Bank Mutual Funds: Sales Practices and Regulatory Issues (Chapter Report,
09/27/95, GAO/GGD-95-210).
Pursuant to congressional requests, GAO reviewed bank and thrift sales
of mutual funds, focusing on: (1) the extent and nature of bank and
thrift mutual fund sales activities; (2) banks' and thrifts' disclosure
of their mutual fund sales practices; and (3) the regulatory framework
for overseeing bank and thrift mutual fund operations.
GAO found that: (1) as of the end of 1993, about 2,300 banks and thrifts
were involved in mutual fund sales and about 114 institutions had
established their own mutual funds; (2) during the 5 previous years, the
value and numbers of bank-owned funds grew faster than the mutual fund
industry as a whole and banks and thrifts became major sellers of
nonproprietary funds; (3) banks and thrifts sell mutual funds to retain
customers and increase fees; (4) in February 1994, bank regulators
issued guidelines on policies and procedures that financial institutions
are to follow in selling nondeposit investment products due to their
concern that banks and thrifts are not disclosing the risks of investing
in mutual funds; (5) GAO visits to selected banks and thrifts in 1994
disclosed that only about one-third of the institutions followed the
disclosure guidelines, while nearly one-fifth of the institutions failed
to disclose any risks; (6) the bank regulators are including steps in
their examinations to assess how well these institutions are complying
with the guidelines; (7) the current regulatory framework is inadequate
to deal with the rapid increase in banks' and thrifts' involvement in
securities sales and management; (8) banks that directly sell to
customers are predominantly regulated by bank regulators, while
securities regulators mainly oversee banks which sell or advise through
affiliates or third party brokers; (9) the current regulatory framework
could lead to inconsistent or overlapping regulatory treatment of the
same activity and to conflict among the regulators; and (10) conflicts
of interest may arise between banks' mutual fund activities and
traditional banking functions.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-95-210
TITLE: Bank Mutual Funds: Sales Practices and Regulatory Issues
DATE: 09/27/95
SUBJECT: Banking regulation
Securities regulation
Bank examination
Mutual funds
Sales
Financial institutions
Conflict of interest
Information disclosure
Compliance
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Cover
================================================================ COVER
Report to Congressional Requesters
September 1995
BANK MUTUAL FUNDS - SALES
PRACTICES AND REGULATORY ISSUES
GAO/GGD-95-210
Bank Sales Practices
(233392)
Abbreviations
=============================================================== ABBREV
FDIC - Federal Deposit Insurance Corporation
FRS - Federal Reserve System
ICI - Investment Company Institute
NASD - National Association of Securities Dealers
NAV - net asset value
OCC - Office of the Comptroller of the Currency
OTS - Office of Thrift Supervision
SEC - Securities and Exchange Commission
SIPC - Securities Investor Protection Corporation
Letter
=============================================================== LETTER
B-259882
September 27, 1995
The Honorable John D. Dingell
Ranking Minority Member
Committee on Commerce
House of Representatives
The Honorable Henry B. Gonzalez
Ranking Minority Member
Committee on Banking and
Financial Services
House of Representatives
This report presents the results of our review of bank and thrift
sales of mutual funds. You requested that we report on the extent to
which banks and thrifts have expanded into mutual fund activities.
You also asked us determine the disclosure and sales practices of
banks and thrifts with respect to mutual funds, and to evaluate the
framework for regulation and oversight of bank and thrift mutual fund
operations. This report recommends that the banking and securities
regulators develop a common approach for conducting examinations of
bank and thrift mutual fund activities.
As agreed with you, unless you publicly release its contents earlier,
we plan no further distribution of this report until 30 days from its
issue date. At that time, we will provide copies to interested
members of Congress, appropriate committees, the Federal Deposit
Insurance Corporation, the Board of Governors of the Federal Reserve
System, the Office of the Comptroller of the Currency, the Office of
Thrift Supervision, the National Association of Securities Dealers,
the Securities and Exchange Commission, other interested parties, and
the public.
Major contributors to this report are listed in appendix X. If you
have any questions, please call me at (202) 512-8678.
James L. Bothwell
Director, Financial Institutions
and Markets Issues
EXECUTIVE SUMMARY
============================================================ Chapter 0
PURPOSE
---------------------------------------------------------- Chapter 0:1
At one time, restrictions in the 1933 Glass-Steagall Act were viewed
as barring banking institutions from most aspects of the mutual fund
business. However, since the early 1980s a series of decisions by
banking regulators and court rulings has allowed banks and thrifts to
engage in a wide variety of mutual fund activities, including selling
mutual funds to retail customers and serving as a fund's investment
adviser. As a result, banks and thrifts have become a major force in
the mutual fund industry. As the influence of banking institutions
on the mutual fund industry has grown, Congress and federal
regulators have become concerned whether the current regulatory
framework and oversight mechanisms, which date from the 1930s, still
address today's realities. Particularly, they are concerned about
whether the existing regulatory framework adequately protects
investors who purchase mutual funds at a bank or thrift and whether
these investors are properly informed of the risks of mutual fund
investments compared to insured deposits.
In separate requests, the former Chairman of the Subcommittee on
Oversight and Investigations of the House Committee on Energy and
Commerce and the former Chairman of the House Committee on Banking,
Finance and Urban Affairs asked GAO to (1) determine the extent and
nature of bank and thrift involvement in mutual fund sales, (2)
collect and analyze data on the sales practices used by banks and
thrifts in selling mutual funds and use the data to evaluate whether
adequate disclosures of the risks of investing in mutual funds are
being made to customers by salespersons in certain banks and thrifts,
and (3) assess the adequacy of the existing regulatory framework for
overseeing bank and thrift sales of mutual funds.
BACKGROUND
---------------------------------------------------------- Chapter 0:2
The mutual fund activities of banks and thrifts are subject to a
variety of securities and banking laws and regulations. The
Securities Act of 1933 requires that all mutual fund shares be
registered with the Securities and Exchange Commission (SEC). SEC
regulates and supervises the operations of all mutual funds under the
Investment Company Act of 1940, and regulates and supervises the
activities of mutual fund investment advisers under a companion law,
the Investment Advisers Act of 1940. The Securities Exchange Act of
1934 requires that a person who sells shares in mutual funds must be
registered as a broker-dealer with, and regulated by, SEC and be a
member of the industry's self-regulatory organization for
broker-dealers, the National Association of Securities Dealers
(NASD). Banks who sell shares in mutual funds are exempt from these
requirements. As a result, banks may choose to sell mutual funds
directly to the public without being subject to some aspects of the
federal securities laws. Similarly, banks that provide advisory
services are exempt from the definition of investment adviser under
the Investment Advisers Act of 1940. They may choose to provide
investment advice to mutual funds without being subject to SEC
regulation under the Advisers Act. Banks that operate their own
mutual funds are, however, required to register these funds with SEC,
and these funds are regulated by SEC.
The mutual fund activities of banks are also subject to the
regulation and supervision of bank regulators. Depending on the type
of bank and the way it has organized its mutual fund operations, this
is done by one of three agencies: the Office of the Comptroller of
the Currency (OCC) for national banks; the Federal Reserve Board for
state-chartered banks that are members of the Federal Reserve System
and for bank holding companies; or the Federal Deposit Insurance
Corporation (FDIC) for federally insured state-chartered banks that
are not members of the Federal Reserve System. The Office of Thrift
Supervision (OTS) regulates thrifts, which do not have the
broker-dealer exemption that banks have. Therefore, mutual fund
sales by thrifts can not be done directly by the institution, but
must be done through a registered broker-dealer.
To collect information on the extent to which banks and thrifts sell
mutual funds and the sales practices they follow, GAO sent a
questionnaire to a random statistical sample of 3,460 banks and
thrifts nationwide. GAO also visited a random sample of 89 banks and
thrifts in 12 metropolitan areas posing as customers interested in
purchasing mutual funds to test whether the sales practices being
followed provided adequate disclosures to bank customers of the risks
of investing in mutual funds. GAO obtained data on the size of the
mutual fund market and the level of bank and thrift participation in
it from a well-known source of data on the mutual funds industry
(Lipper Analytical Services, Inc.). Also, GAO interviewed banking
and securities regulators, officials of bank and thrift institutions,
and industry representatives; and reviewed relevant literature,
testimony, studies, laws, and regulations.
RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3
In the last few years, many banks and thrifts have entered the mutual
fund business to retain customers, increase fee income, and diversify
their operations. As of the end of 1993, about 114 banking
institutions had established their own (proprietary) families of
mutual funds with assets valued at over $219 billion.\1 In addition,
banks and thrifts have also become major sales outlets for other
companies' (nonproprietary) funds. GAO estimates that about 2,300,
or nearly 17 percent, of about 13,500 banks and thrifts in the United
States were offering mutual funds for sale to their customers at the
end of 1993.
The rapid growth of bank mutual fund sales over the last 5 years has
raised concerns that bank customers may not fully understand the
risks of investing in mutual funds compared to insured bank products.
In February 1994, the four banking regulators responded to these
concerns by issuing guidelines to banks and thrifts on the policies
and procedures that these institutions are to follow in selling
nondeposit investment products, such as mutual funds. During visits
to a sample of banks and thrifts in 12 metropolitan areas in March
and April 1994, GAO found that many institutions were not following
the guidelines. About one-third of the institutions visited made all
the risk disclosures called for by the guidelines, and about
one-third did not clearly distinguish their mutual fund sales area
from the deposit-taking area of the bank as required by the
guidelines. The banking regulators have stated that they are
including steps in their examinations to determine how well
institutions are following the guidelines.
The current regulatory framework allows banks to choose how to
structure their mutual fund sales and advisory activities and,
depending on that structure, how they are regulated. As a result,
banks can choose to sell mutual funds directly to their customers 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. Bank 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
different regulators. Similar concerns arise for banks that can
carry out mutual fund investment adviser activities either in the
bank or in a separate affiliate, although--in this case--most banks
carry out such activities in the bank 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 that buy mutual funds from banks.
--------------------
\1 As of the end of 1994, the total value of bank proprietary funds
was almost $306 billion. This amount includes the Dreyfus funds,
which were acquired by Mellon Bank in 1994. If the Dreyfus funds had
been included in the value of bank proprietary funds at the end of
1993, the comparable figure would have been about $294 billion.
<>PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4
BANKS AND THRIFTS HAVE
RAPIDLY EXPANDED THEIR
PARTICIPATION IN THE MUTUAL
FUND INDUSTRY
-------------------------------------------------------- Chapter 0:4.1
As of year-end 1993, 114 bank and thrift companies had established
their own proprietary mutual funds. The value of assets managed by
bank proprietary funds has grown from $46 billion at the end of 1988
to over $219 billion at the end of 1993. This represents a near
doubling of banks' share of the market, from 6 percent to 11 percent
in 5 years. During the same time frame, the total number of bank
proprietary funds rose from 317, or 13 percent of the industry, to
1,415, or 24 percent. Banks and thrifts have also become major
sellers of nonproprietary mutual funds. According to an industry
estimate, in 1993 banks and thrifts sold about $67.5 billion in
fixed-income (bond) and equity (stock) funds, of which slightly more
than half were sales of nonproprietary funds. Nearly 1,800
nonproprietary funds were available through banks and thrifts at the
end of 1993, a 62-percent increase from the 1,100 funds available at
the end of 1991. GAO estimates that about 2,300, or 17 percent, of
the approximately 13,500 banks and thrifts in the United States sold
either proprietary or nonproprietary funds at the end of 1993. The
main reasons given by banks and thrifts for offering mutual funds
were retention of customers and fee income.
INADEQUATE COMPLIANCE WITH
SALES GUIDELINES
---------------------------------------------------------- Chapter 0:5
GAO's visits to banks and thrifts in 12 metropolitan areas disclosed
that many institutions did not adequately inform potential investors
of the risks of investing in mutual funds. Disclosure of these
risks--that mutual funds are not insured by FDIC, are not deposits,
are not guaranteed by the institution, and could involve loss of
principal--is called for by the February 1994 interagency guidance
issued by the banking regulators. Compliance with the guidance is
important to ensure that bank customers fully understand the
differences between these investments and traditional bank products.
Salespersons at only an estimated 32 percent of the institutions in
the 12 areas mentioned all 4 risks during their sales presentations,
and salespersons at an estimated 19 percent of the institutions
failed to mention any of the four risks.
GAO also estimates that about 34 percent of the banks did not clearly
separate the mutual fund sales area from the deposit-taking area as
called for by the guidelines. However, most employees, such as
tellers, who were not designated salespersons were adhering to
restrictions on discussing mutual fund investments with customers.
GAO's review of mutual fund sales literature obtained during the
visits showed that it generally included the required disclosures,
but some documents did not present the disclosures clearly and
conspicuously as required by the guidance.
Although 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. Banking regulators told us that these procedures are
being used during regularly scheduled safety and soundness
examinations. They also said that they are requiring the banks and
thrifts to correct any deficiencies identified as a result of the
examinations.
EXPANDED ROLE OF BANKS IN
MUTUAL FUNDS RAISES REGULATORY
ISSUES
---------------------------------------------------------- Chapter 0:6
As banks have taken on a larger role in selling and managing mutual
funds, the securities regulators have become concerned that the laws
and regulations that govern banks' securities activities may need to
be changed. SEC testified that banks' exemptions from registering as
broker-dealers and investment advisers, which allow bank employees to
sell mutual funds and banks to provide investment advice to mutual
funds without SEC's oversight, should be eliminated because they
could result in inadequate protection for investors who purchase
mutual funds through banks and could impede SEC's ability to fully
enforce the securities laws. SEC's position is that all bank mutual
fund activities should be subject to oversight by the securities
regulators, who have a direct mandate for investor protection. By
contrast, banking regulators have argued that measures they have
taken to strengthen their oversight of mutual fund activities provide
adequate protection to individuals who choose to invest in mutual
funds through banks. In addition, they argue that removing the
exemptions would make it difficult to avoid regulatory overlap or to
ensure comprehensive and integrated risk management of supervised
institutions.
Eliminating banks' exemption from registration as broker-dealers, as
advocated by SEC, would affect relatively few banks. On the basis of
questionnaire responses, GAO estimated that only about 180, or 8
percent, of the 2,300 banks that sold mutual funds did so directly by
using their own employees. The other banks and all thrifts conduct
their sales through SEC-registered broker-dealers.\2 These sales
activities are already subject to the oversight of the securities
regulators and to the banking regulators as well--a situation that
can result in duplication of effort, inconsistency, and conflict
among regulators.
Because banks are exempt from SEC investment adviser regulation, SEC
does not have the authority to fully examine the records of bank
investment advisers to detect potential securities law violations and
conflicts of interest when it examines the related mutual fund. As
of September 1993, 78 of 114 banks (68 percent) that provided
investment advice to mutual funds did so directly, rather than
through an SEC-registered subsidiary or affiliate. For these 78
banks, SEC can examine investment adviser activity, but only as it
applies to the related mutual fund. Any other investment advisory
activity, such as advising bank trust funds, is overseen by bank
regulators. Bank regulators may also examine mutual fund advisory
activity, but not primarily to detect securities law violations.
Those cases that involve both SEC and bank regulators create the
potential for duplication of effort, inconsistency, and conflict
among regulators.
The potential for overlap and conflict among regulators would
continue to exist even if the banks' exemptions from the securities
laws were eliminated, because bank regulators would still have a
continuing responsibility to examine the potential effects of bank
mutual fund activities on bank safety and soundness. Regulators have
begun to take steps to better coordinate their efforts. For example,
in January 1995, NASD and the banking regulators agreed to coordinate
their examinations of broker-dealers selling mutual funds and other
nondeposit investment products on bank premises. However, bank
regulators and SEC have no similar agreement to coordinate their
oversight of investment advisers.
--------------------
\2 Because thrifts do not have the bank exemptions, all securities
sales personnel in thrifts must be registered representatives of a
broker-dealer.
RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:7
GAO recommends that SEC, the Federal Reserve, FDIC, OCC, and OTS work
together to develop and approve a common approach for conducting
examinations of banks' mutual fund activities to provide effective
investor protection, while ensuring bank safety and soundness.
MATTER FOR CONGRESSIONAL
CONSIDERATION
---------------------------------------------------------- Chapter 0:8
Since GAO's visits, the banking regulators said they have adopted
additional examination procedures to help ensure that banks provide
customers accurate and complete information about the risks of mutual
funds. Therefore, GAO is not recommending changes to the regulators'
oversight practices at this time. After the interagency guidelines
have been in place long enough to produce sufficient 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
---------------------------------------------------------- Chapter 0:9
GAO obtained written comments on a draft of this report from FDIC,
the Federal Reserve, OCC, OTS, NASD, and SEC. These comments are
presented and evaluated in chapters 3 and 4. All the organizations
supported GAO's recommendation, and several cited efforts to work
closely together that were underway or recently completed. OCC
commented that in its view this report overemphasizes the potential
for contradictory and inconsistent regulation, but SEC commented that
the report does not take into account sufficiently the regulatory
overlap created by duplicative examinations of broker-dealers.
Nevertheless, OCC and SEC each reported that in June 1995, they
reached an agreement on a framework for conducting joint examinations
of bank advisers to mutual funds. The agencies expect that the
agreement will result in greater coordination and more efficient
oversight of bank mutual fund activities. According to SEC,
preliminary meetings have been held with FDIC staff to discuss
entering into a similar agreement with that agency.
The Federal Reserve, OCC, and OTS commented that the lack of banking
institutions' compliance with the interagency guidelines may have
been attributable to the fact that GAO's on-site visits occurred
during the first 2 months after the guidelines were issued. The
Federal Reserve and OCC indicated that bank practices are now
generally in compliance with the guidelines. Although GAO's visits
were made shortly after the interagency guidance was released, most
of the principles contained in this guidance were quite similar to
those contained in guidance issued by the banking regulators during
1993. Consequently, GAO believes that the interagency guidelines
were a valid basis for evaluating mutual fund sales practices on the
premises of banks and thrifts at the time of its visits.
However, GAO also realizes 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. GAO believes 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, GAO added a matter for
congressional consideration suggesting that after an appropriate
implementation period, Congress may wish to consider requesting the
regulators to provide status reports on the results of their
examination efforts.
INTRODUCTION
============================================================ Chapter 1
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
---------------------------------------------------------- Chapter 1:1
A mutual fund, formally known as an open-end investment company,
pools the money of many investors.\1 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.
--------------------
\1 The term "open-end" refers to the fact that shareholders may
redeem shares issued by the fund on any day on which it is open for
business. Other types of investment companies include "closed-end"
funds, unit investment trusts, and separate accounts of insurance
companies issuing variable annuities. This report does not discuss
these other types of investment companies.
REGULATION OF BANK AND THRIFT
MUTUAL FUND ACTIVITIES
---------------------------------------------------------- Chapter 1:2
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
-------------------------------------------------------- Chapter 1:2.1
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.\2
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\3 and has primary
responsibility for regulating advertising and sales literature used
to solicit and sell mutual funds to investors.
--------------------
\2 Broker-dealers combine the functions of brokers and dealers.
Brokers are agents who handle public orders to buy and sell
securities. Dealers are principals who buy and sell stocks and bonds
for their own accounts and at their own risk.
\3 A registered representative is a person associated with a
broker-dealer who must acquire a background in the securities
business and pass relevant qualifications examinations administered
for the industry by NASD. The broker-dealer must be registered as
such with SEC and be a member of a self-regulatory organization, such
as NASD or a stock exchange.
BANKS ARE EXEMPT FROM
REQUIREMENTS TO REGISTER AS
BROKER-DEALERS AND
INVESTMENT ADVISERS
-------------------------------------------------------- Chapter 1:2.2
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.\4
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.
--------------------
\4 Thrifts are not exempt from the definitions of "broker" and
"dealer" in the Securities Exchange Act of 1934; therefore, all
securities sales personnel in thrifts must be registered
representatives of a broker-dealer. Thrifts similarly are not exempt
from the Investment Advisers Act of 1940, as are banks. Therefore,
thrifts that provide investment advice to mutual funds must do so
through an SEC-registered subsidiary.
FEDERAL BANKING LAWS AND
REGULATION
-------------------------------------------------------- Chapter 1:2.3
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.\5
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.\6
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).
--------------------
\5 The act allows banks and companies affiliated with a bank to
underwrite and deal in certain types of securities known as
bank-eligible securities. These include U.S. government securities,
general obligation bonds of states and municipalities, and securities
issued by specified government agencies or instrumentalities.
\6 Even 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). Under an Office of the Comptroller of the Currency
proposal, subsidiaries of national banks could also be given
permission to engage in securities activities that are not currently
allowed, such as underwriting securities. OCC plans to consider and
decide applications from banks on a case-by-case basis.
OBJECTIVES, SCOPE, AND
METHODOLOGY
---------------------------------------------------------- Chapter 1:3
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
============================================================ Chapter 2
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
---------------------------------------------------------- Chapter 2:1
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.\7 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.
Table 2.1
Increase in Net Assets Managed by Bank
Proprietary Funds Compared to
Nonproprietary Funds
(Dollars in billions)
Net Net
assets assets
as of 12/ as of 12/ Percentage
31/88 31/93 change
---------------------------------- ---------- ---------- ----------
Proprietary Funds\
Retail $23.7 $100.5 324%
Institutional 21.9 118.9 443
======================================================================
Subtotal 45.7 219.4 380
Percent of total 6 11
Nonproprietary Funds
Retail 668.5 1,591.6 138
Institutional 88.3 182.0 106
======================================================================
Subtotal 756.8 1,773.6 134
Percent of total 94 89
======================================================================
Total $802.4 $1,993.0
----------------------------------------------------------------------
Source: Lipper Analytical Services, Inc., and GAO analysis.
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.
Table 2.2
Total Net Assets by Fund Type
(Dollars in billions)
Number of Number of Number of
funds Assets funds Assets funds Assets
-------- ---------- ---------- ---------- ---------- ---------- ----------
Propriet
ary
Funds
Fixed 46 $1.7 305 $30.4 563% 1,688%
income
Equity 89 3.9 432 43.2 385 1,008
Money 103 29.6 461 133.8 348 352
market
Municipa 79 10.4 217 11.9 175 14
l debt
================================================================================
Subtotal 317 45.7 1,415 219.3 346 380
Percent 13% 6% 24% 11%
of
total
Nonpropr
ietary
Funds
Fixed 368 $164.9 946 $346.7 157% 110%
income
Equity 926 207.7 1,877 732.9 103 253
Money 255 240.7 692 448.1 171 86
market
Municipa 506 143.4 921 245.9 82 71
l debt
================================================================================
Subtotal 2,055 756.7 4,436 1,773.6 116 134
Percent 87% 94% 76% 89%
of
total
================================================================================
Total 2,372 $802.4 5,851 $1,992.9 147% 148%
--------------------------------------------------------------------------------
Note: Fixed-income funds include those funds that invest primarily
in fixed-income issues, such as money market instruments, bonds, and
preferred stocks; equity funds include funds that invest primarily in
common stocks, as opposed to bonds; money market funds are funds that
invest in financial instruments with average maturities of less than
90 days; and municipal debt funds are funds that invest primarily in
municipal debt issues.
Source: Lipper Analytical Services, Inc., and GAO analysis.
--------------------
\7 Retail funds are primarily offered to bank customers who are
investing on their own behalf. Institutional funds are primarily
offered to clients of bank trust departments, commercial banks,
thrifts, trust companies, or similar institutions.
BANKS AND THRIFTS HAVE BECOME
MAJOR RETAILERS OF
NONPROPRIETARY FUNDS
---------------------------------------------------------- Chapter 2:2
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
---------------------------------------------------------- Chapter 2:3
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
---------------------------------------------------------- Chapter 2:4
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
============================================================ Chapter 3
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.\8 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.
--------------------
\8 At the 95-percent level of confidence, the sampling error is plus
or minus 17 percent. The estimates in the text relating to risk
disclosures are based on weighted data obtained in our actual visits
to 89 institutions (banks and thrifts) in 12 metropolitan areas and
are generalized to the entire universe of 552 institutions in those
cities. See appendix I for a detailed discussion of our sampling and
testing methodology.
CONCERNS ABOUT BANK SALES OF
MUTUAL FUNDS
---------------------------------------------------------- Chapter 3:1
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
---------------------------------------------------------- Chapter 3:2
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
---------------------------------------------------------- Chapter 3:3
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.\9 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.\10
--------------------
\9 At the 95-percent level of confidence, the sampling error is plus
or minus 17 percent.
\10 SIPC is a nonprofit membership corporation, established by
Congress under the Securities Investor Protection Act of 1970, to
insure the securities and cash in customer accounts of member
brokerage firms against the financial failure of those firms. All
brokers and dealers, with some exceptions, that are registered with
the Securities and Exchange Commission are required to be members of
SIPC. SIPC insures individual brokerage accounts to an overall
maximum of $500,000 per customer, with a limit of $100,000 on cash.
SIPC provides coverage only if a brokerage firm goes bankrupt and
does not have sufficient assets to settle its customer accounts. It
does not protect investors against market risk or against losses due
to poor performance of investments. Unlike FDIC, SIPC is neither an
agency of the U.S. government nor a regulatory authority.
SALES PERSONNEL AT MANY
INSTITUTIONS DID NOT ORALLY
DISCLOSE THE RISKS
ASSOCIATED WITH INVESTING IN
MUTUAL FUNDS
-------------------------------------------------------- Chapter 3:3.1
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\11 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)\12 disclosed at least
three of the four risks. At the other end of the disclosure
spectrum, sales personnel at 19 percent\13 of the institutions did
not mention any of the four risks.
Figure 3.1: Risk Disclosures
of Mutual Fund by All Sales
Representatives.
(See figure in printed
edition.)
Note: Full disclosure is communicating all four risks of investing
in mutual funds.
Source: GAO analysis.
--------------------
\11 At the 95-percent level of confidence, the sampling error is plus
or minus 17 percent.
\12 At a 95-percent level of confidence, the sampling errors for this
estimate is 19 percent.
\13 At a 95-percent level of confidence, the sampling error for this
estimate is plus or minus 16 percent.
NEITHER BANK EMPLOYEES NOR
BROKER-DEALER EMPLOYEES
ADEQUATELY DISCLOSED RISKS
-------------------------------------------------------- Chapter 3:3.2
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.\14 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.
--------------------
\14 Of the total sales personnel, we identified 21 percent as bank
employees and 62 percent as broker-dealer employees. We could not
identify the employee affiliation for the remaining 17 percent.
About 18.5 percent of the group of salespersons that we could not
positively identify as either bank or broker-dealer employees made
all four disclosures. Similarly, 41 percent of this group failed to
make any disclosures. Because these figures are not included in this
analysis, the percentages differ from figure 3.1, which includes all
sales personnel.
DISCLOSURE OF BOND FUND
RISKS WAS INADEQUATE AT OVER
30 PERCENT OF THE
INSTITUTIONS
-------------------------------------------------------- Chapter 3:3.3
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.\15 About 3 percent of the institutions visited did not sell bond
funds.
Listed below are several representative examples found during our
visits of what we believed was adequate disclosure:
"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."
Following are examples of inadequate disclosure:
"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."
--------------------
\15 The sampling error is plus or minus 15 percent at the 95-percent
level of confidence.
THERE WERE NO MISLEADING
REFERENCES TO SIPC INSURANCE
-------------------------------------------------------- Chapter 3:3.4
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
---------------------------------------------------------- Chapter 3:4
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.
On the basis of our subjective evaluations, we estimate that about 34
percent of the institutions had little or no success in clearly
distinguishing the area in which mutual funds were sold from the
deposit-taking area.\16 In addition, 79 percent of the institutions
with on-site sales areas or desks did not have a sign indicating that
products sold there were not insured by FDIC.\17 Following are some
observations made during our visits:
"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)."
However, we also observed examples of clear separation:
"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."
--------------------
\16 At a 95-percent level of confidence, the sampling error is plus
or minus 11 percent.
\17 At a 95-percent level of confidence, the sampling error is plus
or minus 9 percent.
ROLES AND RESPONSIBILITIES OF
EMPLOYEES IN DEPOSIT-TAKING
AREAS GENERALLY COMPLIED WITH
REGULATORY GUIDANCE
---------------------------------------------------------- Chapter 3:5
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
---------------------------------------------------------- Chapter 3:6
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.\18 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.\19 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.
Following are examples of what we classified as confusing,
misleading, or inadequate disclosure:
"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 [of the brochure] 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.
--------------------
\18 Of the 89 banks visited, 21 sold proprietary funds. However, we
were not able to obtain proprietary fund literature at six of these
institutions.
\19 The interagency guidance does not define the term "conspicuous"
nor does it address the issue of where in the literature disclosures
should be made. In February 1994, OCC issued additional guidance to
its examiners that states: "Advertisements and brochures
should...feature these disclosures at least as large as the text
describing the bank's nondeposit investment products. The OCC
believes that these disclosures are conspicuous when they appear on
the cover of a brochure or on the first part of relevant written
text. A bank's disclosures could also be considered conspicuous if
it prints the required disclosures in a box or by displaying them in
bold type or with bullet points."
SOME INSTITUTIONS PROVIDED
INCENTIVES FOR SELLING
PROPRIETARY FUNDS
---------------------------------------------------------- Chapter 3:7
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.\20
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.
--------------------
\20 In commenting on a draft of this report, NASD stated that there
are sales practices, suitability, and investor protection issues that
are considered by NASD when proprietary products with a higher payout
are sold. NASD also stated that in the recent past there have been
major changes in the way broker-dealers compensate their sales
representatives, and that most major firms now provide the same
payout for both proprietary and outside products. We did not verify
the accuracy of this statement.
CUSTOMER ACCOUNT INFORMATION
WAS WIDELY USED TO MARKET
MUTUAL FUNDS
---------------------------------------------------------- Chapter 3:8
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
---------------------------------------------------------- Chapter 3:9
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.\21
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.
--------------------
\21 In commenting on a draft of this report, OCC cited its own
efforts to organize an interagency mystery shopping initiative. SEC
and the Federal Reserve declined to participate, and OCC did not
continue the effort. OCC said it is cooperating with FDIC on this
initiative.
CONCLUSIONS
--------------------------------------------------------- Chapter 3:10
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
--------------------------------------------------------- Chapter 3:11
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
--------------------------------------------------------- Chapter 3:12
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
============================================================ Chapter 4
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
---------------------------------------------------------- Chapter 4:1
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.\22 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.\23
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\24 . 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.
--------------------
\22 Underwriting is the public distribution of new issues of
securities; dealing refers to the business of holding oneself out to
the public as being willing to make a secondary market in a security
by offering to buy and sell securities as principal.
\23 In commenting on a draft of this report, NASD stated that while
the interagency guidelines are directly enforceable over banks and
bank employees, they are not directly enforceable over broker-dealers
and their associated persons. Conversely, rules currently being
proposed by NASD to govern the conduct of bank broker-dealers would
not apply to banks that sell mutual funds directly through their own
employees. (See pg 54. )
\24 In its comments on a draft of this report, NASD disagreed that
the interagency guidance exceeds SEC and NASD requirements.
MOST BANKS CHOOSE TO SELL FUNDS
THROUGH SEC-REGISTERED
BROKER-DEALERS
---------------------------------------------------------- Chapter 4:2
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.\25 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.\26
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.\27 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.
Table 4.1
How Mutual Funds Are Sold by Banks by
Asset Size and Method of Sale
Banks Directly by Through
(by bank Through dual affiliate
asset employees only employees or subsidiary Through third
size) (percent) (percent) (percent) party (percent)
-------- ---------------- ---------------- ---------------- ----------------
<$150M 7 43 17 46
$150- 12 50 29 27
$250M
$250M- 14 41 31 34
$1bn
$1bn and 4 39 68 27
up
================================================================================
Total 8 43 29 38
for all
banks
--------------------------------------------------------------------------------
Note: Totals do not equal 100 percent because, other than the
"directly by bank employees only" category, the methods of sale are
not mutually exclusive. For example, when a bank sells funds using
dual employees, the employee works for both the bank and the bank's
subsidiary broker-dealer. In such cases, the respondent might have
checked both the dual employee and subsidiary/affiliate boxes.
Source: GAO analysis of questionnaire data.
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.
--------------------
\25 Dual employees who perform brokerage activities must register as
representatives of the broker and pass the appropriate examinations.
Although dual employees are not employees of the broker in the normal
meaning of the term, as they are frequently not paid directly by the
broker, they are supervised by the broker and work on the broker's
behalf.
\26 Thrifts are not exempt from the definitions of "broker" and
"dealer" under the Securities Exchange Act of 1934. Therefore, sales
of mutual funds by thrifts must be made through a registered
broker-dealer.
\27 Another 5 percent of the banks reported that they sold mutual
funds using their own employees and sold funds either by using dual
employees or an affiliated or third-party brokerage. When we combine
these institutions with the 8 percent of banks that sold funds only
through their own employees, and after we weight for differences in
bank size, we estimate that about 12 percent of banks in the 12
metropolitan areas use their own employees to sell mutual funds.
REGULATORY FRAMEWORK FOR MUTUAL
FUND SALES IN BANKS CAN CAUSE
CONFLICT AND OVERLAP AMONG THE
REGULATORS
---------------------------------------------------------- Chapter 4:3
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.\28 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.\29 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.
--------------------
\28 In commenting on a draft of this report, FDIC stated that it is
not necessary that the interagency guidance and NASD rules be exactly
the same. However, the interagency guidance applies not only to
sales of investment products on bank premises done directly by
employees of the bank, but also to sales by employees of
third-parties, such as broker-dealers. Inconsistencies between the
guidance and NASD rules, which also apply to broker-dealer employees,
may lead to confusion and disparities in how bank mutual fund
customers are treated.
\29 SEC evaluates the quality of NASD oversight in enforcing member
compliance with federal securities laws in part by examining a sample
of broker-dealer firms that NASD previously examined to assess the
quality of NASD examinations. See Securities Industry:
Strengthening Sales Practice Oversight (GAO/GGD-91-52, April 25,
1991).
BOTH SEC AND BANKING REGULATORS
HAVE RESPONSIBILITY FOR BANK
FUND INVESTMENT ADVISERS
---------------------------------------------------------- Chapter 4:4
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
---------------------------------------------------------- Chapter 4:5
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
---------------------------------------------------------- Chapter 4:6
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\30 at the beginning of each new fiscal
year. Each region is responsible for preparing an annual inspection
plan that responds to these overall objectives.
--------------------
\30 This office was established effective May 1, 1995, to centralize
SEC's inspection program for investment companies, investment
advisers, broker-dealers, and self-regulatory organizations. The new
office is intended to enhance SEC's inspection efforts and promote a
more effective use of its examination resources. Prior to the
reorganization, the Division of Investment Management oversaw
investment company and investment adviser inspections, and the
Division of Market Regulation oversaw broker-dealer inspections.
FISCAL YEARS 1991 TO 1993
-------------------------------------------------------- Chapter 4:6.1
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
-------------------------------------------------------- Chapter 4:6.2
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
-------------------------------------------------------- Chapter 4:6.3
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
---------------------------------------------------------- Chapter 4:7
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
-------------------------------------------------------- Chapter 4:7.1
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.\31
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).\32 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.
--------------------
\31 In commenting on a draft of this report, OCC pointed out that
bank custodial activities are also reviewed and supervised by federal
bank regulators. OCC stated that because both the securities and
banking laws apply to bank custodial activities, these activities may
be subject to more intensive oversight than those of custodians that
are not banks.
\32 DTC is a central securities repository where stock and bond
certificates are exchanged. Most of these exchanges now take place
electronically, and few paper certificates actually change hands.
DTC is a member of the Federal Reserve System and is owned by most of
the brokerage houses on Wall Street and the New York Stock Exchange.
SOME BANK LOANS TO
AFFILIATED FUNDS ARE
PERMITTED
-------------------------------------------------------- Chapter 4:7.2
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
-------------------------------------------------------- Chapter 4:7.3
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.\33
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.
--------------------
\33 Banking law may also impose a fiduciary duty on the bank adviser
in certain cases, such as when a bank is investing trust assets.
MANAGEMENT INTERLOCKS
BETWEEN SOME BANKS AND
MUTUAL FUNDS COULD OCCUR
-------------------------------------------------------- Chapter 4:7.4
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
---------------------------------------------------------- Chapter 4:8
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.\34
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.
--------------------
\34 Under securities laws the sponsor must invest a minimum of
$100,000 seed capital in the mutual fund by purchasing $100,000 worth
of shares in the company. The sponsor often is the mutual fund's
investment adviser or underwriter. The distributor or underwriter
contracts with the mutual fund to market the fund's shares to the
public. The distributor may sell the fund directly, by mail, or
through its employees or may contract with other broker-dealers or
banks to sell the fund to retail customers. Retail brokers and banks
purchase and redeem mutual fund shares for their customers typically
by forwarding orders to the distributor. These retail brokers
typically are compensated by receiving a portion of the sales load
and/or 12b-1 marketing fee from the distributor. In some cases the
roles of sponsor and underwriter may be shared.
CONCLUSIONS
---------------------------------------------------------- Chapter 4:9
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
--------------------------------------------------------- Chapter 4:10
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
--------------------------------------------------------- Chapter 4:11
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.
OBJECTIVES, SCOPE, AND METHODOLOGY
SURVEY OF BANKS AND THRIFTS
=========================================================== Appendix I
Congress asked us to determine the extent of bank and thrift
involvement in the mutual fund industry and to assess mutual fund
sales practices followed by those banks and thrifts. To respond to
this request, we developed and mailed questionnaires to a random
sample of 2,610 banks and 850 thrifts. The results of that survey
are representative of the entire bank and thrift industry.
Our questionnaire gathered data on the number and type of funds
offered for sale and also on the dollar amount of sales in 1992 and
1993. We also asked questions about bank and thrift policies and
procedures for the sale of mutual funds. The fieldwork for the
survey was conducted from February through June of 1994.
SURVEY SAMPLE PLAN
------------------------------------------------------- Appendix I:0.1
We developed the survey frame (a listing, without duplicates or
omissions, of each element in the population of U.S. banks and
thrifts) from a file containing the June 1993 Call Report data. This
database listed 13,360 banks. After removing International Banking
Associations and New York Investment Companies (which we felt were
mostly commercial institutions unlikely to have retail mutual fund
sales programs), our frame contained 11,769 banks. To that we added
the 1,841 thrifts in another part of the June 1993 Call Report
database, for a total population, or universe, of 13,610 banks and
thrifts.
From this frame, we randomly sampled 3,460 banks and thrifts. We
divided the institutions in the frame into 20 strata (see table I.1),
and we distributed our sample across those strata so that survey
estimates from each stratum would be likely to have sampling errors
for the most important questions of no more than � 5% at the
95-percent level of confidence. Unless otherwise noted, the survey
statistics in this report have sampling errors within that range.
Because we surveyed only one of a large number of possible samples of
the bank and thrift population to develop the statistics used in this
report, each of the estimates made from this sample has a sampling
error, which is a measure of the precision with which the estimate
approximates the population value. The sampling error is the maximum
amount by which estimates derived from our sample could differ from
estimates from any other sample of the same size and design and is
stated at a certain confidence level, usually 95 percent. This means
that if all possible samples were selected, the interval defined by
their sampling errors would include the true population value 95
percent of the time. In addition to sampling error, all sample
surveys may also be subject to error from a number of other sources,
as described in the section on survey error and data quality below.
QUESTIONNAIRE DESIGN AND
ADMINISTRATION
------------------------------------------------------- Appendix I:0.2
We developed our questionnaire in consultation with experts in the
finance industry and at regulatory agencies, and we conducted six
pretests with banks that represented a range of sizes and regulators.
We made revisions to the questionnaire on the basis of the comments
we received. See appendix II for a complete copy of the
questionnaire.
We addressed each questionnaire to the office of the President or CEO
at each institution, using the mailing address information listed in
the Call Report file.
We mailed questionnaires to all 3,460 sampled banks and thrifts in
early February of 1994. To the 1,453 institutions not responding to
our survey by the end of March 1994, we sent a follow-up
questionnaire on April 1, 1994. We ended the fieldwork for this
survey on June 16, 1994, discarding any questionnaire returned after
that date.
SURVEY RESPONSE
------------------------------------------------------- Appendix I:0.3
By the end of the survey fieldwork period, we had received 2,519
completed questionnaires, accounting for 74 percent of the banks and
thrifts in our sample. Table I.1 displays, by strata, the
dispositions of the questionnaires we sent out. Because banks and
thrifts in different strata were sampled at different rates, and
because institutions responded at different rates across the strata,
the survey estimates made in this report were weighted, or
statistically adjusted, so that the answers given by institutions in
different strata were represented in proportion to their actual
numbers in the entire population.
There was a tendency for the smaller institutions (in terms of asset
size) to respond at higher rates than larger institutions. Also,
those responding early in the survey period tended to be the banks
and thrifts not selling mutual funds (such questionnaires required
little work on the part of our respondents, making it easier to fill
out the questionnaire.) While we have no reason to believe that these
patterns of response had any impact on the accuracy of the survey
estimates, we conducted no follow-up contacts with any of the
nonrespondents to determine if their answers were significantly
different from those who did respond.
Table I.1
Survey Dispositions of Sampled Banks and
Thrifts
Returned
undeliverabl Returned Returned
Ineligible\ e unusable usable
Strata (institution type and asset Original Initial b Adjusted by Post questionnaire\ questionnair Response
size) population\a sample from sample sample\c Office\d e e rate\f
-------------------------------------- ------------------ ---------- ----------- ---------- ------------ -------------- ------------ --------
FRS national banks up to $150 million 2,514 350 2 348 12 2 265 76%
$150-$250 million 348 174 4 170 6 0 122 72
$250 MM-$1 billion 388 194 5 189 10 0 98 52
$1 billion and up 202 150 4 146 4 2 75 51
FRS state banks up to $150 million 749 270 1 269 8 1 207 77
$150-$250 million 76 76 2 74 4 0 47 64
$250 MM-$1 billion 84 84 0 84 3 0 55 65
$1 billion and up 63 63 1 62 5 0 33 53
FDIC banks up to $150 million 5,900 375 4 371 9 2 284 77
$150-$250 million 428 214 2 212 7 0 143 67
$250 MM-$1 billion 350 175 4 171 13 1 120 70
$1 billion and up 108 108 2 106 10 1 59 56
Mutual savings banks up to $150 272 150 4 146 1 0 123 84
million
$150-$250 million 100 80 0 80 0 0 69 86
$250 MM-$1 billion 140 100 1 99 1 0 85 86
$1 billion and up 47 47 0 47 1 0 34 72
Thrifts up to $50 million 486 243 1 242 1 0 208 86
$50-$100 million 440 220 3 217 1 0 191 88
$100 MM-$1 billion 778 250 3 247 2 2 196 79
$1 billion and up 137 137 0 137 2 0 105 77
=====================================================================================================================================================
Totals 13,610 3,460 43 3,417 100 11 2,519 74
-----------------------------------------------------------------------------------------------------------------------------------------------------
\a All banks and thrifts identified in the June 1993 Call Report,
except International Bank Associations and New York Investment
Companies.
\b Sampled elements outside the survey population due to no existing
address, merger, receivership, or other cessation of operations as a
depository institution.
\c Number in original sample minus number ineligible.
\d Sampled elements in the survey population, but questionnaire
returned undeliverable due to insufficient address or unknown address
and forwarding order expiration.
\e Blank, incomplete, or refused questionnaire returned, or returned
after cutoff date.
\f Response rate calculated as the number of banks and thrifts
completing usable questionnaires divided by the number of eligible
banks and thrifts in the adjusted sample.
SURVEY ERROR AND DATA
QUALITY
------------------------------------------------------- Appendix I:0.4
In addition to the presence of sampling errors, as discussed above,
the practical difficulties of conducting any survey may introduce
other types of errors, commonly referred to as nonsampling errors.
For example, differences in how a particular question is interpreted,
in the sources of information that are available to respondents, or
in the types of people who do not respond can introduce unwanted
variability into the survey results.
We included steps in both the data collection and data analysis
stages for the purpose of minimizing such nonsampling errors. We
selected our sample from the most complete and up-to-date listing of
banks and thrifts available, and we attempted to increase the
response rate by conducting a follow-up mailing accompanied by cover
letters stressing the importance of the survey. To minimize errors
in measurement, we pretested the questionnaire thoroughly and
obtained reviews from industry experts and agency officials.
To ensure data processing integrity, all data were double-keyed and
verified during data entry. Computer analyses were performed to
identify inconsistencies or other indication of errors, and all
computer analyses were checked by a second independent analyst.
Finally, we performed limited validation of a number of returned
questionnaires through contacts with respondents or review of other
agency records.
BANK SHOPPER SURVEY/BANK
SHOPPER VISITS/SHOPPER AUDIT
--------------------------------------------------------- Appendix I:1
To help determine what sales and disclosure practices are being
followed by banks selling mutual funds, we visited branches of 89
randomly selected banks and thrift sellers of mutual funds in 12
metropolitan areas. GAO evaluators posing as retail customers
shopping for mutual fund investment opportunities received sales
presentations and assessed the physical characteristics of the sales
area, the roles played by bank and broker personnel they made contact
with, the risk disclosures made by sales personnel, and the written
information provided as part of the sales presentations.
The results of the visits are statistically generalizable to the
larger population of institutions offering mutual funds for sale
across the 12 metropolitan areas. While the results can be projected
to that banking community in the aggregate, they cannot be used to
definitively assess any one bank's practices, due to the potential
variability in a bank's practices, because we met with only one
salesperson, at one branch, on one day. The fieldwork was conducted
between March 25, 1994, and April 13, 1994.
VISIT SAMPLE PLAN
------------------------------------------------------- Appendix I:1.1
Banks and thrifts were selected in 12 metropolitan areas only where
GAO had field offices (see table I.2). Only banks and thrifts in the
Metropolitan Statistical Area\35 surrounding these cities were
considered.
Banks and thrifts were selected primarily from the sample frame of
the mail questionnaire survey (see table I.3). A list was developed
of those banks that had returned questionnaires and identified
themselves as mutual fund sellers and of those not yet returning the
questionnaire, some of which could be mutual fund sellers. Banks and
thrifts responding that they did not sell mutual funds were
automatically excluded from the sample. In addition, a number of
FDIC and FRS national banks with assets under $150 million were
selected into the sample directly from the Call Report database even
though they were not included in the mail questionnaire survey frame,
because this group was initially underrepresented in the shopper's
visit sample.
All banks and thrifts in the sample were screened through telephone
calls to their main branch, headquarters office, or customer services
department to discover or confirm that they sold mutual funds,
without the identity of the caller as a GAO evaluator being
disclosed. Only those banks and thrifts selling mutual funds
remained candidates for a visit. During this call, we also
determined the branch or office location that was to be visited.
In choosing which location to visit within a bank or thrift, we
attempted to locate the main branch, headquarters office, "model"
branch, or largest location that sold mutual funds. If no such
single location existed, or if mutual funds were sold only by
appointment with a sales representative at any location, we attempted
to visit the largest location that was most convenient for the
shopper team to visit. We visited only one location for each sampled
bank.
Table I.2
Geographical Distribution of Shopper
Visit Sample
Metropolitan statistical area Visits completed
---------------------------------------------------- ----------------
Atlanta 4
Boston 12
Chicago 13
Cincinnati 3
Dallas 6
Denver 6
Los Angeles 10
New York 16
Philadelphia 5
St. Louis 3
San Francisco 7
Seattle 4
======================================================================
Total 89
----------------------------------------------------------------------
Table I.3
Source and Disposition of Shopper Visit
Sample
Unscreene
d
Populatio (sellers
n and Screened Complet
in 12 nonseller (sellers e
Category cities s) only) visits
----------------------------- --------- --------- -------- -------
Banks in mail survey frame
Found to NOT sell mutual 376 0 0 0
funds
Found to sell mutual funds 94 44 44 32
No response to questionnaire 410 248 103 55
Banks outside mail survey
frame
Small Banks 509 37 3 2
All Others 839 0 0 0
======================================================================
Total 2,228 329 150 89
----------------------------------------------------------------------
--------------------
\35 A Metropolitan Statistical Area is a relatively free-standing
metropolitan area centered around a large population nucleus, and it
includes adjacent communities that have a high degree of economic and
social integration with that nucleus. It is a standard geographical
designation used by the Bureau of the Census.
DESIGN AND IMPLEMENTATION OF
VISIT METHODS
------------------------------------------------------- Appendix I:1.2
GAO evaluators, posing as prospective mutual fund investors, were
trained to follow a scripted visit to each sampled bank or thrift.
Most of the visits were conducted by pairs of GAO testers.
Throughout their contacts with bank and thrift personnel, they
presented themselves as investors with $5,000 to $10,000 in expiring
Certificate of Deposit funds, trying to obtain information on mutual
funds in which to invest. Without revealing their identities as GAO
evaluators, they were to observe the layout of the sales on that
occasion and to note the statements made by the sales representative
and other personnel they contacted in the bank or thrift. See
appendix III for a copy of the questionnaire filled out by the
shopper teams after each visit.
The general plan of the visits consisted of four parts: an initial
observation of the lobby and platform area of the branch office;
direct contact with personnel at the teller window to inquire about
mutual fund investments; the sales presentation; and collection of
brochures and other written documents for proprietary mutual funds,
if any.
In the first part of the visit, shopper teams assessed the degree of
separation between the mutual funds sales area and the platform areas
where more traditional bank products were sold. In addition to
physical separation, the shopper teams recorded their observations of
how the bank or thrift designated the mutual fund sales area, perhaps
through signs or banners. At the teller window, the shoppers were to
state: "I have a CD maturing soon. What kinds of mutual funds do
you sell here? Can you recommend one?" The teller's response and
subsequent actions were also recorded on the questionnaire. Upon
contacting the sales representative in the third stage of the visit,
the evaluators repeated their query and offered only the limited
biographical information about their financial situations described
above. After the sales presentation, shoppers asked for proprietary
mutual fund brochures to review later.
After leaving the bank or thrift, both testers (for visits with two
testers assigned) filled out the questionnaire on their own and then
resolved any disagreements in their questionnaires while completing a
third questionnaire together with the final data.
ANALYSIS AND STATISTICAL
SIGNIFICANCE
------------------------------------------------------- Appendix I:1.3
Because of the limited scope of our investigation into the sales
practices of each of the 89 banking institutions, we cannot make
definitive statements about each institution's operations. However,
analyzing the shoppers' data in the aggregate, we can make overall
assessments of the approximately 552 banks that we project sell
mutual funds in the 12 metropolitan areas that we studied.
The results of the shoppers' visits are weighted to represent the
entire population of mutual fund-selling banks. The precision of the
data is subject to sampling and nonsampling error, as with the mail
questionnaire survey (see page 72). The sampling errors associated
with the shoppers' visits are disclosed in various footnotes in
chapter 3 of this report. To reduce the presence of such errors, we
pilot-tested the data collection protocol in 27 visits before
finalizing it. Also, by having pairs of testers fill out the
questionnaires separately before completing a consensus version for
their final answers, we were able to gauge the reliability of the
measures we were using.
(See figure in printed edition.)Appendix II
QUESTIONNAIRE
=========================================================== Appendix I
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(See figure in printed edition.)Appendix III
DATA COLLECTION INSTRUMENTS FOR
SHOPPERS' VISITS
=========================================================== Appendix I
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(See figure in printed edition.)Appendix IV
COMMENTS FROM THE FEDERAL DEPOSIT
INSURANCE CORPORATION
=========================================================== Appendix I
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(See figure in printed edition.)Appendix V
COMMENTS FROM THE FEDERAL RESERVE
SYSTEM
=========================================================== Appendix I
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(See figure in printed edition.)Appendix VI
COMMENTS FROM THE NATIONAL
ASSOCIATION OF SECURITIES DEALERS
=========================================================== Appendix I
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and 54.
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The following are GAO's comments on NASD's letter dated June 16,
1995.
GAO COMMENTS
--------------------------------------------------------- Appendix I:2
1. Revised to reflect NASD's concerns. Now on page 17.
2. While we do not have a position on the individual rules
themselves, we applaud NASD's effort to regulate the conduct of
broker-dealers who conduct business on the premises of a financial
institution. Additional text has been added to the report to reflect
the reason why NASD is proposing additional rules governing the
conduct of broker-dealers operating on the premises of financial
institutions.
3. We have modified this sentence so as not to draw a comparison
between bank employees and broker-dealer employees.
4. We have deleted this example.
5. We believe that the footnote as written provides a more complete
description of what a dual employee is than does the revision
suggested by NASD. This definition was obtained from the
publication, Mutual Fund Activities of Banks, by Melanie L. Fein,
Victoria E. Schoenfeld, and David F. Freeman, Jr. (published by
Prentice Hall Law and Business, 1993).
6. NASD's comments on press inaccuracies and the NASD proposed rules
do not specifically address the points we discuss in the report. The
284 comment letters NASD received on its proposed rules indicate that
others beside the press have concerns about the rules.
7. We have changed the text where appropriate and have deleted this
last sentence from the final report.
8. This is an area of apparent disagreement between OCC and NASD
that might be resolved by working more closely together as we
recommend. For effective regulation of financial institutions whose
activities are becoming more alike, regulators will have to work well
together under any regulatory scheme with more than one regulator.
(See figure in printed edition.)Appendix VII
COMMENTS FROM THE COMPTROLLER OF
THE CURRENCY
=========================================================== Appendix I
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The following are GAO's comments on OCC's letter dated July 5, 1995.
GAO COMMENTS
--------------------------------------------------------- Appendix I:3
1. Although the shoppers were not to provide detailed financial
information and were not able to follow through by making an actual
purchase of a fund, the discussions with the sales representatives
were of such length and substance that the sales representative
should have orally disclosed the risks of investing in mutual funds,
as recommended by the interagency guidance. While we agree that had
the transaction actually been completed the disclosure rate may have
been better, the interagency guidance requires that these disclosures
be made orally during any sales presentation.
2. The report does not intend to suggest that the interagency
guidance is the only regulatory guidance that applies to banks'
mutual fund activities. However, this report focused on the
interaction between the bank or its broker-dealer and the customer at
the time of a sale. Recordkeeping, confirmation, and fiduciary
requirements were not within the scope of our review, and we did not
attempt to compare these requirements to those in the securities
laws. With respect to the proposed rulemaking process, we have added
a statement to the report on page 18 that OCC plans to consider and
decide applications on a case-by-case basis.
3. The OCC examination procedures state that examiners are to
determine whether policies governing the permissible uses of bank
customer information address the steps to be taken to reduce possible
confusion among depositors who are being solicited to purchase
nondeposit investment products. However, there are no other
examination steps, and it is up to the bank to determine the
permissible uses of customer account information. Therefore, we do
not agree that specific guidance has been provided to banks either
directly or through application of examination steps. In commenting
on this point, FDIC noted that there is no reliable definition of
what customer information is confidential and what is public. FDIC
stated that while banks must comply with laws concerning the
confidentiality of customer information, it did not want to prohibit
the use of customer information that is otherwise available publicly
or among a bank's affiliates. (See app. VII.)
4. The NASD proposal states: "Employees of the financial
institution who are not registered with the NASD member may not
engage in any broker-dealer services on behalf of the member, nor
receive any compensation from the member, cash or non-cash, in
connection with but not limited to the referral of customers of the
financial institution to the member, or locating or introducing
customers of the financial institution to the member." In June 1995,
a NASD official told us that NASD does not have the power to affect a
contractual relationship between a bank and a broker-dealer.
Therefore, a bank could use money that it would earn as a result of
this relationship the way it wants to. However, he said a direct
transfer of fees from the broker to the bank, then to the employee,
would be a violation of the proposed NASD rule. Therefore, we have
not modified the report.
5. We were requested to study particular issues that arise when
banking institutions advise mutual funds. Accordingly, the scope of
our work did not include reviewing the activities of nonbank
securities firms that have proprietary mutual funds. We are,
therefore, unable to affirm the accuracy of OCC's statement that
similar conflicts could arise for diversified securities firms that
may be advising and brokering proprietary funds while also engaged in
a variety of other relationships with an issuer whose securities are
owned by the funds. With respect to the adviser's relationship with
the fund, the report states on page 67 that the adviser has a
fiduciary obligation to the fund under the Investment Company Act of
1940. In addition, we note that banking laws may impose additional
fiduciary obligation in certain cases.
(See figure in printed edition.)Appendix VIII
COMMENTS FROM THE OFFICE OF THRIFT
SUPERVISION
=========================================================== Appendix I
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on the Office of Thrift
Supervision's letter dated June 23, 1995.
GAO COMMENTS
--------------------------------------------------------- Appendix I:4
1. We have clarified the terminology where appropriate.
2. The sentence in the report was intended to draw attention to the
fact that each of the regulators separately issued sales guidance in
1993. To avoid confusion, the sentence has been deleted from the
report.
3. This reference has been deleted from the text.
(See figure in printed edition.)Appendix IX
COMMENTS FROM THE SECURITIES AND
EXCHANGE COMMISSION
=========================================================== Appendix I
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The following are GAO's comments on the Securities and Exchange
Commission's letter dated June 12, 1995.
GAO COMMENTS
--------------------------------------------------------- Appendix I:5
1. This statement has been deleted from the report.
2. We have revised the report to reflect that SEC believes it will
be able to inspect investment companies and their advisers with
reasonable frequency if its fiscal year 1996 request for 50
additional positions is approved. (See pp. 61 and 63.)
3. Our work was not intended to address the functional regulation
issue.
MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix X
GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C.
--------------------------------------------------------- Appendix X:1
Michael A. Burnett, Assistant Director, Financial Institutions
and Markets Issues
Frank J. Philippi, Evaluator-in-Charge
Gloria Cano, Evaluator
Maia Greco, Bank Policies Analyst
Gillian M. Martin, Evaluator
Wesley M. Phillips, Evaluator
Barry L. Reed, Senior Social Science Analyst
Carl M. Ramirez, Senior Social Science Analyst
NEW YORK REGIONAL OFFICE
--------------------------------------------------------- Appendix X:2
Dorothy T. LaValle, Senior Evaluator
Jeffrey Shapiro, Evaluator
Bryon S. Gordon, Evaluator
SAN FRANCISCO REGIONAL OFFICE
--------------------------------------------------------- Appendix X:3
Susan J. Kramer, Evaluator
OFFICE OF THE GENERAL COUNSEL,
WASHINGTON, D.C.
--------------------------------------------------------- Appendix X:4
Lorna J. MacLeod, Attorney