Both mutual fund companies and banks are financial intermediaries, that is, they raise funds from savers and channel these funds back to the economy by investing them. Banks generally use their deposits either to make loans or to invest in certain debt securities, principally government bonds. Mutual funds do not make loans, but they do invest in securities, primarily bonds and stocks. Money from these funds, in turn, flows either directly (through primary securities markets) or indirectly (through secondary securities markets) to the issuers of such securities. Long before the recent mutual fund boom, the relative importance of bank loans as a source of finance had been declining. As early as the 1960s, some large businesses had been replacing their usage of bank loans by issuing short-term securities called commercial paper. Subsequently, more companies found ways to tap the securities markets for their financial needs, lessening their dependence on bank loans. For example, corporations’ reliance on bank loans as a percentage of their credit market debt declined from 28 percent in 1970 to 20 percent in 1994. The household sector (generally residential and consumer borrowers) also has become less dependent on bank loans for the ultimate source of financing. Beginning in the mid-1970s, and to a much greater extent since the early 1980s, major portions of home mortgage portfolios have been sold by banks and thrifts to financial intermediaries who use them as collateral for marketable securities and then sell the securities to investors. More recently, significant amounts of consumers’ credit card debt and automobile loans have been similarly financed by securities instead of bank credit. Through securitization, banks and thrifts provide the initial financing for these mortgage, credit card, and automobile loans. However, once the loans are sold, it is the securities market that is the ultimate source of financing. More broadly, the term securitization describes a process through which securities issuance supplants bank credit as a source of finance, even if the borrower originally received funds from a bank. In addition, the relative importance of bank loans has been further diminished by the increased provision of direct loans by nonbank financial intermediaries, including securities firms, insurance companies, and finance companies. In this report, discussion of the “impact of mutual funds on deposits” or of the “movement of money from deposits to mutual funds” refers not merely to direct withdrawal of deposits by customers for the sake of investing in mutual fund shares but also to customers’ diversion into mutual funds of new receipts that otherwise might have been placed in deposits. To assess the impact of mutual funds on deposits, we examined and compared available data published by industry sources and the bank regulators. Data on deposits in banks are routinely reported to and published by the bank regulators. Data on mutual funds are gathered and published by an industry association, the Investment Company Institute (ICI). Moreover, the Federal Reserve maintains and publishes the Flow of Funds Accounts, which is an attempt to capture the entire framework of financial transactions in the economy, including all major groupings of participants and instruments. This publication includes the bank data and mutual funds data that we used (the Federal Reserve obtains the mutual fund data from ICI). In the Flow of Funds Accounts, the Federal Reserve presents statistics on (1) the amounts outstanding at the end of each quarter and each year and (2) the net flows during each quarter and each year. For bank deposit information, the change of the level from one period to the next is used to determine the net flows into or out of deposits during that period. The same method is used for money market mutual funds, where the funds’ managers intend to maintain the value of a share constant at one dollar on a daily basis. For longer-term mutual funds, however, the period-to-period change in the fund’s value generally does not equal the net flows during the period because the value fluctuates with (1) the flows of customer money, (2) the changing prices of the stocks and bonds held by the mutual funds, and (3) the reinvestment of dividends and interest in the fund. In the Flow of Funds Accounts, the net flows into mutual funds are calculated from industry data on changes in amounts outstanding and adjusted for movements of security-price averages. To assess the impact of mutual funds’ growth on the total supply of loanable and investable funds, we examined the Flow of Funds Accounts data on the sources of finance for the economy. In addition, we did a literature search for research articles examining (1) how residential, consumer, and business borrowers obtain financing, not only from bank loans or securities issuance but also from other sources and (2) how lenders, including banks as well as nonbank providers such as finance companies, funded the financing they provided and whether they sold or securitized their finance. We supplemented our search of the statistical sources with other material. We used research articles published by the Federal Reserve and documents published by securities industry sources over the last 5 years. In addition, we interviewed Federal Reserve experts on the previously mentioned topics. We also drew upon information gathered from banks and mutual fund specialists who were interviewed for an ongoing related GAO assignment. The Federal Reserve provided written comments on a draft of this report. These comments are discussed on page 15. We did our review in Washington, D.C., from March 1994 to November 1994 in accordance with generally accepted government auditing standards. The Federal Reserve and the Securities Industry Association (SIA) agreed that the flow of funds into mutual funds has had a significant impact on bank deposits. Although some observers dispute the magnitude of this impact, the evidence we reviewed supports the view that mutual funds have attracted sizable amounts of money that otherwise might have been placed in bank deposits. At year-end 1994, the amount of money in mutual funds ($2,172 billion) was considerably less than that in bank deposits ($3,462 billion). The mutual fund total, however, had risen by almost $1.2 trillion since year-end 1989, most of it from net new inflows, while the deposit total was $89 billion less than at year-end 1989. Despite these data, some observers maintain that deposits have not been a major source of the flow of money into mutual funds in recent years. For example, one study by a securities firm claims that “mutual fund inflows do not depend on outflows from the banking system,” arguing that “net new savings” are more important. ICI, a mutual funds industry association, stated that “CD proceeds play minor role as source for investment in stock and bond mutual funds,” and that “current income” and “the proceeds from other investments” were far more important. Nonetheless, most observers whose studies we reviewed agree that mutual funds have had a significant effect on bank deposits. Federal Reserve publications state that there has been a movement from deposits into mutual funds. The same view is propounded by SIA. Moreover, in a 1994 survey of 205 bank chief executives, nearly half said that their banks had started selling mutual funds in order to retain customers. We did not find any reliable quantification of the full impact of mutual funds on deposits, including both the direct withdrawals and customers’ diversion of new receipts that otherwise might have been placed in deposits. We assessed two quantitative approaches: (1) the total net flows into mutual funds and (2) ICI’s estimate of the impact on deposits. Because both approaches were incomplete, we examined a third alternative: the relationship between deposits and overall economic activity. This third approach also has limitations because there are a variety of factors that affect the relationship between deposits and gross domestic product (GDP). Nonetheless, it provided a more comprehensive look than the other approaches. Using the ratio of deposits to GDP as a benchmark, we estimated that—for the period 1990 through 1994—the total impact of mutual funds on deposits may have been sizable, but probably less than $700 billion. The total net flows into mutual funds from all sources during 1990 through 1994 were $1,067 billion. (See table 1.) The impact on deposits had to be less than this amount because the evidence indicated there were also flows into mutual funds from nondeposit sources. For example, some of the money placed in mutual funds by the household sector probably derived from the sales of stocks and bonds since, in 1991 and 1993, the household sector sold more individual securities than it bought. (See table 2.) Another possible source of flows into mutual funds was the frequent occurrence of sizable lump-sum distributions to individuals from retirement plans and job-termination arrangements. According to both the Federal Reserve and SIA, much of this money was placed in mutual funds by the recipients. SIA’s estimate of the impact of mutual funds on deposits was incomplete because it dealt only with the direct impact, i.e., the withdrawal of existing deposits for the sake of investing in mutual funds. Even this estimate of the direct impact was incomplete because it was primarily based on net withdrawals of banks’ time deposits, rather than total deposits. Using time deposits as a measure, SIA stated that the flow from deposits into mutual funds could have been about $200 billion in 1992 and 1993 combined. In fact, during this period declines in time deposits were largely offset by increases in demand deposits. Since there is no reporting of either the destinations of deposit withdrawals or of the origins of deposit placements, we cannot be certain whether time deposit withdrawals went into mutual funds or if part of them went into demand deposits. In any event, we found no estimates of the indirect effects, i.e., the diversion of new receipts into mutual funds rather than into deposits. Such a measure is more important in a growing economy because, even if deposits are growing, they may not be growing as fast as they would absent the diversion to mutual funds. We attempted to derive a reasonable estimate of the combined direct and indirect impact of mutual funds on deposits by examining the relationship of deposits to total economic activity, as measured by GDP.