicly offered shares of any issuer, including mutual funds, be registered with SEC. In addition, SEC has adopted rules under that act to require extensive disclosures in a fund’s prospectus, including information about the fund’s investment objectives and policies, investment risks, and all fees and expenses. The act also regulates mutual fund advertising.

In addition to the above laws, another securities law, the Securities Exchange Act of 1934, regulates how shares in mutual funds are sold. This act requires that persons distributing shares or executing purchase or sale transactions in mutual fund shares be registered with SEC as securities broker-dealers.

SEC oversees the regulation of mutual funds and their investment advisers under the Investment Company Act and the Investment Advisers Act. SEC reviews disclosure documents, such as prospectuses, and inspects mutual fund operations. It also registers and inspects investment advisers. Broker-dealers who sell mutual funds are regulated and examined by SEC and the National Association of Securities Dealers (NASD). NASD was established pursuant to the Securities Exchange Act of 1934 as a self-regulatory organization for brokerage firms, including those that engage in mutual fund distribution, and is itself subject to SEC’s oversight. SEC and NASD regulate broker-dealers by regularly examining broker-dealer operations on-site and investigating customer complaints. NASD has also established Rules of Fair Practice, which govern standards for advertising and sales literature, including filing requirements, review procedures, approval and recordkeeping obligations, and general standards. In addition, NASD tests individuals to certify their qualifications as registered representatives and has primary responsibility for regulating advertising and sales literature used to solicit and sell mutual funds to investors.

Banks Are Exempt From Requirements to Register as Broker-Dealers and Investment Advisers

The Securities Exchange Act of 1934 exempts banks from its broker-dealer registration requirements. As a result, banks may choose to have their own employees sell mutual funds and other nondeposit investment instruments without the need to be associated with an SEC-registered broker-dealer or subject to NASD oversight. In those instances, the banking regulators, instead of NASD, are responsible for overseeing the sales activities of bank employees.

Banks are also exempt from being defined as investment advisers under the Investment Advisers Act. As a result, banks may serve as investment advisers to mutual funds without registering with SEC. However, some banking organizations place their advisory activities in a nonbank subsidiary of a bank holding company. In these cases, the subsidiary is required to register as an investment adviser and is subject to SEC oversight under the Investment Advisers Act.

Federal Banking Laws and Regulation

In addition to the oversight provided by securities regulators, a number of banking laws apply to banking organizations’ mutual fund activities. One such law is the Glass-Steagall Act, which was enacted in 1933. The Glass-Steagall Act was designed to curb perceived securities abuses and speculative investments by banks that were thought to have contributed to the collapse of commercial banking in the early 1930s. The act prohibits certain securities activities by banks and their affiliates. For example, the act generally prohibits all banks from underwriting (publicly distributing new issues of securities) and dealing (trading for its own account) in certain securities directly. It also prohibits Federal Reserve System member banks from purchasing certain securities for the bank’s own account and from having interlocking management relationships with firms that are engaged primarily or principally in underwriting securities.Until the early 1980s, Glass-Steagall was viewed as prohibiting banks from engaging in most mutual fund activities. Since then, a series of federal banking agency decisions and court rulings have eroded the Glass-Steagall restrictions and allowed banks to engage in a wide variety of mutual fund activities that had not been permitted previously. These include serving as the investment adviser to a mutual fund, selling mutual funds to retail and institutional customers, and offering various administrative services, such as recordkeeping and custodial functions. Essentially, banks can now do everything but underwrite a mutual fund.

While the Glass-Steagall Act restricts banks’ mutual fund activities, the actual powers granted banks to engage in these activities and the framework for their regulation and oversight are found in other laws. The powers of national banks to engage in mutual fund activities are contained in the National Bank Act, which is administered by the Office of the Comptroller of the Currency (OCC). State-chartered banks derive their powers from the state laws under which they are chartered, subject to restrictions imposed by the Federal Reserve Act if they are members of the Federal Reserve System. State-chartered banks that are members of the Federal Reserve System are supervised by the Federal Reserve Board as well as by state-level banking authorities. Federally insured state-chartered banks that are not Federal Reserve members are subject to regulation and oversight by the Federal Deposit Insurance Corporation (FDIC) under the Federal Deposit Insurance Act and state banking authorities. The powers of bank holding companies are found in the Bank Holding Company Act of 1956, which is administered by the Federal Reserve Board. The authority for thrifts and their affiliates to engage in mutual fund activities is contained in federal and state laws applicable to savings and loan associations, particularly the Home Owners’ Loan Act and the Federal Deposit Insurance Act. Thrifts are supervised by the Office of Thrift Supervision (OTS).

Objectives, Scope, and Methodology

This report was prepared in response to requests from the former Chairmen of the House Committee on Banking, Finance, and Urban Affairs and the Subcommittee on Oversight and Investigations of the House Committee on Energy and Commerce that we examine the disclosure and sales practices of banks with respect to mutual funds. Our objectives were to (1) determine the extent and nature of bank and thrift involvement in mutual fund sales, (2) assess whether the sales practices followed by banks and thrifts provide bank customers adequate disclosures of the risks of investing in mutual funds, and (3) analyze whether the existing framework for regulation and oversight of bank and thrift mutual fund sales practices and proprietary fund operations adequately protects investors.

To determine the extent and nature of bank and thrift involvement in mutual fund sales, we gathered and analyzed information on the size of the mutual fund market, the level of bank and thrift participation in it, and the methods by which banks and thrifts market mutual funds to their customers. To do this, we obtained data from Lipper Analytical Services, Incorporated, a well-known source of data on the mutual fund industry. Lipper maintains a database of information on bank-related mutual funds and publishes a semiannual report, “Lipper Bank-Related Fund Analysis,” which we used as a source for some of the information in this report. We also used other information accumulated by Lipper on the mutual fund industry as a whole. We did not verify the data we obtained from Lipper; however, we asked Lipper to provide us a detailed description of the methods it uses to accumulate data and the internal controls it employs to ensure its accuracy. We used the description to determine that these methods and controls would provide reasonable assurance that the information supplied by Lipper was accurate. In addition, we determined that Lipper’s mutual fund data are widely used in the financial services industry and are considered reliable by those who use it. Because Lipper’s database does not cover the extent to which nonproprietary funds are sold through banks, we also surveyed a random sample of 2,610 banks and 850 thrifts to obtain comprehensive data on which of these institutions offer mutual funds for sale, the types of funds they sold, and their recent sales data. In addition, to obtain additional information on the characteristics of mutual fund sales through banks and thrifts, we reviewed pertinent regulatory and industry studies, particularly a survey of mutual funds that was released by ICI in November 1994.

To determine whether the sales practices followed by banks and thrifts provide bank customers adequate disclosures of the risks of investing in mutual funds, we developed and mailed a questionnaire to a random sample of banks and thrifts asking these institutions to provide information concerning how and by whom mutual funds are sold to retail customers, how sales personnel are compensated, whether written policies and procedures have been established, and the types of disclosures that are made to retail customers. Posing as bank customers interested in a mutual fund investment, we also visited a randomly selected sample of 89 central offices of banks and thrifts in 12 cities. The purpose of these visits was to observe and document the sales practices of institutions selling mutual funds and to test whether salespersons were following the federal banking regulators’ guidance concerning mutual fund sales programs. A detailed explanation of the methodology we used in our survey questionnaire and in our visits to banks and thrifts is contained in appendix I.

To gain an understanding of how the existing regulatory framework for overseeing bank sales of mutual funds protects investors, we (1) interviewed selected bank and thrift regulators, securities regulators, bank and thrift officials, and industry representatives in Washington, D.C.; New York, New York; Boston, Massachusetts; Philadelphia, Pennsylvania; San Francisco, California; and Chicago, Illinois; (2) reviewed relevant literature, congressional testimony, studies, regulations, and laws; and (3) reviewed and analyzed financial regulators’ examination policies, procedures, reports, and workpapers.

We did our work between May 1993 and December 1994 in accordance with generally accepted government auditing standards.

We provided a draft of this report to FDIC, the Federal Reserve, NASD, OCC, OTS, and SEC for comment. Their comments are presented and evaluated in Chapters 3 and 4, and their letters are reprinted in full in appendixes IV through IX, along with our additional comments. The organizations also suggested several technical changes to clarify or improve the accuracy of the report. We considered these suggestions and made changes where appropriate.

Banks and Thrifts Have Rapidly Expanded Their Participation in the Mutual Fund Industry

Since restrictions on banks’ mutual fund activities were liberalized in the 1980s, banks and thrifts have rapidly expanded their participation in the mutual fund industry. Many institutions have established their own families of mutual funds, called proprietary funds, and the sales of these funds as a percentage of total industry sales have grown sharply. Banks and thrifts have also become major sales outlets for nonproprietary mutual funds. Institutions with assets greater than $1 billion are more likely to sell mutual funds than are those with less assets, but most of the institutions that have begun selling mutual funds since the end of 1991 are the smaller ones. Most banks and thrifts reported that they sell mutual funds for two reasons: to keep their customers and to increase their fee income.

Growth of Proprietary Funds Has Outpaced the Industry as a Whole

As of December 31, 1993, about 114 bank and thrift companies had established proprietary mutual funds. These are funds for which a bank or one of its subsidiaries or affiliates acts as the investment adviser and that are marketed primarily through the bank. Most of these have been established by very large banking organizations; of the 114 companies that had proprietary funds as of December 31, 1993, 79 were among the top 100 bank holding companies in the United States.

During the 5 years between the end of 1988 and the end of 1993, the growth of bank proprietary funds in terms of the value of assets managed by the funds has been much greater than the growth of the industry as a whole. As shown in table 2.1, between December 31, 1988, and December 31, 1993, the value of assets managed by bank proprietary funds grew from about $46 billion, or 6 percent of the industry total, to about $219 billion, or 11 percent of the industry total. Although banks greatly increased their sales of mutual funds to retail customers during the 5 years, the increase in their sales to institutional customers was even greater. Retail sales grew by 324 percent, and institutional sales grew by 443 percent. Nearly $119 billion of the $219 billion (54 percent) of the assets in bank proprietary funds at year-end 1993 were in funds marketed primarily to institutional customers. In contrast, only about 10 percent of the assets in nonproprietary funds were marketed primarily to institutional customers.

The number of proprietary funds offered by banks also grew faster than the industry as a whole. As shown in table 2.2, as of December 31, 1988, there were 317 bank proprietary funds, representing about 13 percent of the 2,372 total mutual funds in existence at that time. By December 31, 1993, banks offered 1,415 proprietary mutual funds, or 24 percent of the industry total of 5,851 funds. Table 2.2 also shows that, while more than one-half of the assets in bank funds were in money market funds, the greatest growth, both in the number of funds offered and assets managed, was in taxable fixed-income (bond) funds, followed by equity funds.

Banks and Thrifts Have Become Major Retailers of Nonproprietary Funds

In addition to sales of proprietary funds, banks and thrifts also have become major sales outlets for nonproprietary funds. These are funds managed by an independent fund company and sold by the bank or bank affiliate. Nonproprietary funds are also available to investors outside the bank through an unaffiliated broker-dealer. According to data compiled by ICI, 1,780 nonproprietary funds were available through the bank channel (banks and thrifts) at the end of 1993. This represents a 62-percent increase from the 1,100 funds available as of the end of 1991.

ICI’s data also show that new sales of fixed-income and equity funds through the bank channel rose from $28.1 billion in 1991 to $67.5 billion in 1993. However, because sales of fixed-income and equity funds through nonbank channels also rose considerably, the percentage of sales through the bank channel to total sales increased only slightly, from 13 percent in 1991 to 14 percent in 1993. In addition, ICI found that about 55 percent of banks’ sales of fixed-income and equity funds in 1991 was attributable to sales of nonproprietary funds. This figure rose to 59 percent in 1992, then dropped to 51 percent in 1993. An ICI official told us that the increase in bank sales of nonproprietary funds in 1992 was caused by a strong demand for equity funds—a segment of the market in which bank proprietary funds were not as well represented as were nonproprietary funds. In 1993, there was a surge in demand for fixed-income funds, a segment in which bank funds were well represented. Also, by 1993 banks had introduced more equity funds. As a result, bank sales of proprietary funds increased in 1993 compared to their sales of nonproprietary funds.

ICI’s data show that, as of the end of 1993, the assets of funds attributable to bank sales were about $298 billion, or 14.2 percent of the $2.1 trillion in total mutual fund assets. This figure includes both proprietary and nonproprietary funds sold through banks and thrifts. In 1991, the comparable percentage was 11.6 percent, and in 1992, 13.8 percent. In breaking down the total between money market funds and long-term funds (fixed-income and equity funds), ICI found that in 1993, nearly 29 percent of all money market fund assets were attributable to bank and thrift sales. Less than 9 percent of long-term fund assets were attributable to bank and thrift sales, indicating the relatively strong presence of banking institutions in the money market fund area. However, the 9 percent of long-term fund assets attributable to bank and thrift sales at year-end 1993 represents a near doubling of the comparable figure at year-end 1991.

Larger Institutions More Likely to Have Fund Sales, but Smaller Institutions Are Increasingly Entering the Market

On the basis of the responses to the questionnaire we sent to a nationwide sample of banks and thrifts, we estimate that nearly 17 percent, or about 2,300 of the approximately 13,500 banks and thrifts in the United States, were offering mutual funds for sale as of the end of 1993. The results also indicated that the larger the size of the institution, the greater the likelihood that it had a mutual fund sales program. About 74 percent of the banks with $1 billion or more in assets had mutual fund sales programs, but only 11 percent of the banks with assets less than $150 million sold mutual funds. Similarly, about 60 percent of thrifts with assets of $1 billion or more had sales programs, but only about 3 percent of thrifts with assets less than $100 million sold mutual funds.

Our data also show that while larger institutions are more likely to sell mutual funds, smaller institutions are increasingly introducing mutual fund sales programs. We estimate that about 49 percent of all banks and thrifts that had mutual fund sales programs began selling funds within the last 2 years. About 74 percent of those banks entering the mutual fund sales arena over the previous 2 years had assets of less than $250 million.

Customer Retention and Fee Income Are the Main Reasons Banks and Thrifts Said They Sell Mutual Funds

About 94 percent of the banks and thrifts responding to our questionnaire cited retention of customers as of great or very great importance in their decisions to begin selling mutual funds to their retail customers, and about 49 percent reported that fee income was of great or very great importance in their decisions. However, fee income may become more important after sales begin.

Discussions we had with bank officials showed that once the mutual fund sales program is established, the objectives of the program may broaden to include the generation of fee income. For example, an official of one very large bank with a large and widely marketed family of proprietary funds told us that initially the bank began offering uninsured investments, including mutual funds, as a defensive measure to retain customers. The bank now offers a full line of investment products and recognizes this as a key customer service and revenue-generator. A July 1994 survey by Dalbar Financial Services, Inc., of Boston, Massachusetts, a mutual funds research and consulting firm, confirmed that fee income becomes more important as a mutual fund sales program matures. Dalbar’s survey of over 200 bank executives indicated that while almost half of the respondents said they got into the business to retain customers, only 36 percent said that was still their top priority. In contrast, about 30 percent of the bankers said that they were now in the business to increase fee income, up from 19 percent who said that was the reason they got into the business in the first place.

Inadequate Disclosure of Risks Associated With Mutual Fund Investing

In response to the rapid growth of sales of mutual funds by banks and concerns that bank customers may be confused or ill-informed about the differences between mutual funds and traditional bank products, the federal banking regulators have increased their regulatory and supervisory oversight of banks’ mutual fund sales activities. Our visits to banking institutions demonstrated the need for this increased emphasis as well as for continued vigilance by regulators. We estimate that about one-third of the institutions that sold mutual funds in the 12 metropolitan areas we sampled fully complied with the bank regulators’ guidance on disclosing the risks of investing in mutual funds. Further, about one-third of the institutions did not clearly distinguish their mutual fund sales area from the deposit-taking areas of the bank as stated in the guidance. Many banking institutions paid employees in the deposit-taking areas to refer customers to mutual fund sales representatives. During our visits to the institutions we found that these employees complied with statements in the guidance about not providing investment advice. However, some of the sales literature we were provided did not clearly and conspicuously disclose the risks of investing in mutual funds.

Concerns About Bank Sales of Mutual Funds

As banking institutions have become major retailers of mutual funds, regulators, Congress, and the public have become increasingly concerned that investors who are likely to purchase mutual funds through a bank or thrift may not fully understand the differences between these investments and traditional bank savings products, such as certificates of deposit and money market deposit accounts. In particular, there is concern that sales of mutual funds in a bank lobby or through bank employees may mislead customers into believing that mutual funds are federally insured. Further, bank customers may not understand that even mutual funds that appear to be conservative investments, such as government bond funds, may be subject to fluctuations in value and could involve loss of principal.

In November 1993, SEC released the results of a survey taken to determine the degree to which investors understand the risks associated with mutual funds. The survey was limited to 1,000 randomly selected households, 47 percent of which reported that they owned shares of mutual funds. The survey results indicated that confusion about the risks of investing in mutual funds was not limited to those who purchased mutual funds through a bank. For example, 66 percent of the investors in the survey who bought money market mutual funds through a bank and 41 percent of all holders of mutual funds incorrectly believed that these funds are federally insured. In addition, 39 percent of all mutual fund holders and 49 percent of those who purchased a mutual fund through a bank incorrectly believed that mutual funds purchased from a stockbroker are federally insured.

Federal Banking Regulators Have Issued Guidance on How Mutual Fund Sales Are to Be Conducted

Between June and October 1993, each of the four banking regulators—OCC, FRS, FDIC, and OTS—issued guidance to the institutions they regulate concerning how sales of mutual funds and other nondeposit investment products should be conducted. In February 1994, the four regulators jointly issued the “Interagency Statement on Retail Sales of Nondeposit Investment Products.” This new guidance superseded the guidelines previously issued and unified the guidance to banks and thrifts on the policies and procedures that they should follow in selling mutual funds and other nondeposit investment products.

The interagency statement contains guidelines on disclosures and advertising, the physical setting and circumstances for bank sales of investment products, qualifications and training of sales personnel, suitability and sales practices, compensation practices, and internal control systems. In particular, it emphasizes that banking institutions are to ensure that bank customers are made aware that the products (1) are not FDIC-insured; (2) are not deposits or other obligations of the institution; (3) are not guaranteed by the institution; and (4) involve investment risks, including possible loss of principal. The statement applies to bank employees as well as employees of either an affiliated or unaffiliated third-party broker-dealer when the sales activity occurs on the premises of the institution. It also applies to sales resulting from a referral of retail customers by the institution to a third party when the institution receives a benefit from the referral. With regard to qualifications and training of sales personnel, the guidance states that if bank personnel sell or recommend securities, the training they receive should be the substantive equivalent of that required for personnel qualified to sell securities as registered representatives under the securities laws.

Some Institutions Did Not Adequately Disclose the Risks of Mutual Fund Investing

Oral disclosure of the risks of mutual fund investing is very important in making sure that customers fully understand the nature of these investments. On the basis of our visits to 89 banking institutions in 12 metropolitan areas, we estimate that about 32 percent of the institutions in these areas that sell mutual funds completely disclosed the risks associated with investing in mutual funds in accordance with the banking regulators’ guidance. In addition, disclosure of the risks of investing in bond funds was inadequate, when compared to the guidance, at about 31 percent of the institutions. However, there were no misleading references to Securities Investor Protection Corporation (SIPC) insurance during our visits.

Sales Personnel at Many Institutions Did Not Orally Disclose the Risks Associated With Investing in Mutual Funds

The most important difference between a bank’s mutual fund investments and deposits is the risk to the investor. Bank depositors’ accounts are insured up to $100,000 by FDIC. Mutual funds are not insured against market loss and, consequently, are more risky to the investor. The guidance issued by the banking regulators states that retail customers must be clearly and fully informed about the nature and risks associated with nondeposit investment products. Specifically, when nondeposit investment products are either recommended or sold to retail customers, the disclosures must specify that the product is (1) not insured by FDIC; (2) not a deposit or other obligation of the institution; (3) not guaranteed by the institution; and (4) subject to investment risks, including possible loss of the principal amount invested.

The interagency guidance states that these disclosures should be provided to the customer orally during any sales presentation, orally when investment advice concerning nondeposit investment products is provided, orally and in writing prior to or at the time an investment account is opened to purchase these products, and in advertisements and other promotional materials. In addition, guidance issued by NASD in December 1993 stated that its bank-affiliated members must develop procedures that require registered sales persons to reiterate to customers, in all oral and written communications, the material differences between insured depository instruments and investments in securities that carry risk to principal. The NASD guidance specifically noted that advertising and sales presentations should disclose that mutual funds purchased through banks are not deposits of, or guaranteed by, the bank and are not federally insured or otherwise guaranteed by the federal government.

The interagency guidance emphasizes that bank customers should clearly and fully understand the risks of investing in mutual funds. Therefore, we tested whether the sales representative made the disclosures called for in the interagency guidance without our prompting.

We found that sales personnel at many of the institutions we visited in our survey of bank sales practices did not fully comply with the disclosure requirements. As shown in figure 3.1, sales personnel at an estimated 32 percent of the banks and thrifts we visited disclosed all four of the critical facts concerning the nature and risks associated with mutual fund investments during their sales presentations, and less than half (43 percent) disclosed at least three of the four risks. At the other end of the disclosure spectrum, sales personnel at 19 percent of the institutions did not mention any of the four risks.

Neither Bank Employees Nor Broker-Dealer Employees Adequately Disclosed Risks

Because of the small size of our sample, none of the differences in performance between bank and broker-dealer employees that could be identified are statistically significant. Less than half of each group made all the disclosures called for in the guidance. For example, an estimated 44 percent of bank employees disclosed all four risks, as compared to 32 percent who were employees of broker-dealers. Similarly, about 6 percent of bank employees failed to make any of the disclosures called for in the guidance, and 18 percent of the broker-dealers made no disclosures.

Disclosure of Bond Fund Risks Was Inadequate at Over 30 Percent of the Institutions

Investors who purchase mutual funds through a bank or thrift are likely to be more conservative than those who purchase mutual funds elsewhere and to be more interested in purchasing a bond fund because they believe these funds are relatively safe. However, the prices of bonds and bond mutual funds are affected by changes—or the expectations of changes—in interest rates. In general, the value of bonds and bond mutual funds moves in the opposite direction of interest rates. If interest rates rise on new bonds, the prices of older ones decline. Thus, investors who own shares of bond mutual funds could find that the value of their investment is worth less than they paid for it if interest rates go up after they purchased the funds.

NASD has recognized that investors with deposits, such as maturing certificates of deposit, may be interested in purchasing bond mutual funds because of their higher yields, but they may not be aware of the risks posed by these investments. In December 1993, NASD told its members that they “...have a significant obligation in their oral as well as their written communications to provide customers, seeking non-depository alternatives to depository accounts, with full and fair disclosure of the material differences between the products, especially the greater degree of risk to capital that the customer may experience.” With regard to bond funds, NASD stated that investors should receive clear disclosures that although such funds may pay higher rates than certificates of deposit, their NAVs are sensitive to interest rate movement, and a rise in interest rates can result in a decline in the value of the customer’s investment.

In our visits, we wanted to determine whether the salesperson fully explained the effect of interest rate fluctuations—either up or down—on the value of the underlying bonds in a bond mutual fund and, consequently, the value of the fund shares. We estimated that at 66 percent of the institutions sales personnel explained the effect of interest rate movement on the value of the underlying bonds in the fund and the value of the fund shares. At 31 percent of the institutions the explanations were either nonexistent or unclear to us. About 3 percent of the institutions visited did not sell bond funds. “He explained that although bond funds are more conservative, they are still exposed to risk, especially as interest rates rise, prices of bond funds decline. He stressed that before recommending any particular fund he would need to discuss our personal financial information.” “Early in his presentation, the representative discussed in general terms the impact of the movement of interest rates on bond values. When asked about the safety of bonds, he provided more detail on the relationship of bond values and changes in interest rates. He used an example that clearly illustrated the relationship along with discussing the impact of the recent decision by the Federal Reserve to raise interest rates on current bond values.” “The sales representative did a very good job of explaining the effect of interest rate fluctuations on the value of bonds. The representative put no particular emphasis on either stock or bond funds. She clearly explained the difference in terms of risk and discussed the effect of interest rate fluctuations on bond funds early on.” “He said a lot about bond funds, but was very unclear. If he made this relationship, I missed it. He said bonds had higher yield, but were more volatile. He also said that they were FDIC insured ’like CDs’.” “The salesperson provided very little information on bond funds other than they are “safe” relative to stocks. She stressed that all of the bank’s funds are safe because they are relatively conservative funds.”

There Were No Misleading References to SIPC Insurance

A critical part of the disclosure issue is the use of potentially misleading or confusing information concerning FDIC insurance coverage for mutual fund investments. The banking regulators’ guidance statement states that when any sales presentations involve reference to insurance coverage by any entity other than FDIC, such as SIPC, a state insurance fund, or a private insurance company, the customer must be provided with clear and accurate explanations to minimize any possible confusion with FDIC insurance. Further, the guidance states that such representations should not suggest or imply that any alternative insurance coverage is the same as or similar to FDIC insurance. In our visits, we did not observe any instances of inadequate or confusing or misleading references to SIPC during the sales presentations.

Distinction Between Mutual Fund Sales Areas and Deposit-Taking Areas Was Not Always Clear

Selling or recommending mutual funds or other nondeposit investment products on the premises of a depository institution may give the impression that the products are FDIC-insured or are obligations of the depository institution. To minimize confusion, the guidance states that sales or recommendations of nondeposit investment products on the premises of the institution should be conducted in a physical location distinct from the retail deposit-taking area. In situations where physical considerations prevent sales of nondeposit products from being conducted in a distinct area, the institution has a responsibility to ensure that appropriate measures are in place to minimize customer confusion.

In our visits to banking institutions, we evaluated what measures had been taken to clearly separate their retail deposit-taking areas, such as teller windows and new account desks where accounts and deposits could be taken, from the area where nondeposit investment products were sold. As part of our visits, we observed the physical layout of the bank to ascertain whether the bank clearly distinguished its mutual funds/investment services sales area from its traditional banking activities area. In some cases, we were directed to separate offices located in another building, where we also evaluated the physical layout of those offices. We looked for such things as partitions, roping, separate cubicles, floor space, and glass walls. We also looked for signs and other means of visible communications to differentiate the area from the traditional banking activities. At the end of the visit, we evaluated the extent to which the facilities appeared to clearly separate the areas for mutual funds sales activities from traditional banking activities. “There was no separation of mutual funds and banking activities. The sales representative sat at an unmarked desk in the middle of the bank floor. There were no signs present. However, her business cards were on the desk. All brochures of mutual fund activities were in her desk drawer. No signs indicating non-FDIC insured, non-bank product or potential loss of principal.” “There was nothing at all to indicate mutual fund sales. No signs, no posters, no brochures, nothing. In fact, we thought the sales area would be in the adjacent loan section, where we were told to enter. But there were no signs there. The only clue was a sign on the person’s desk saying that he was a registered representative for a company. For the entire time we were in the bank until we met with him, we could not have known that they sold mutual funds. The mutual fund sales desk was co-located in an area offering traditional banking activities such as new accounts and customer service. The mutual fund sales desk did not contain any signs or displays to distinguish it from other banking activities. In fact, the mutual fund sales desk was located next to the main bank reception desk near the front door of the bank. (All desks were separated by 3-foot partitions).” “The bank floor space was extremely limited. Desks were fairly close together—all bank activities were in close proximity to one another. Although the space was limited, there was a hanging sign clearly marked “Investment Services.” There was one sign on the desk approximately 10” x 12” displaying the proprietary fund which stated non-FDIC insured and not guaranteed by the bank. This information was at the bottom of the sign and readable, the size of the print was fine. A kiosk next to the desk also identified the same information. Overall, disclosure was fairly clear to a new customer.” “Two desks were located at the far end of the lobby approximately 25 feet from the teller windows. They were the only 2 desks in that space—one desk belonged to the mutual fund sales representative and the other to his assistant. Both desks faced the lobby with the representative’s desk on the right if one were looking at the mutual fund area. To the right of the representative’s desk was a very large (3’x 5’), lighted sign indicating the sale of mutual funds. A rack of mutual fund brochures was to the right of the sign. No other bank activities were near the mutual fund area.”

Roles and Responsibilities of Employees in Deposit-Taking Areas Generally Complied With Regulatory Guidance

The banking regulators’ guidance states that “in no case” should tellers and other employees, while located in the routine deposit-taking area, such as the teller window, make general or specific investment recommendations regarding nondeposit investment products, qualify a customer as eligible to purchase such products, or accept orders for such products, even if unsolicited. However, tellers and other employees who are not authorized to sell nondeposit investment products may refer customers to individuals who are specifically designated and trained to assist customers interested in the purchase of such products.

Most of the banks and thrifts that sold mutual funds indicated in their responses to our questionnaire that they limited their employees—tellers, other branch employees, and bank and branch managers—to referring customers to designated nondeposit investment sales personnel. The activities of bank tellers were the most restricted—only about 3 percent were permitted to do anything other than refer customers to designated investment sales personnel. Other bank branch employees who were not licensed to sell securities, such as those who open new accounts and process loan applications, and branch managers were less restricted—about 13 percent of bank branch employees and 18 percent of branch managers were allowed to perform sales activities other than refer customers to designated sales representatives.

With regard to the specific activities that bank and thrift employees are allowed to perform, about 1 percent of the banks and thrifts that sold mutual funds reported that they allowed tellers to discuss the investment needs of the customer and noninsured products available through the institution; about 8 percent of other branch employees and 12 percent of branch managers were permitted to perform this function. Almost none of the institutions reported that they permitted tellers or other branch employees to suggest that a customer should invest in a specific investment product. Less than 2 percent reported that they allowed branch managers to offer specific investment advice to customers. NASD noted that if these activities were permitted to occur in the deposit-taking area of the bank they would appear to violate the interagency guidance. In addition, if a bank broker-dealer is involved and the bank employees performing these activities are unregistered, current NASD rules, which prohibit unregistered persons from providing investment advice, would also appear to be violated.

In our visits to banks in 12 metropolitan areas, we found that most banks and thrifts were limiting the activities of personnel in the deposit-taking area of the bank. We found that only 1 percent of bank tellers we met discussed investment needs in general or noninsured products available through the bank. None of these discussions related to specific investments.

The guidance permits institutions to pay tellers and other bank employees who are not authorized to sell investment products nominal, one-time, fixed dollar fees for each referral to a sales representative whether or not a transaction takes place. SEC, however, has taken the position that referral fees to financial institution personnel who are not qualified to sell investment products should be eliminated. According to SEC, because investors who purchase securities on the premises of a financial institution may not be aware that the securities are not guaranteed by that institution or by the federal government, the payment of referral fees creates an inappropriate incentive for unqualified bank employees to offer unauthorized investment advice to their customers. In addition, in December 1994, NASD issued a notice requesting comment on proposed amendments to its rules governing broker-dealers operating on the premises of financial institutions. Under these proposed rules changes, broker-dealers would be prohibited from making any payments, including referral fees, to individuals employed with the financial institution who are not registered representatives of the broker-dealer. As of June 1995, NASD had completed its review of 284 comment letters received on its proposal, and the letters were being considered by NASD’s bank broker-dealer committee.

About 43 percent of the institutions that responded to our questionnaire indicated that they compensated at least one of the following groups with referral payments: tellers, other unlicensed branch employees, and bank and branch managers. According to officials of several banking institutions, these payments are typically for $5 or $10 and not contingent on whether a sale is actually made.

Proprietary Fund Sales Literature Generally Contained Key Disclosures but Presentation Was Not Always Clear

Our evaluation of proprietary fund sales literature obtained from the banks we visited showed that the great majority of documents contained disclosures of the risks of investing in mutual funds. However, in some cases the disclosures were not clear and conspicuous.

Under SEC rules, fund advertisements and sales literature may not be materially misleading. Money market funds, in particular, must disclose prominently that their shares are not insured or guaranteed by the U.S. Government, and that there can be no assurance that the fund will be able to maintain a stable net asset value of $1.00 per share. In addition, SEC requires disclosure by bank-sold and bank-advised funds that their shares are not deposits or guaranteed by the bank or insured by any U.S. government agency. Mutual fund advertisements and sales literature are required to be filed with NASD (if the fund’s shares are sold by an NASD member) or with SEC. According to SEC, as a practical matter, most fund ads and sales literature are filed with NASD rather than with SEC. NASD’s advertising department is to review advertisements and sales literature for compliance with both SEC’s rules and the NASD Rules of Fair Practice.

In addition to the requirements of the securities regulators, the banking regulators’ guidance states that advertisements and other promotional and sales material about nondeposit investment products sold to retail customers of depository institutions should conspicuously disclose that these products are not insured by FDIC; are not a deposit or other obligation of, or guaranteed by, the institution; and are subject to investment risks, including possible loss of principal. When we visited banks, we obtained sales literature for proprietary funds, which we analyzed to determine if it contained the required disclosures. In total, we analyzed 26 documents that we obtained at 15 banks. All of the documents we reviewed stated that the funds are not insured by FDIC and not guaranteed by the bank. All but three documents cautioned that mutual fund investments are subject to investment risks, including loss of principal, and all but four disclosed that mutual fund investments are not bank deposits.

We also reviewed the literature to determine whether it complied with the interagency guidance instructions that the risks be presented in a conspicuous, clear, and concise manner. We did this by looking at the placement of the disclosures, the size of the print used, the segregation of information in the literature as it pertains to FDIC-insured and noninsured products, and by making judgments about whether any obviously misleading or confusing information was presented. We were particularly concerned with whether any of the sales or marketing brochures suggested or conveyed any inaccurate or misleading impressions that the mutual funds were insured products or guaranteed. In our subjective evaluation, nearly half of the sales literature had disclosures that were conspicuous and readable to a great or very great extent. However, we characterized about 15 percent of the literature as having little or no success in achieving this objective. None of the advertising and sales brochures describing mutual fund products that we reviewed had the FDIC-insured logo or “Member FDIC” imprinted on them. “The disclosure information on risks is located at the bottom of the back page in very small print. It is very difficult to locate and read. In general, I do not believe the brochure gives proper emphasis to the fact that these funds are not insured by FDIC and may mislead someone into thinking that these funds are backed or guaranteed by the bank. All four brochures have the disclosure statement in small print on the back cover. There is no further discussion of those points in the literature and, in my opinion, the point could be easily overlooked.” “The brochure we received on behalf of the bank itself was an introductory booklet with application materials. This material all contained the required disclosures basically, although the disclosures do not state lack of FDIC insurance specifically, and disclosures are very small and are placed at the very back, bottom of the page. Very poor job of disclosing risks and uninsured nature. Also, much information is given in the brochure that would give the impression of a very safe, almost guaranteed investment, and very high returns. “ “One possible misleading or confusing statement is that the bank’s name is used on the cover without clearly identifying it as an investment instrument of the securities firm, and not the bank. Another piece of literature in the packet states that the funds are managed by investment professionals at the bank. Finally, the one page disclosure form is covered by other material and is the last item on the right-hand side. However, the disclosure form does have a section for the investor’s signature. The disclosure form is very effective, but it was the last item placed in the information packet. Nowhere in the first five plus pages was there any mention of the four required elements. A smaller brochure within the information packet included a statement on the back cover in very small print.”

In September 1994, OCC released the results of a review it did of materials used by national banks in the sale of mutual funds and annuities. The review included about 8,500 documents that were voluntarily submitted by over 700 banks. The review identified many documents that were not consistent with the interagency statement. Problems uncovered by OCC, together with OCC’s advice on how the problems should be corrected, included the following:

Conspicuousness: Not all documents met OCC’s standards—disclosures in type at least as large as the predominant type and boxed, bolded, or bulleted if they appear other than on the cover or at the beginning of the relevant portion of a document. As a result of its review, OCC determined that disclosures on the back of documents were not conspicuous. Also, OCC now encourages banks to make the key disclosures in type that is larger and bolder than the predominant type in the document.

Key disclosures: OCC found that some documents did not include the disclosures that the product was not FDIC-insured, was not a deposit or obligation of the bank, was not guaranteed by the bank, and could result in the possible loss of principal. In some cases, the agency told the affected banks that they could correct the problem by adding stickers that conspicuously provided the disclosure. In other cases, such as when the document contained qualifying remarks that limited the effectiveness of the disclosure, banks were advised to stop distributing the documents in question.

Fees: Some documents did not disclose applicable fees, penalties, or surrender charges. OCC counseled banks to make sure that fees were disclosed to customers and suggested that banks develop suitable written acknowledgement forms.

SIPC insurance: Some documents contained incomplete or confusing references to SIPC insurance. OCC told banks that they could correct these problems by using printed supplements that provide a more detailed description of SIPC coverage.

Relationships: Some documents did not disclose an advisory or other material relationship between the bank or an affiliate of the bank and the mutual fund whose shares were the subject of the document. Banks were reminded that such relationships should be disclosed.

Out-of-date forms: Some banks were using documents supplied by third-party vendors that were not the most current version provided by that vendor and did not contain all of the disclosure messages required by the interagency statement. OCC advised banks to remove and replace outdated forms and establish systems for controlling documents.

In commenting on a draft of this report, OCC stated that it is now reviewing sales-related documents as part of its regular on-site examinations and that it is finding that banks have improved their materials.

Some Institutions Provided Incentives for Selling Proprietary Funds

According to the banking regulators’ guidance, personnel who are authorized to sell nondeposit investment products may receive incentive compensation, including commissions. The guidance cautions that incentive programs should not result in unsuitable recommendations or sales to customers. It makes clear that sales personnel in banks should obtain directly from the customer certain minimum information, such as his or her financial and tax status and investment objectives, upon which to base their investment recommendations. However, banks are not prohibited from providing sales personnel greater compensation for selling proprietary, as compared to nonproprietary, funds, nor are they required to disclose any such arrangement to the customer.

In response to congressional interest in the extent to which incentives exist for sales personnel on bank premises to sell proprietary funds versus nonproprietary funds, our questionnaire asked banks and thrifts to describe their sales compensation policies. We also discussed the issue with a senior NASD official, who told us that it is a common and well-established practice in the industry for a sales representative to receive greater compensation, or a “better payout,” for selling the firm’s proprietary fund over third-party funds.

Eleven percent of the banks and thrifts that sold proprietary funds stated that sales personnel in their institutions received greater compensation or special incentives for selling proprietary funds than for selling nonproprietary funds. Of the banks that described their sales compensation policies, most stated that proprietary funds rewarded the salesperson with a greater payout or additional revenue. For example, one bank told us that both proprietary and nonproprietary funds pay a commission of 3.2 percent, but an extra 15 percent is added to the amount of the commission for a proprietary fund. We also asked the banks and thrifts that received our questionnaire to indicate whether or not sales personnel were expected to meet quotas or targets for the sale of proprietary funds. Eighteen percent of the banks that sold proprietary funds responded that sales personnel were expected to meet sales quotas or targets for proprietary fund sales. Most of the institutions that answered this question indicated that they expected proprietary fund sales to be a certain percentage of all mutual fund or bank product sales, or a specific dollar amount each month.

Customer Account Information Was Widely Used to Market Mutual Funds

The interagency guidance does not prohibit banks and thrifts from providing confidential financial information to mutual fund sales representatives. However, the guidance states that the institution’s written policies and procedures should include the permissible uses of customer information, but the guidance does not suggest what would or would not be permissible uses. Whether banking institutions should be allowed to share financial information on their customers with broker-dealers is a controversial issue. In March 1994, the North American Securities Administrators Association testified in favor of placing a prohibition on banks’ sharing confidential customer information with any affiliated securities operations. Also, NASD’s December 1994 proposed rule governing broker-dealers operating on bank premises included a provision that would prohibit its members from using confidential financial information maintained by the financial institution to solicit customers for its broker-dealer services. As of March 1995, NASD was still evaluating comments on its proposal. However, reports in banking industry journals indicated that many banks and banking regulators were strongly opposed to the rule. They characterize the rule as being unfair because (1) nonbank brokerages are permitted to supply their brokers with information about their customers’ use of bank-like services, such as certificates of deposit; and (2) the rule does not clearly define what is meant by confidential customer information. The latter issue could prove to be particularly difficult to resolve. For example, in commenting on a draft of this report, FDIC stated that it knows of no reliable definition of what customer information is confidential and what information is public. FDIC noted that, while banks must comply with laws concerning confidentiality of customer information, it did not want to prohibit the use of information that is otherwise available publicly or among a bank’s affiliates.

To obtain information on the extent to which banks and thrifts were using customer information in their mutual fund sales programs, we asked the institutions that received our questionnaire (1) whether they had written policies and procedures that covered the permissible uses of customer account information; and (2) to describe how they marketed their mutual funds and, if applicable, what customer information was used. About 68 percent of the institutions that responded to the question stated that they had written policies or procedures that described how customer account information is to be used. About 40 percent of the institutions that sold mutual funds stated that they provided customer information, such as account balances or CD maturity dates, to mutual fund sales personnel. Almost half of these (49 percent) said they provided sales personnel CD maturity lists; others said their sales personnel had access to all customer data (24 percent), and a minority (15 percent) provided customer account balances to their sales personnel. With regard to the use of other marketing techniques that are likely to make use of customer account information, 65 percent of our respondents used telephone calls to market their mutual funds; 63 percent targeted mailings to existing bank customers, such as holders of CDs; and 59 percent used inserts in monthly account statements.

Banking Regulators Have Developed Additional Examination Procedures

Although technically the interagency guidance does not have the same authority as a regulation, each of the banking regulators has developed additional examination procedures to evaluate bank and thrift compliance with the guidelines. In February 1994, about a week after the interagency guidance was issued, OCC issued examination procedures and an internal control questionnaire that specifically address sales of retail nondeposit investment products. OCC officials told us that these examination procedures are being used during the scheduled safety and soundness examination for each bank, which is either once every 12 months for large national banks, or once every 18 months for smaller national banks. The first examinations are to be a complete review of each bank’s mutual fund operations. OCC expected to complete these “benchmark” reviews by the end of 1995. Subsequent examinations could be less exhaustive depending on the results of the initial examinations. However, certain components of each review are mandatory, including separation of mutual fund sales activities, compliance with disclosure requirements, and review of suitability determinations. OCC officials told us that as of May 1995, their examinations have not shown any systemic problems with bank mutual fund sales programs. They have identified problems at individual banks, including failure to properly document suitability determinations and uncertainty about responsibilities for overseeing third-party broker-dealers, which they said these banks corrected. They also said that OCC has taken no formal enforcement actions against any bank as a result of the bank’s mutual fund sales program.

FDIC issued examination procedures for state nonmember banks participating in the sales of nondeposit investment products on April 28, 1994. According to an FDIC official, these procedures are being applied during the regularly scheduled safety and soundness examinations. FDIC’s procedures require that its examiners complete a questionnaire at each examination or visit in which the bank’s sale of nondeposit investment products is reviewed. The questionnaire includes a variety of questions on whether the bank is complying with various provisions of the interagency guidance. Copies of the completed questionnaires are to be forwarded to the responsible FDIC regional office, and significant deficiencies found during examinations are to be commented on in the examination report together with the recommended corrective action. An FDIC official told us that as of May 1995 FDIC had not taken enforcement actions against any bank with regard to the operation of the bank’s mutual fund sales program. However, FDIC examiners have found that written agreements between banks and third-party broker-dealers have, in some cases, not been complete. In addition, the examiners have found instances in which banks’ written policies governing their mutual fund programs needed to be more precise. An FDIC official said that FDIC has required banks to correct these problems. He also said that FDIC is conducting its own shopper visits to banks to test bank compliance with the interagency guidance. FDIC expects to complete these visits in late summer 1995 and expects to share the results of these visits with the other banking regulators.

On May 26, 1994, the Federal Reserve issued examination procedures for retail sales of nondeposit investment products. The procedures were to be used during examinations of state banks that are members of the Federal Reserve System as well as during inspections of nonbank subsidiaries that engage in securities sales on bank premises. According to Federal Reserve officials, the examination procedures were being used during annual safety and soundness examinations. All state-chartered banks that are members of the Federal Reserve System are to be examined using the new procedures by the end of 1995. Federal Reserve officials said that no material abuses have been found, but in some cases better recordkeeping and training of employees were needed. With regard to training of bank employees, Federal Reserve examiners have found some instances in which untrained bank employees were performing duties, such as gathering detailed financial information from customers, that are reserved to either licensed broker-dealers or to bank employees with training equivalent to licensed broker-dealers. The official said the Federal Reserve has been emphasizing to banks that employees who are not licensed by NASD are limited in the activities they can perform and has required banks to either appropriately train these employees or take measures to restrict their activities.

In addition to the additional procedures incorporated into the annual safety and soundness examinations, the Federal Reserve conducted an in-depth review of three large banks’ mutual fund programs. Federal Reserve officials told us that they have also developed consumer education seminars for elderly investors that are to be provided at the 12 Federal Reserve banks. Further, they said they are conducting banker education conferences at the 12 Federal Reserve banks to promote banks’ understanding of and conformance with the Federal Reserve’s requirements for mutual fund sales.

In April 1994, OTS issued guidelines for examining the securities brokerage activities of thrifts, including mutual fund sales. OTS’ guidelines focus on determining the adequacy of internal controls in containing the level of risk presented to the thrift and minimizing potential customer confusion between FDIC-insured and non-FDIC-insured investment products. The procedures call for the examiners to review advertising and promotional material, disclosure policies, procedures on the use of customer information, compensation policies, referral fees and practices, training and qualification policies and procedures, and systems for ensuring that investment recommendations are suitable for a particular customer. OTS officials told us that no systemic problems have been found in its examinations of thrifts’ mutual fund programs as of May 1995.

Conclusions

At the time of our review, many bank and thrift institutions did not fully comply with the guidance issued by the banking regulators. As a result, customers of those banks and thrifts may not have had accurate and complete information about the risks of investing in mutual funds. In addition, institutions that were not following the guidance opened themselves to the possibility of private lawsuits, particularly under the securities laws, that could affect the safety and soundness of the institution.

The banking regulators have recognized the importance of closely monitoring institutions’ mutual fund sales programs and have adopted procedures to be included in periodic safety and soundness examinations, which they are currently implementing.

Matter for Congressional Consideration

Because the banking regulators have adopted additional examination procedures to help ensure that banks provide customers accurate and complete information about the risks of mutual funds since the completion of our field work, we are not recommending changes to the regulators’ oversight practices at this time. However, after the interagency guidelines have been in place long enough to provide data for trend analysis, Congress may wish to consider requiring that the banking regulators report on the results of their efforts to improve banks’ compliance with the interagency guidance.

Agency Comments and Our Evaluation

In commenting on a draft of this report, OCC, OTS, and the Federal Reserve noted that we visited banks less than a month after the bank regulatory agencies issued the interagency guidance. These banking agencies indicated that the deficiencies we noted may have been attributable to the fact that during this time the institutions were in the process of implementing new procedures, and the agencies had not yet implemented related examination procedures. OCC commented that it believes that bank practices have changed significantly since we completed our visits. OCC also commented that the conclusions, captions, and discussion in this chapter did not adequately distinguish between the adequacy of banks’ oral and written disclosures. OCC believed that our conclusion that disclosure was inadequate appears to refer to the oral disclosure requirements, and the description of banks’ written disclosure efforts did not support a conclusion of inadequate overall compliance.

The Federal Reserve commented that since May 1994 its examiners have been confirming that state member banks are aware of, and making efforts to ensure that their sales programs are in conformance with, the guidelines. According to the Federal Reserve in those few cases where its examiners have discovered deficiencies, the banks in question have taken voluntary corrective action to address the problems.

Our visits to banks were made in March and April 1994. The timing of these visits was dictated by our desire to respond promptly to the Committees’ requests for information on the actual practices being followed by banks and thrifts in the sale of mutual funds. As noted in the report, these requests were driven by concern that customers of banking institutions were confused about how mutual funds differ from insured deposit products. Although our visits occurred shortly after the interagency guidance was issued, each regulator had issued guidance in 1993 that banking institutions should have been following. This guidance largely paralleled the February 1994 interagency guidance. For example, on July 19, 1993, OCC released guidance to national banks that covered many of the same areas that were included, and strengthened, in the February 1994 guidance. The July 1993 OCC guidance called for banks to take steps to separate, as much as possible, retail deposit-taking and retail nondeposit sales functions. It noted that disclosure of the differences between investment products and insured bank deposits needs to be made conspicuously in all written or oral sales presentations, advertising and promotional materials, and statements that included information on both deposit and nondeposit products. Further, it recommended that banks ensure that their sales personnel are properly qualified and adequately trained to sell investment products. Similar guidelines were issued by the Federal Reserve in June 1993, by OTS in September 1993, and by FDIC in October 1993.

While we believe that the results of our shoppers visits to banks and thrifts accurately portray those banks’ mutual fund sales activities at the time of our visits, we also realize that the institutions’ activities may change over time as the regulators implement their new examination procedures to ensure that the institutions comply with the interagency guidelines. We also believe that compliance with the guidelines is essential to ensure that investors obtain accurate and complete information about mutual fund risks. Thus, we believe that Congress may find it useful in exercising its oversight responsibilities to receive information on the banks’ compliance with the interagency guidelines after the banks and banking regulators have had sufficient time to fully implement their changes. Accordingly, we added a matter for congressional consideration suggesting that once the interagency guidelines have been in place long enough to provide sufficient data for trend analysis, Congress may wish to consider requesting the regulators to provide status reports on the results of their examination efforts. Such reports, for example, could be made a part of congressional oversight hearings.

We disagree with OCC’s comment that the report captions do not clearly distinguish between oral and written risk disclosures. (See pp. 29 and 37, for example). Further, we tested the extent of oral disclosures because of the importance placed on these disclosures by the interagency guidance. We believe that this is an appropriate emphasis because customers are highly influenced by what they hear during sales presentations. Further, although we found that most sales literature contained the required disclosures, the disclosures were not always clear and conspicuous. This paralleled OCC’s own findings in its September 1994 review of national banks that sold mutual funds. (See pp. 39 and 40.)

SEC commented that our testing of compliance with the interagency guidelines and discussion of the banking agencies examination procedures, as opposed to compliance with the federal securities laws and rules, appeared to place undue emphasis on the guidelines as a source of consumer protection in this area. SEC summarized the various means by which it and NASD regulate and oversee mutual fund sales practices of broker-dealers, including those operating on bank premises. SEC also outlined the ways in which it and NASD regulate and oversee mutual fund disclosure documents, including registrations, prospectuses, advertising, and sales literature. SEC stated that although the banking regulators’ guidelines are useful, the federal securities laws remain the most important set of investor protection criteria applicable to mutual funds and sales practices of broker-dealers. NASD made similar comments, noting that although the interagency guidelines are directly enforceable over banks and bank employees, they do not provide the bank regulators with direct and equal regulatory authority over SEC-registered NASD member broker-dealers, including the authority to bring enforcement actions for serious violations.

By using the interagency guidance as criteria to assess the sales practices being followed by banks and thrifts, we did not intend to minimize the importance of securities laws and regulations. Rather, we used the interagency guidance because it provided guidelines that applied to all mutual fund sales on bank premises, including indirectly to broker-dealers working under a contractual arrangement with a bank, and it contained bank-specific requirements that we wanted to test. In addition, we noted that the guidelines are similar in many respects to securities rules.

Expanded Role of Banks and Thrifts in the Mutual Fund Industry Raises Regulatory Issues

The current regulatory framework allows banking institutions to choose how to structure their mutual fund sales and advisory activities and, depending on that structure, how they are regulated. For example, banks can choose to sell mutual funds directly and be subject to oversight by the banking regulators, but not by securities regulators. However, most banks that sell mutual funds choose to do so through affiliates that are subject to the oversight of the securities regulators. Banking regulators also have issued guidance to banks that sell mutual funds through these affiliates. This creates a potential for different regulatory treatment of the same activity and a potential for conflict and inconsistency among banking and securities regulators. Similar concerns arise for banks and thrifts that can carry out investment adviser activities either in the bank or thrift or in a separate affiliate, although—in this case—most institutions carry out such activities directly rather than in an affiliate. While the banking and securities regulators have been taking steps to better coordinate their efforts, additional coordination could help alleviate differences in regulatory treatment meant to protect customers who buy mutual funds from banks and thrifts.

Increase in Bank Mutual Fund Activities Has Raised Concerns About Adequacy of Current Regulatory Structure

When the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940 were enacted, the 1933 Glass-Steagall Act barred banks from engaging in most securities activities and limited bank securities activities to (1) underwriting and dealing in government securities, which were exempt from Glass-Steagall Act restrictions; and (2) providing brokerage services solely for customer accounts. Because banks were already subject to federal banking regulation, the securities laws exempted banks from the regulatory scheme provided for brokers and dealers and for investment advisers. However, over the last 2 decades the federal banking regulators and the courts have interpreted the Glass-Steagall Act in ways that allow banks to provide a wide range of brokerage, advisory, and other securities activities comparable to services offered by SEC-registered broker-dealers and investment advisers. Consequently, banks have rapidly expanded their presence in the mutual funds industry.

Because of the rapid increase in banks’ mutual fund activities, some Members of Congress and the securities regulators have expressed concern that the current regulatory framework and oversight and enforcement mechanisms have not kept up with changes in the market and may no longer be adequate to protect the interests of investors who purchase mutual funds through a bank. SEC has testified that eliminating the banks’ exemptions from registering as broker-dealers and investment advisers would result in better investor protection and allow uniform regulation of securities activities regardless of industry classifications. SEC contends that when banks sell mutual funds directly using their own employees, customers are not afforded the same level of protection as customers who make their purchases through a broker-dealer. Specifically, SEC makes the following arguments:

Guidelines issued by the banking regulators concerning retail sales of mutual funds are not regulations. Therefore, SEC believes they are not legally enforceable by the bank regulators or customers; are too general; do not contain sufficient provisions for training bank personnel, especially with regard to making suitability determinations; and raise potential problems of regulatory overlap and conflict with respect to registered broker-dealers that assist banks in the sale of securities products.

The banking regulators’ primary focus is not investor protection, but the safety and soundness of the institution. As a result, SEC believes bank regulators minimize their disclosure of enforcement actions to protect the bank from adverse customer reactions in contrast to securities regulators, who make their enforcement actions a matter of public record to get maximum deterrent effect. SEC also argues that the securities regulators are better trained and have more expertise in assessing suitability determinations; that is, ensuring that customers make investments that are compatible with their income, assets, and investment goals.

SEC also testified that banks’ exemption from the Investment Advisers Act should be repealed for banks that advise mutual funds and that SEC should have the authority to regulate and inspect the mutual fund advisory and sales activities of banks. In addition, SEC has testified that when banks manage proprietary funds, there may be potential conflicts of interest between the funds and the bank’s other clients—conflicts that SEC may be unable to detect because of its lack of jurisdiction over bank investment advisers.

In response to criticisms that their guidelines are inadequate, the banking regulators have argued that, in some cases, their guidance exceeds SEC and NASD requirements for nonbank mutual fund companies. For example, they say the guidance requires banks to disclose orally and in writing to potential customers that their mutual fund investments are not FDIC-insured and are subject to market fluctuations in value. Banks are required to ensure that customers sign written statements acknowledging that they understand the risks associated with mutual fund investments. By contrast, nonbank mutual fund customers are not required to sign written statements acknowledging the risks associated with mutual funds.

Bank regulatory officials also reject the argument that the guidelines represent a less enforceable standard than SEC regulations. The bank regulators have informed banks that the adequacy of their mutual fund operations will be assessed on the basis of the new guidelines during the next scheduled safety and soundness exam. According to the regulators, they will bring any identified deficiencies in bank mutual fund operations to the attention of senior bank managers and directors. The managers and directors will be required to correct these deficiencies within a specified period of time. Failure to make needed improvements could result in a variety of enforcement actions, such as cease and desist orders or civil money penalties. Because of such possible sanctions, the regulators believe that bank managers will establish mutual fund sales operations that comply with the interagency guidelines.

Most Banks Choose to Sell Funds Through SEC-Registered Broker-Dealers

Under current laws and regulations, sales of mutual funds in banks can be made either by employees of the bank; by employees of an affiliate, subsidiary, or third-party broker working on behalf of the bank; or by “dual employees”—individuals who work for both the bank and a broker. If the salesperson is an employee of a broker or is a dual employee, he or she must be registered with NASD and is subject to SEC and NASD oversight. However, because the 1934 act exempts banks from being defined as a “broker” or a “dealer,” a bank can choose to use its own employees to sell mutual funds or other securities. These employees may do so without registering with NASD or being subject to SEC and NASD rules and oversight.

Banks that use their own employees to broker securities are not subject to SEC regulation and oversight. However, responses to our questionnaire showed that the vast majority of banks that sell mutual funds on their premises choose to do so through SEC-registered broker-dealers, either affiliates or subsidiaries of banks or third-party broker-dealers, rather than directly by unlicensed bank employees.

As shown by table 4.1, only about 8 percent of banking institutions that responded to our questionnaire reported that only their own employees directly sold mutual funds to retail customers. On the basis of these responses, we estimate that about 180 of the 2,300 banking institutions that were selling mutual funds to their retail customers at the end of 1993 did so directly using only their own employees. About 43 percent reported sales by “dual employees” of the bank or thrift (or its affiliate or subsidiary) and a registered broker-dealer, 29 percent through an affiliated or subsidiary broker-dealer organization, and 38 percent through a networking or leasing arrangement with a registered third-party broker-dealer. When we analyzed these results by bank size, we found that small banks were least likely to sell mutual funds directly with their own employees. Only 7 percent of banks with assets less than $150 million reported selling mutual funds exclusively with their own employees. In contrast, about 14 percent of banks with assets between $250 million and $1 billion responded that their own employees, rather than broker-dealers, sold funds at their banks.

According to the American Bankers Association, banks that choose to offer brokerage services directly through the bank do so because they do not yet have sufficient business to justify the expense of employing a registered broker-dealer. As a result, some in the banking industry have asserted that eliminating banks’ exemption from registering as broker-dealers would unfairly penalize banks that had a small volume of brokerage transactions. To gather information on this issue, we contacted about 80 percent of the banks that reported selling mutual funds through their own employees to find out why they sold funds directly, rather than through a broker-dealer. They cited three reasons for selling funds directly through their own employees: (1) they wanted to maintain control over their relationship with their customers, rather than turn it over to a broker-dealer; (2) they did not do enough business to justify establishing an arrangement with a broker-dealer or setting up their own affiliate; and (3) they sold funds mainly as a convenience to their customers. Three of the banks we contacted sold proprietary funds, although one of these has since switched to selling funds through a third-party broker-dealer.

Regulatory Framework for Mutual Fund Sales in Banks Can Cause Conflict and Overlap Among the Regulators

Under the current regulatory framework, broker-dealers that operate on the premises of banks and thrifts are subject to regulation by SEC and indirectly to oversight by banking regulators. This can cause conflict over what rules these broker-dealers are to follow in conducting their mutual fund sales programs and can also cause duplication of effort and an unnecessary burden on the broker-dealer when the regulators carry out examinations of these activities.

For example, in December 1994, NASD released for comment proposed rules governing broker-dealers operating on the premises of banking institutions. According to NASD, these rules are designed to fill a regulatory void by specifically governing the activities of NASD member bank broker-dealers who conduct a securities business on the premises of a financial institution. They differ from the banking regulators’ interagency guidance in several respects. First, the proposed NASD rules prohibit the payment of referral fees by the broker-dealer to employees of the financial institution. The interagency guidance permits payment of these fees. Second, the proposed rules place restrictions on brokers’ use of the bank’s or thrift’s customer lists that are stricter than the interagency guidance. Specifically, the proposed NASD rules state that confidential financial information maintained by the financial institution can not be used to solicit customers for the brokerage. This appears to rule out the use of information such as certificate of deposit maturity dates and balances. The interagency guidance requires only that the banking institution’s policies and procedures include procedures for the use of information regarding the institution’s customers in connection with the retail sale of nondeposit investment products. Third, the proposed NASD rules appear to place limits on the use of bank or thrift logos in advertising materials. For example, the proposed rules state that advertising and other sales materials that are issued by the broker-dealer must indicate prominently that the broker-dealer services are being provided by the broker-dealer, not the banking institution. Further, the financial institution may only be referenced in a nonprominent manner in advertising or promotional materials solely for the purpose of identifying the location where broker-dealer services are available. In contrast, the interagency guidance requires only that advertising or promotional material clearly identify the company selling the nondeposit investment product and not suggest that the banking institution is the seller.

NASD’s proposal has generated controversy in the banking industry. According to the financial press, some bankers have complained that the proposed NASD rules hold bank brokerages to standards that are higher than for nonbank brokerages. They point out, for example, that, unlike bank brokerages, nonbank brokerages are not required to disclose that mutual funds are not federally insured. In response, an NASD official said that when a customer deals with a brokerage in a bank, that brokerage has a higher responsibility to ensure that the customer understands the risk involved in investing in securities as compared to savings accounts or certificates of deposit.

Another area of concern is the potential for overlapping examinations or examinations that may result in conflicting guidance. Under the current regulatory framework, a broker-dealer in a bank could be examined periodically by NASD to determine if it is in compliance with securities rules, by SEC if it is doing an oversight inspection of NASD or is doing an inspection for “cause,” and also by the banking regulators to determine if the bank is complying with the interagency guidance. Although we found that a number of steps have been taken to avoid overlapping and conflicting activities, some problems have not been resolved.

For example, SEC is concerned that the banking regulators, particularly OCC, have begun to examine registered broker-dealers that sell securities in banks and has plans to examine mutual funds advised by banks. SEC testified that because registered broker-dealers and mutual funds are already subject to regulation by SEC and NASD under the federal securities laws, imposing an additional layer of banking regulator examination and oversight is unnecessary and may result in firms receiving inconsistent guidance on compliance issues.

Because of SEC’s concern, we reviewed examination guidelines issued by OCC, the Federal Reserve, and FDIC to determine the degree to which they required examiners to review broker-dealer records, especially third-party broker-dealers. OCC’s February 1994 guidelines for examination of retail nondeposit investment sales require that contracts between banks and broker-dealers provide bank examiners access to the records of third-party vendors (broker-dealers). However, the emphasis of the guidelines is on determining whether the bank has exercised the proper management control over the third-party vendor, rather than on a specific examination of the vendor’s operations. For example, the guidelines state that when (1) preliminary examination findings clearly show that bank management has properly discharged its responsibility to oversee the third party’s operations, (2) only a few complaints have been filed against the vendor, and (3) the vendor’s reports to the bank are timely and properly prepared, examiner access to third-party records should generally be limited to reports furnished to bank management by the vendor. The guidelines are not clear, however, as to what actions examiners are to take if these conditions are not met, stating only that “After making a judgment about the effectiveness of the oversight of third party vendor sales, complete any other examination procedures that appear appropriate.”

According to an OCC official, before OCC examiners do a bank inspection, they typically ask the bank to provide the results of the broker-dealer’s last NASD inspection. The NASD inspection report is to be reviewed to determine if it addresses any concerns about the bank’s mutual fund program. If the OCC examiners have concerns about the bank’s mutual fund program, they may do a limited inspection of the broker-dealer’s books and records. OCC may also direct the bank to hire an accounting firm to audit the broker-dealer if the limited OCC inspection identifies problems. This official said that OCC’s inspection approach is designed to avoid duplication by placing on the bank the responsibility for controlling and overseeing the broker-dealer’s operations. During its inspections, OCC is to check the adequacy of these controls and the bank’s oversight of broker-dealer compliance. According to the OCC official, OCC inspections of the broker-dealer should be a rare event if the bank exercises adequate oversight. In commenting on a draft of this report, OCC reiterated that any inspections of third-party broker-dealers would be limited to pertinent books and records and would not be complete examinations.

The Federal Reserve’s examination guidelines do not contain provisions that imply its examiners will review the operations of a third party in detail. The guidelines state that the examination procedures have been tailored to avoid duplication of examination efforts by relying on the most recent examination results or sales practice review conducted by NASD and provided to the third party. For example, the guidelines state that in making determinations about suitability and sales practices involving registered broker dealers, Federal Reserve examiners should rely on NASD’s review of sales practices or its examination to assess the organization’s compliance with suitability requirements.

The emphasis of FDIC’s examination guidelines is similar to the Federal Reserve’s. The guidelines state that examinations of banks that have contracts with a third party should focus on the agreement with the third party and the bank’s methods for determining the vendor’s compliance with bank policies and with provisions of the interagency statement.

Banking and securities regulators have begun to take steps to better coordinate their efforts. In January 1995, NASD and the four banking regulators signed an agreement in principle to coordinate their examinations of broker-dealers selling mutual funds and other nondeposit investment products on bank premises. The agreement calls for the agencies to share examination schedules, NASD to share its examination findings with the banking regulators, referral of any violations of banking or securities laws to the appropriate agencies, and other matters. Also in January 1995, NASD agreed to establish a new committee for bank-affiliated brokerages. This committee is to join 32 other standing NASD committees that represent specific interests; it is to recommend to the NASD board of governors rules and procedures for bank-affiliated brokerages and third-party brokerages that are doing business on bank premises.

Both SEC and Banking Regulators Have Responsibility for Bank Fund Investment Advisers

Many banks now provide investment advice to their own mutual fund families. Because the Investment Advisers Act of 1940 exempts banks from being defined as investment advisers, bank advisers do not have to register with SEC and are not subject to SEC regulations and oversight. As a result, when SEC inspects the records of a bank-advised fund, it does not have the authority to review certain records of the investment adviser that may be pertinent to an examination of the fund’s portfolio transactions.

According to SEC officials, when a bank serves as the investment adviser to a mutual fund and is not registered with SEC, SEC is limited to reviewing only the activities of the adviser as the activities relate to the mutual fund. If, for example, the bank serves as the investment adviser to a mutual fund, a pension fund, and private trust funds, SEC can look at the bank’s activities only with respect to the mutual fund. SEC can not review the records of the other funds or accounts to determine if conflicts of interest exist or if the mutual fund was disadvantaged in some manner in relation to the other funds the bank is advising by the decisions of the investment adviser.

Banks nevertheless may establish a separate SEC-registered subsidiary or affiliate to provide investment advice to a mutual fund, or they may provide such advice directly. While some banks have established SEC-registered subsidiaries or affiliates in which to conduct their mutual fund investment advisory activities, most provide such advice directly. According to SEC’s records, 78 of the 114 (68 percent) banking organizations that provided investment advisory services to mutual funds as of September 1993 did so directly rather than through SEC-registered subsidiaries or affiliates. If the bank chooses to conduct its mutual fund investment advisory activities directly, these activities are overseen principally by the banking regulator responsible for supervising and examining that bank and by SEC to the extent bank advisory activities relate to mutual funds subject to the Investment Company Act.

Banks that provide investment advice to their proprietary mutual funds are subject to examinations of these activities by the banking regulators. These examinations are carried out regardless of whether the investment advisory function is also subject to inspection by SEC. While the banking regulators’ examinations have traditionally focused on safety and soundness issues, rather than enforcement of securities laws, OCC is drafting guidelines for examination of mutual fund activities that indicate OCC examiners may attempt to determine whether bank and fund practices comply with the Investment Company Act of 1940. This concerns SEC because it believes such guidelines raise potential problems of conflict and overlap among the regulators.

OCC officials told us that although the agency has been doing examinations of investment advisers for years as part of the trust examination process, the new examination guidelines will focus examiners’ attention more directly on potential conflicts of interest that can arise when banks advise mutual funds. These potential conflicts of interest may violate securities laws and could enrich fund advisers at the expense of fund investors.

The Federal Reserve also examines investment advisers in state-chartered member banks and in subsidiaries of bank holding companies. If the investment adviser is the trust department of a state member bank, the examination is to be carried out as part of its examination of trust activities. If the investment adviser is a subsidiary of a bank holding company, on-site inspections are to be conducted as an integral part of bank holding company inspections. Although investment advisory subsidiaries of bank holding companies are required to register with SEC and are subject to SEC supervision and examination, the Federal Reserve’s guidelines note that such examinations are infrequent. Therefore, examinations by Federal Reserve Bank examiners are to be undertaken whenever they consider the investment adviser activities to be significant. Among the factors Federal Reserve examiners are to consider in deciding whether to schedule an examination of an investment advisory subsidiary of a bank holding company are volume and type of activity, date and results of previous Federal Reserve Bank and/or SEC inspections, and the extent of services provided to affiliated banks or trust companies.

The Federal Reserve’s guidelines for inspections of investment advisory subsidiaries of bank holding companies state that these inspections are primarily focused on safety and soundness considerations and not on compliance with securities laws. The objectives of these inspections are to (1) determine whether the adviser’s organizational structure and management qualifications are satisfactory; (2) evaluate the adequacy of the adviser’s financial condition and internal controls; (3) review the appropriateness of the adviser’s investment practices; (4) determine whether the institution has adequate policies and procedures to prevent self-dealing and similar improper conflicts; and (5) evaluate compliance with bank holding company laws, regulations, and interpretations.

According to an FDIC official, if an FDIC-regulated bank has an affiliate that provides investment advisory services to a proprietary mutual fund, that entity would be supervised and inspected by the Federal Reserve under the holding company inspection system. In addition, a small number of state nonmember banks provide investment advisory services to mutual funds through their trust departments. FDIC examiners are to inspect these advisers as part of FDIC’s overall trust and compliance examination program. The trust examination guidelines address a number of areas involving the investment advisers’ activities. Specifically, the guidelines focus on the advisers’ supervision and organization, operations controls and audits, asset administration, account administration, and conflicts of interest and self-dealing.

Eliminating Banks’ Exemptions Would Not Resolve All Problems

Under the current regulatory framework, many banks’ securities activities are subject to review by both the securities and banking regulators. As shown by the responses to our questionnaire, over 90 percent of institutions that sell mutual funds do so through SEC-registered and supervised broker-dealers. These broker-dealers are subject to review by NASD and SEC, who attempt to ensure investor protection through enforcement of the securities laws; and by the banking regulators, who, among other things, attempt to ensure that the institution is operating its mutual fund program in a safe and sound manner and in compliance with the interagency guidance. A similar situation exists in the regulation of investment advisers. We noted, for example, that even when the bank conducts its mutual fund advisory functions in a separate subsidiary, the Federal Reserve continues to conduct its own inspections of these subsidiaries. In addition, OCC is drafting examination guidelines that will call for assessing banks’ compliance with various provisions of the Investment Company Act of 1940. To the extent that these examinations would be carried out at entities already subject to SEC oversight, banks and their affiliates may be subject to having the same activities examined by two sets of regulators.

The securities regulators have proposed that the regulatory framework could be simplified if a system of functional regulation were adopted. Under a “pure” functional regulation system—regulation according to function and not according to entity performing the function—SEC and the other securities regulators would be responsible for ensuring that banks comply with the securities laws. The securities activities of banks would be conducted in separate subsidiaries and affiliates, and banking regulators would be precluded from conducting examinations of the securities subsidiaries and affiliates of banks, which would eliminate duplicative regulation and oversight. However, the Comptroller of the Currency has testified that under this framework, the banking examiners would be unable to properly assess whether the securities activities were affecting the safety and soundness of the bank because they would have to rely on reports from the functional regulator that could be too infrequent, insufficiently detailed, or insufficiently comprehensive to allow the examiners to make a determination.

Eliminating banks’ exemptions from the securities laws would expand SEC’s authority to oversee banks’ securities activities and would appear to address SEC’s concerns that (1) investors are not adequately protected by the securities laws when retail securities sales are made directly by bank employees, and (2) it can not fully examine the transactions of mutual fund investment advisers when the adviser is a bank. However, just eliminating the exemptions does not remove the potential for duplication and conflict between the banking and securities regulators because each group will continue to be involved in supervising banks’ securities activities.

Scope and Frequency of SEC’s Inspections Has Been Limited, but Resources May Be Increasing

In the past, SEC has had trouble keeping up with its existing workload because the size of its inspection staff has not kept pace with the explosive growth in the size and complexity of the mutual fund industry. As a result, the agency was forced to reduce the scope and frequency of its inspections over the past decade. The size of SEC’s mutual fund company inspection staff began to increase in fiscal year 1994, and the agency believes that with the additional staff it is adding in fiscal year 1995 and has requested for fiscal year 1996, it will be able to examine mutual fund companies and their advisers with reasonable frequency. However, if these additional resources are not approved or if the financial services industry continues to expand as it has in recent years, SEC may continue to face challenges meeting its responsibility to oversee mutual funds and their advisers.

SEC’s inspections of investment companies and their related investment advisers are to be carried out by staff in SEC’s regional and district offices in accordance with general examination objectives that are established by SEC’s Office of Compliance Inspections and Examinations at the beginning of each new fiscal year. Each region is responsible for preparing an annual inspection plan that responds to these overall objectives.

Fiscal Years 1991 to 1993

SEC’s objective for inspecting investment companies and investment advisers during fiscal years 1991 through 1993 was to get the greatest dollar coverage with the limited staff available. With this in mind, SEC had a program for inspecting investment companies during this period that called for inspecting funds in the 100 largest fund families and all money market funds. To the extent that time was available after SEC completed inspections of the 100 largest fund families and money market funds, SEC’s 1993 program called for its regions and districts to also inspect smaller fund families, with priority to be placed on inspecting families that had never been inspected. Moreover, SEC testified that its investment company inspections were limited in scope, focusing primarily on portfolio management to determine whether fund activities were consistent with the information given investors and whether funds accurately valued their shares. SEC stated, for example, that it rarely scrutinized important activities, such as fund marketing and shareholder services. Inspections of money market funds focused on compliance with a 1940 act rule that specifies the quality and maturity of permissible instruments that may be held for money market funds and the requirements for portfolio diversification.

According to SEC officials, SEC staff review the activities of advisers to investment companies concurrent with their examination of the investment company. In addition, between 1991 and 1993, SEC’s inspection programs called for inspecting all investment advisers with $1 billion or more in assets under management, with about one-third to be done in each of the 3 years. If time permitted, the regions and districts were also to inspect some advisers with less than $1 billion under management that had custody or discretionary management authority over client assets or conducted their business in a way that regional or district office staff believed needed review.

Fiscal Year 1994

For fiscal year 1994, SEC changed its inspection approach to (1) reintroduce an element of surprise into the inspections, and (2) allow the staff to focus on investment companies and advisers that they considered more likely to have problems. To accomplish these objectives, SEC headquarters informed SEC’s regions and districts that they were to inspect all medium and small fund families that had not been examined since 1990 and all new fund families formed during the year. SEC estimated that 350 families had not been inspected since 1990; and many of them, especially those connected with banks, had never been reviewed. As in preceding years, the guidance stated that, except for families that had never been inspected, inspections should be limited in scope with an emphasis on portfolio management activities. For families connected with banks, staff were to closely review advertising and the procedures by which shares were distributed to shareholders. According to SEC, during fiscal year 1994, its staff conducted inspections of 303 small and medium fund families, including 225 money market portfolios within those families. The staff inspected funds in the 100 largest fund families only when a cause inspection was necessary.

With respect to inspections of investment advisers in fiscal year 1994, SEC headquarters instructed SEC’s regions and districts to focus on potentially higher risk small and medium size advisers with discretionary management authority that had not been inspected in the prior 4 years, with no particular emphasis on large entities. SEC reported that as a result of the shift to inspections of smaller, higher risk investment advisers, the assets under management of inspected advisers decreased from $1.7 trillion in 1993 to $520 billion in 1994. However, the number of deficiencies identified increased by 57 percent, from 5,523 to 8,672.

Size of Inspection Staff Is Increasing, but Challenges Remain

Until recently, SEC believed that it did not have enough staff to properly oversee the mutual fund industry. For example, in November 1993 SEC testified that despite efforts to use its resources more effectively, such as by obtaining data in electronic format and beginning development of a risk assessment program for investment companies, it needed more and better trained people to deal with the mutual fund industry. An SEC official told us that SEC needs a total of 300 examiners to inspect investment companies and 210 examiners to inspect investment advisers. At the end of fiscal year 1994, SEC had about 200 staff assigned to inspections of investment companies and about 50 to inspections of investment advisers.

In December 1993, the Office of Management and Budget approved the hiring of 150 additional investment company examiners (50 each year beginning in fiscal year 1994 through 1996). With the additional staff, SEC plans to perform comprehensive inspections of the 50 largest mutual fund families over a 2-year period. Funds in the other families would be inspected comprehensively about once every 4 years. With respect to investment adviser examiners, in its fiscal year 1996 budget SEC is requesting an additional 193 staff years for the investment adviser inspection activity. If it receives the additional staff, SEC estimates that it will be able to inspect advisers much more frequently than it has in the past. Currently, about 21,000 investment advisers are registered with SEC, but only about 7,000 to 8,000 actually exercise discretion over client assets. According to SEC, it allocates more of its inspection resources to the advisers with discretionary authority and expects to examine these advisers every 6 to 8 years. An SEC official told us that if SEC were required to oversee bank-related investment advisers that are not currently registered with the Commission, it would have little or no effect on their resources because this would add relatively few (fewer than 100) advisers to their total inventory of advisers. Further, SEC staff already examine the activities of many of these advisers during their inspections of the related investment companies.

Even if SEC acquires additional inspection staff, it will face major challenges in adhering to its planned inspection schedule. There have been time lags in hiring new examiners, and they need to be trained over a period of several months. In addition, though there has been a slowdown recently, the number of new mutual funds continues to increase. Also, such issues as the mutual funds’ use of derivatives and personal trading by fund managers have come to the forefront.

Potential Conflicts of Interest May Arise When Banks Manage Mutual Funds

The increase in the number of banks that manage their own proprietary funds has caused the securities regulators and some in Congress to be concerned as to whether the banking and securities regulations are adequate to prevent certain conflicts of interest when banks operate proprietary mutual funds. Specific concerns are whether, or under what circumstances, (1) banks should be permitted to serve as custodians for their own mutual funds, (2) banks should be permitted to loan money to their mutual funds, (3) bank funds should be permitted to purchase securities issued by a borrower of the bank when the proceeds are used to pay off a loan to the bank, (4) banks should be permitted to extend credit to customers to purchase shares of bank funds, and (5) limits should exist on interlocking management relationships between banks and their mutual funds.

Banks May Act as Custodians of Their Own Mutual Funds

The Investment Company Act of 1940 (the 1940 act) does not prohibit a bank from acting as both the advisor and the custodian for the same mutual fund. This has caused concern among securities regulators that a bank could cause its affiliated (proprietary) mutual fund to select the bank as fund custodian, thereby depriving the fund of an independent custodian and creating the potential for abuse and self-dealing.

The fund custodian holds all securities and other fund assets on behalf of the fund. The 1940 act requires a mutual fund to place and maintain its securities and similar investments in the custody of a bank with aggregate capital and surplus and undivided profits of not less than $500,000; a company that is a member of a national securities exchange; or the fund itself. In practice, the fund custodian is almost always a bank.

Although the 1940 act does not prohibit a bank from acting as both adviser and custodian for a mutual fund, SEC’s position is that such banks are subject to its self-custody rule. That rule requires that securities and investments of a mutual fund maintained in the custody of the fund must be verified by actual examination by an independent public accountant at least three times a year, two of which must be without prior notice. These requirements, among others, must be satisfied when a bank acts as adviser (or is affiliated with the adviser) and as custodian or subcustodian of a fund. In addition, SEC has advocated changing the 1940 act to subject affiliated bank custodianships to specific SEC rule-making authority.

Our analysis of the data provided by Lipper showed that as of September 30, 1993, 53 of 114 banks that advised funds also acted as custodians of those funds. According to the SEC official in charge of SEC’s inspections of mutual funds, auditors must file a certificate reflecting securities verification, which SEC examiners typically review when examining the mutual funds. This official noted, however, that the SEC rule requiring verifications three times a year was written when securities were issued in physical form, such as stock certificates. Today, securities are issued in book-entry form rather than in physical form, requiring more elaborate verification procedures. Independent auditors now evaluate the process and controls used by the custodian to make a daily reconciliation of statements of securities held by the mutual fund with the Depository Trust Company (DTC). However, physical examination of pertinent records is still required to review the custodian’s reconciliations. The SEC official also told us that there have been no specific examples of abuses relating to the custody of securities that have occurred when banks also acted as the funds’ investment advisor.

Some Bank Loans to Affiliated Funds Are Permitted

The 1940 act allows a mutual fund to borrow up to one-third of its net asset value from any bank. Because the act does not expressly prohibit a mutual fund from borrowing money from an affiliated bank, securities regulators are concerned that the lack of such a prohibition creates the potential for overreaching by a bank in a loan transaction with an affiliated investment company.

Several banking laws, however, restrict banks’ ability to make loans to affiliated mutual funds. For example, section 23A of the Federal Reserve Act prohibits a member bank from lending more than 10 percent of its total capital (capital stock and surplus) to a mutual fund that is advised by the bank or its affiliates and 20 percent to all affiliates (a mutual fund advised by the bank is defined as an affiliate). Section 23B of the Federal Reserve Act states that all such lending must be on an arm’s length basis.

The Federal Deposit Insurance Act applies Sections 23A and B restrictions to all federally insured nonmember banks. Under Regulation Y, the Federal Reserve prohibited banking organizations (bank holding companies and their bank and nonbank subsidiaries) from extending credit to any mutual fund company advised by a bank within the organization or its affiliates. In addition, a rule adopted by FDIC permits nonmember state banks to extend credit to an affiliated mutual fund subject to the Sections 23A and B restrictions. These must be stand-alone banks and not holding companies. Holding companies must comply with Regulation Y.

The Federal Reserve’s bank holding company supervision manual contains detailed guidelines for examining for compliance with Sections 23A and B. The chief examiners in three Federal Reserve district offices told us these examinations are conducted regularly. According to the Federal Reserve official responsible for overseeing enforcement actions, the Federal Reserve has never taken any enforcement actions charging that bank holding companies or member banks had violated Sections 23A or B provisions relating to proprietary mutual funds.

Mutual Funds Are Not Prohibited From Purchasing Securities Issued by Borrowers From Affiliated Banks

The 1940 act does not expressly prohibit a mutual fund from purchasing the securities of companies that have borrowed money from an affiliated bank, but it does prohibit most transactions between a fund and its affiliates. In addition, Sections 23A and 23B of the Federal Reserve Act, which prohibit banks from engaging in certain transactions with affiliates, do not impose restrictions on the ability of proprietary funds to purchase the securities of companies that are borrowers from an affiliated bank. As a result, securities regulators believe that there is a risk that a bank may use its affiliated mutual fund to purchase securities of a financially troubled borrower of the bank. The indebtedness to the bank would be repaid, but the mutual fund may be left with risky or potentially overvalued assets.

A Federal Reserve Board attorney told us that while Sections 23A and 23B do not specifically prohibit proprietary funds from purchasing securities from a borrower of the affiliated bank, such activities are generally violations of state conflict-of-interest laws if the participants intend to prop up a weak bank borrower. This official said that the Federal Reserve enforces these laws as part of its examination and compliance process as do state regulators. This official also told us that bank commercial lending departments are prohibited from sharing sensitive loan information with trust departments. However, if a fund purchases the securities of a bank borrower, such an action would not necessarily be considered a violation of the restrictions. Illegality would depend upon the intent of the participants, that is, an intent to rescue a failing corporate borrower. Similarly, a bank intentionally causing an affiliated fund to acquire the securities of a troubled borrower to shore up the borrower’s finances may be in violation of the affiliated transaction provision of the 1940 act, and the bank would be violating its fiduciary obligations as an adviser to the fund.

Officials of two very large banks that we visited told us that it was possible, even likely, that their proprietary funds would make investments in entities to which the bank had loaned money. For example, a bank official told us that if one were to examine his bank’s loan portfolio, it would not be inconceivable to find IBM as a borrower and, likewise, IBM would probably turn up as one of the stocks held by that bank’s mutual fund family. Even so, this would be coincidental rather than the result of any planned activity, as many of the Fortune 500 companies are likely to be customers of his bank and others like it. Officials at both banks stressed that the lending and investment advising activities are quite separate and that their controls for separating these activities precluded any abuses.

Management Interlocks Between Some Banks and Mutual Funds Could Occur

To eliminate potential conflicts of interest between securities firms (including mutual funds) and banks, Section 32 of the Glass-Steagall Act and regulations of the Federal Reserve Board prohibit interlocks among officers, directors, and employees of these entities. However, because of interpretations by the Federal Reserve Board and FDIC, there are opportunities for interlocks to occur between banking organizations and mutual funds. Whether these interlocks have resulted in actual problems is uncertain; regulators told us that no cases have been reported.

Section 32 of the Glass-Steagall Act, as interpreted by the Federal Reserve Board, prohibits employee, officer, and director interlocks between banks that are members of the Federal Reserve System and mutual funds. The Board has applied Section 32 to bank holding companies; consequently, a bank holding company with member bank subsidiaries may not have an interlock with a mutual fund. However, the Board has indicated that interlocks between nonbanking subsidiaries of bank holding companies and securities firms are not subject to Section 32. Therefore, a nonbanking subsidiary of a holding company could have an interlock with a mutual fund.

Section 32 does not apply to banks that are not members of the Federal Reserve. Thus, a nonmember state bank could maintain an interlock with a mutual fund. In addition, FDIC’s regulations do not prohibit interlocks between a state nonmember bank and a mutual fund for which it acts as an investment adviser. However, a nonmember bank with a bona fide subsidiary or securities affiliate that engages in mutual fund activities impermissible for the bank itself (such as acting as the fund’s underwriter) would be subject to restrictions. The bona fide subsidiary or securities affiliate may not have common officers with the bank and would be required to have a majority of independent directors.

The 1940 act does not prohibit interlocks between banks and investment companies. However, Section 10(c) of the act prohibits a registered investment company from having a majority of its board consist of officers, directors, or employees of any one bank. The act defines the term “bank” to include a member bank of the Federal Reserve System. In addition, section 10(a) requires that at least 40 percent of a fund’s board members be “disinterested persons.” These are persons who are not to be affiliated with a fund’s adviser, including a bank adviser, or with the fund’s principal underwriter.

The Prohibition on Sponsorship and Underwriting of Mutual Funds by Banks May Increase Banks’ Costs

A bank may serve as the investment adviser to a mutual fund; act as an agent in purchasing mutual funds for customers (i.e., provide discount brokerage services); provide full brokerage services to customers, including investment advice concerning mutual funds; provide administrative services to mutual funds; and serve as the custodian and transfer agent to mutual funds. However, the Glass-Steagall Act prohibits banks that are members of the Federal Reserve System and bank holding companies from sponsoring mutual funds or underwriting and distributing the shares of mutual funds. These restrictions also apply to affiliates of banks that are members of the Federal Reserve System and to nonmember banks. They do not apply, however, to subsidiaries or affiliates of state banks that are not members of the Federal Reserve System. So, a subsidiary of a state nonmember bank (if it does not have a member bank affiliate) may provide these services, as may an affiliate of a savings association (if it does not have a member bank affiliate).

Most parties seem to agree that the restrictions on sponsoring, underwriting, and distributing mutual funds are insignificant in practical terms. Shares of mutual funds are not “underwritten” in the traditional sense, whereby an underwriter commits as principal to purchase large blocks of securities for resale to the public or agrees to use its “best efforts” to sell securities to the public. Instead, investors generally purchase shares of mutual funds either directly from a fund or from securities firms, financial planners, life insurance organizations, or depository institutions. An official of one bank we visited said that he did not regard the Glass-Steagall prohibitions on sponsorship and underwriting as a necessary guard against conflicts of interest. In his opinion, the original (1933) concern about a bank exposing itself to risk by acting as principal in the underwriting of securities does not apply to the issue of bank sales of mutual funds because the bank sells mutual funds on an agency basis; since it does not act as principal, it does not expose its capital to risk.

The major cost of the Glass-Steagall restrictions to banks is that they must contract with unaffiliated distributors that perform underwriting functions in return for fees. One banker told us that the elimination of the Glass-Steagall provisions that prevent commercial banks from underwriting securities would eliminate the banks’ need to hire such organizations and pay such fees. He also said that without Glass-Steagall restrictions, the banks might be able to operate more efficiently.

Conclusions

Eliminating banks’ exemption from the Securities Exchange Act of 1934 and requiring that all mutual fund sales by banks be conducted through broker-dealers, as suggested by SEC, currently would affect less than 10 percent of all banks. Banks that sell mutual funds directly through their own employees rather than a broker-dealer generally do so either because they want to maintain control of their customer relationship or they do not have a sufficient volume of business to justify establishing a relationship with a broker-dealer. Eliminating the exemption would allow SEC and self-regulatory organizations, such as NASD, to enforce the securities laws uniformly in connection with the sale of mutual funds. However, the fact that SEC does not now have oversight of direct retail sales by bank employees does not mean that these banks are free to conduct these sales without any supervision. The bank regulators’ interagency guidance applies to all sales activities on the premises of the banking institution, regardless of whether they are done through a broker-dealer or directly by a bank employee, and the banking regulators have taken steps in their examinations to increase their scrutiny of banks’ compliance with the guidance.

Similarly, removing the exemption from the definition of investment adviser under the Investment Advisers Act of 1940 for banks that advise funds, as suggested by SEC, would allow SEC to more fully inspect previously unregistered advisers to determine that the adviser is carrying out securities transactions in a way that is fair to all of its clients, including the mutual fund. However, removing the exemption may also permit SEC to make limited inspections of bank activities that have been solely within the domain of the banking regulators, such as transactions involving trust accounts. These activities are regularly examined by the banking regulators. The banking regulators’ examinations, however, focus principally on safety and soundness considerations, rather than on compliance with the securities laws.

Although removing the exemptions would allow the securities regulators to extend their oversight of banks’ mutual fund activities, this action would not, by itself, resolve conflict and overlap among the regulators. This is because the banking regulators in their role of overseeing the safety and soundness of banks would continue to be involved in conducting examinations and issuing rules and guidance on banks’ securities activities. Although the regulators have taken some actions to work more closely together, as in the January 1995 agreement between NASD and the banking regulators on coordinating their examinations, there are areas in which additional coordination would be desirable. For example, although NASD’s December 1994 proposed rules governing securities broker-dealers operating on bank premises paralleled the interagency guidance in many respects, they have caused controversy because they contain provisions that differ from the banking regulators’ interagency guidance. NASD officials commenting on this report said these differences are purposeful and provide a more explicit, well-defined, and enforceable approach to regulating these NASD members. In addition, the banking regulators and SEC do not currently have an agreement to coordinate their oversight of investment advisers similar to the one between NASD and the banking regulators for sales practice examinations. SEC is concerned that OCC examiners will be attempting to enforce securities laws as part of their examinations of investment advisers, and it would appear that development of such an agreement, to include a common approach for conducting and coordinating these examinations, would help eliminate overlapping examinations and conflicting guidance.

Recommendation

We recommend that SEC, the Federal Reserve, FDIC, OTS, and OCC work together to develop and approve a common approach for conducting examinations of banks’ mutual fund activities to avoid duplication of effort and conflict, while providing efficient and effective investor protection and ensuring bank safety and soundness.

Agency Comments and Our Evaluation

Each of the organizations (SEC, NASD, OCC, FDIC, the Federal Reserve, and OTS) that provided comments on a draft of this report supported our recommendation. Several agencies cited efforts that have been recently completed or are currently under way to work closely together, including implementing the January 1995 agreement between the banking regulators, SEC, and NASD to coordinate examinations. However, OCC believed the report overemphasized the potential for inconsistent or contradictory regulation.

In addition, SEC and OCC stated that in June 1995 they reached agreement on a framework for conducting joint examinations of mutual funds and advisory entities in which both agencies have regulatory interests. Their comments indicated that they expect this agreement to result in increased coordination and result in more efficient oversight of bank mutual fund activities. According to SEC, its staff and OCC staff have informally discussed examination procedures and are beginning to schedule joint examinations. SEC also stated that its staff has met preliminarily with the staff of FDIC to discuss entering into a similar arrangement.